In recent months, an increasing number of Wall Street analysts have warned investors against investing in Netflix (NASDAQ: NFLX). A sharp slowdown in subscriber growth during Q2 appeared to support this bearish viewpoint.
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However, Netflix proved the doubters wrong yet again on Monday afternoon, delivering a blowout Q3 earnings report. The company's strong results and optimistic Q4 guidance suggest that Netflix remains on track for rapid revenue and earnings growth over the next few years.
Netflix returns to form
Netflix hit the nail on the head with its Q3 revenue forecast. However, for every other key metric, Netflix outperformed its July guidance by a comfortable margin.
Data source: Netflix Q2 2016 and Q3 2016 subscriber letters. Chart by author.
Domestic subscriber growth remained slow in Q3, due to a combination of seasonality, market saturation, and the impact of "un-grandfathering" subscribers who had been paying lower prices for their Netflix subscriptions until recently.
However, the flip side of un-grandfathering was a double-digit increase in average revenue per user (ARPU). As a result, Netflix's domestic contribution profit surged 15% sequentially and 38% year over year to reach $475 million. ARPU will continue to rise quickly for another quarter or two.
Meanwhile, international subscriber growth picked up again last quarter after a blip in Q2. Netflix added 3.2 million international subscribers in Q3, blowing past its forecast by 60%. That was also well ahead of the 2.74 million net additions it achieved outside the U.S. in Q3 2015.
Finally, Netflix's international contribution loss was flat sequentially at $69 million: better than the $95 million loss management had forecast back in July. The discrepancy was driven primarily by the timing of content spending.
Solid outlook for Q4
The fourth quarter is typically a seasonally strong period for Netflix, and the company expects 2016 to be no different. Management projects that the company will add a respectable 1.45 million domestic subscribers and 3.75 million international subscribers in the coming quarter.
On the profitability side, Netflix will continue to benefit from rising ARPU in the U.S., sending its domestic contribution profit higher. Its international contribution profit should remain roughly stable as strong revenue and subscriber growth balances out Netflix's heavy investments in content and localization. The net result will be continued growth in operating income and earnings per share.
Netflix's revenue is rising fast enough to offset its big content investments. Image source: The Motley Fool.
Some (minor) causes for concern
There wasn't much for investors to worry about in Netflix's Q3 earnings report. However, two somewhat concerning trends continued.
First, Netflix's other operating expenses -- essentially its administrative and IT overhead costs -- continued to surge, rising 31% year over year. Rising overhead costs will crimp Netflix's margin expansion.
Second, free cash flow moved even deeper into the red. Netflix burned about $250 million a quarter over the previous year, but free cash flow slumped to -$506 million in Q3 due to front-loaded spending on original content. Netflix expects a similar result in Q4. Thus, Netflix is only earning a profit on paper; from a cash perspective it is losing more money than ever.
Neither of these issues is serious enough to warrant avoiding Netflix stock altogether. Operating expense growth should moderate after Netflix completes more of its localization work. And free cash flow will improve dramatically as the company's new international markets mature.
Thus, there was a lot to like in Netflix's Q3 report -- and no major red flags. Not surprisingly, investors have piled back into Netflix stock in after-hours trading. As of 5:15 p.m. ET, the stock had jumped 20%.
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Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.