Netflix (NFLX) Stock: Advertising Move Not Out Of Desperation

Netflix (NASDAQ:NFLX) has had a rough year after reporting that it lost almost a million subscribers in Q2, the first time it lost subscribers in more than a decade. The stock was down more than 49% in April 2022 alone. The only other time the stock did that was in 2011, when the Qwikster debacle almost led to the company’s demise.

In response, Netflix announced that they were going into advertising in a bid to reaccelerate their growth. A business they previously said on many occasions they wouldn’t pursue. Media coverage seemed to gloat about Netflix succumbing to ads, with this headline for example saying the company bowed to advertising reality. The reality Netflix was facing according to media coverage was that it was a new world in streaming, one where Netflix couldn’t raise prices without losing subscribers to competitors. As a result, adding an ad-supported tier was an important component of fighting customer churn.

But what if that wasn’t the reality at all? What if the move into advertising was actually a calculated one?

Why Netflix Never Sold Ads

Netflix had a very compelling reason not to sell ads; it simply couldn’t compete. Here is Reed Hastings in Q4 of 2019:

Google and Facebook and Amazon are tremendously powerful at online advertising because they’re integrating so much data from so many sources. And there’s a business cost to that, but it makes the advertising more targeted and effective. And so I think those 3 are going to get most of the online advertising business. And then to grow $5 billion or $10 billion advertising business, you have to rip that away from other advertisers. In this case, say — or other providers, Amazon, Google and Facebook, which is quite challenging. So don’t think of that as — in the long term, there’s not easy money there.

So Netflix was competitively-disadvantaged in the ads market. It simply couldn’t compete with the likes of Alphabet Inc. (GOOG) (GOOGL), Meta Platforms, Inc. (META), or Amazon.com, Inc. (AMZN). Advertising was a data arms race, and Netflix had a knife while those three stormed in with their tanks. As a result, Netflix management thought the best move to do is position the company as the premium brand that was ad-free.

That situation has however changed considerably since 2019.

Apple Can Help Netflix Build A Massive Ads Business

Apple’s introduction of ATT (App Tracking Transparency) has taken a lot of the armored-piercing ammunition out of those tanks. I discussed the impact of the introduction of ATT here and here. This article builds on the ideas mentioned in those two. The short version is Apple’s move to limit tracking of its customers is causing a repositioning in digital advertising. The crucial point about ATT is that many digital ad companies have lost the ability to know their users, and as a result lost the ability to personalize their ads, which in turn made their ads less valuable to advertisers. Netflix could be one of the winners from that change. Here is The Trade Desk (TTD) CEO Jeff Green explaining why:

CTV is now reaching the kind of scale where it is forcing change across the advertising ecosystem. CTV leaders will help forge the future of identity…It’s where advertisers now have globally scaled premium content alternatives to user generated content. And because CTV has a massive authenticated logged in user base is where advertisers and publishers will innovate new ways to create personalized experiences while also improving consumer privacy and better explaining the quid pro quo of the Internet.

So Netflix can use viewership data to segment its customers. It is possible to segment customers based on age or gender from viewing habits. It will not be perfect, but thanks to ATT it will be close enough to what the big 3 ad companies can do. In addition to how companies like TTD can do to help in that regard. Then there is also the potential for brand advertising, which monetizes the attention paid to the biggest hits on the platform.

So while it’s possible that Netflix management succumbed to the pressure of losing subscribers, one should be cognizant of the possibility that business conditions in the ad market coincided with the subscriber losses.

Netflix’s Ad Business Can Be A Big Chunk Of Revenue

Netflix’s ad business won’t be the next Google. But it is large enough, along with the changes in the ad landscape, to compete with Meta, TikTok and other smaller digital advertisers, who in turn are taking share from TV advertising. It is also one of the few online media properties that has 800 million to a billion users. The company would generate significant revenue depending on how much of this user base it chooses to nudge towards the ad-supported tier.

So how big can advertising be? It has been reported that Netflix will charge a $60-80 CPM. The same report said they hope to get 500k subscribers by year-end. If those subs viewed just one ad a day, the company would generate 11 million in ad-revenue a year.

Now, the company most probably has its own internal subscribers and revenue targets. With 1 in 3 households watching Netflix via a shared password, let’s assume the company will aim to convert half of those households to an ad-tier in three years’ time. And let’s assume that the ad-tier will be a very light 1 ad a day (compared to the customary 3 minutes of ads an hour). That would be (12 million users*$60 ad cost)/1000 view * 365 days = $262 million in ad-revenue. With $8 in monthly subscription, the total is $1.4 billion in revenue, with significant potential for ad load growth.

But what would the company need to do to generate $10 billion in ads mentioned by Hastings in the earlier quote? They would need to sign up 35 million to their ad tier with an ad-load of 12 ad-views a day per user (ads are actually placed per hour, so the 12 ad-views is close to 2 minutes per hour of content, with customers watching a couple of hours a day on average).

Now, adding to the complexity is that as the ad-tier subscriptions grow, the ad business will compound in growth. Because each subscription will normally carry multiple users. So Netflix might not need anywhere near 35 million subscriptions to hit $10 billion. The number could be closer to 14 million if each subscription had 3 users who each watch 12 ads a day. Yes, the $8 a month would be divided by those 3 users, but the ad revenue more than makes up for that loss.

The point here isn’t to predict how much ad business Netflix will bring in, it is too soon for that. Rather, it is to help investors be prepared with a general idea, so that they can quickly form an opinion on Netflix’s valuation as management shares its views on the business.