What No One’s Seeing About Advertising Push At Netflix And Roku (ROKU) (NFLX)

As Roku (NASDAQ:ROKU) continues to struggle to claw back more of its 2022 losses, the main thesis put forward by the bulls continues to shift away from its hardware division and now focuses almost exclusively on its potential to become an advertising powerhouse – which is offered as justification for the company taking its Player side further into negative margin territory, to acquire more accounts.

This advertising argument may seem to have been enhanced by the fact that Netflix (NASDAQ:NFLX) is now embracing advertising as well, after almost two decades of insisting on a purely ad-free platform. Is it time for me to reconsider my previous skepticism about advertising potential for non-affiliated (with the Big Three) streaming services?

Prior Research and Positions

Back at the end of July, I wrote up a pair of bullish articles on two of the stocks which are most closely associated with the streaming revolution, Netflix and Roku. The increasing pessimism about streaming had driven both down to almost insanely low valuations, and I thought they had fallen far enough to become good value plays.

My Netflix buy has worked out very well, my Roku buy… much less so. Altogether, between the two I have still outperformed the market since August 1^st, but it is clear that I could have stretched my money for a lot more shares if I’d held off my Roku purchase for a while longer. In my Roku article I mentioned that I had recommended against buying at $42 four years ago and that part of me was tempted to wait until it hit that level again before buying in.

Should have listened to that thought. The bottom was right in the low $40s. But what should I do now with these pair of investments, which I bought into under very similar theses as part of a broader industry perspective?

My Advertising Thesis

My take on Roku advertising has always been a reflection of that perspective: while Roku will certainly generate advertising revenue, it is unlikely to generate advertising profit, because it cannot hope to match the advertising targeting capabilities of the more powerful platforms like Alphabet’s (GOOG) (GOOGL) YouTube, Meta (META) and Amazon (AMZN) can generate. Its advertising revenue will more or less equal the costs of the content it inserts the ads into. That’s been more or less my take on all non-Big Three advertising; eventually its profits will be competed away to nothing.

My views on this always seemed to align with the views of Netflix’s now former CEO Reed Hastings, who elevated himself to the chairman position and passed his half of the co-CEO duties to former Chief Operating Officer Greg Peters. During his 25-year run as Netflix CEO and co-Founder, Hastings consistently declined to offer an advertising supported tier of Netflix’s streaming service.

His reasoning, as he explained repeatedly, including on the Q4 2019 earnings call came down to much the same thing as I’ve been saying about Roku:

Google and Facebook and Amazon are tremendously powerful at online advertising. Because they’re integrating so much data from so many sources. There’s a business cost to that but they makes the advertising more targeted and effective. And so I think those three 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…Amazon, Google and Facebook which is quite challenging…[we] don’t think of that as in a long term, there’s not easy money there…we think with our model that we’ll actually get to a larger revenue, a larger profits, larger market cap because we don’t have the exposure to something that were strategically disadvantaged at which is online advertising against those big three, which over the next 10-years are just going to integrate incredible amounts of data about everybody…if you wanted to succeed in online advertising, you can’t just have a little data. To keep up with those giants, you’ve got to spend very heavily on that and track locations and all kinds of other things that we’re not interested in doing. We want to be the safe respite where you can explore; you can get stimulated, have fun, enjoy, relax and have none of the controversy around exploiting users with advertising.

–CEO Reed Hastings Q4 2019 earnings call

An Earnings [Call] Shocker

And yet, whether because of longstanding internal discussions or just a panicked reaction to the subscriber slump of first-half 2022, even the last bastion of ad-free content eventually fell. That came as a major surprise to me, but I might have been just about the only one. MoffettNathanson has been saying for years that Netflix needed an ad tier, Jason Kilar said it on his way out the door last year and you can add pretty much everyone in the industry outside of Netflix to that list at one time or another.

In my own (meager) defense, it seemed to come as a bit of a surprise to Netflix itself as well. On March 8^th, CFO Spencer Neumann said that advertising was something that was “not in our plans right now.” Six weeks later, on the Q1 earnings call Hastings announced that Netflix would launch an advertising tier, after all. Quite a rapid turnaround.

Was Neumann just playing coy? Maybe. Yet, when he made the March statement, Netflix had only just suspended service in Russia two days before, a move which we now know cost Netflix 700,000 subscribers and was the difference between reporting a net subscriber gain and the net subscriber loss they ended reporting in Q1, stunning the market.

Given how narrow the Q1 subscriber loss was, Hastings may honestly not have known on March 8^th that they would in fact be reporting a net loss – a report which sent the stock plunging down by 35% in a single day and 52% in a matter of weeks. So, the advertising pivot did seem to some of us to have a whiff of the reactionary about it, rather than the carefully planned strategic shift Hastings and his team have tried to present it as.

Hastings First Argument

Netflix has at times offered two different justifications for their about face. The first, which Hastings elucidated on that same earnings call, was that advertising technology and marketplace had advanced to the point where it was now possible to act as a straight publisher and simply sell advertising slots to other companies who would focus on the data gathering and collection to target the ads.

That theory is not completely implausible, but it does more to rephrase the question than to answer it. If Netflix is going to sell the ad slots to someone else, how is that company going to match the Big Three in targeting prowess? And if they can’t really do so, why would they spend any more to buy the slots from Netflix than Netflix could get by selling the ad space directly?

So unless Netflix was going to sell the ad space directly to one of the Big Three – which they’re not, Microsoft (MSFT) won the Netflix contract – this answer never really satisfied me.

Recent Earnings Brings New Insights

Perhaps recognizing this, incoming co-CEO Greg Peters fleshed out a rather different argument in the most recent earnings call. And this one was, frankly, a bit more intriguing. When the interviewer pointed out Hastings’s past Big Three comments, she asked if management’s views had changed. But Peters indicated it hadn’t, actually:

I would say that initially, we’re competing mostly with that sort of traditional TV advertising pool. Now I think we can layer into that over time, components of what has made digital advertising so effective. So if you think about the targeting capability, the fact that we signed in fully addressable. If you think about the growing relevance of first-party data and how we do that, those are real big advantages that we can bring relative certainly to the traditional TV world.

But again, the form that we have at least for the next couple of years will still be in that sort of lean back – primarily in that lean back experience. And so that lends itself to certain kinds of advertising and certain kind of advertising goal. And a lot of the demand collection component that a Google or a Facebook is really good at. We won’t be well suited to compete with that for at least some time to come.

-Q4 2022 earnings call

I find this quote very interesting, but less for what it says and more for what it seems to assume. As Peters himself indicated, Netflix is planning on integrating some aspects of digital advertising, such as data-mining targeting into its advertising engine. So clearly, he expects TV advertising, of even the brand rather than demand variety, to become more like online advertising. And since that makes it more efficient, on its own that makes perfect sense.

But of course, that’s precisely the same thing that makes the Big Three so powerful in advertising. The mere fact that brand advertising is not demand-response driven doesn’t make data any less valuable. And if TV advertising is going to become more “digital-like” in this respect, surely Amazon and Alphabet have the same advantages over competitors regardless of whether TV advertising becomes more demand-like or remains primarily brand-driven?

The Peters Theorem

So the second half of Peters’ argument, the unspoken half, seems to be that while TV advertising will advance technologically, it will remain partitioned industrially. While TV advertisers will take whatever targeting breakthroughs their traditional partners are able to make, they won’t abandon the traditional dichotomy of TV advertising to shift large amounts of money towards new-era platforms like Alphabet’s YouTube and Amazon’s Prime and Freevee services. Advertising’s inertia, Peters seems to imply, will ensure TV ad spending remains available only to certain companies with long-standing affiliations with TV ad spending.

This is, admittedly, an interpretation from me, but it seems to follow inevitably from the words Peters actually says. It is also a fascinating, albeit questionable, assertion which does a far better job of explaining why Netflix made such a fundamental change all of a sudden (again, simple panic always being the other plausible explanation).

Unlike Hastings earlier explanation, this actually answers, instead of just trying to pass off to the next guy, the issue of competing with the Big Three in advertising. Unable to match their unprecedented targeting prowess for ads with unparalleled customer data? Doesn’t matter; YouTube and Amazon Prime can’t get their foot in the door. You only need to beat traditional broadcasters like Paramount (PARA) and Warner Bros. Discovery (WBD) who have even less first-party data than Netflix and Roku do since they haven’t been streaming as long.

This unspoken assumption seems to explain another rather analog-leaning move Netflix made recently. Not long after Paramount’s CBS broadcast network announced it was abandoning the upfronts in favor of more individualized pitches to advertisers, Netflix announced that it would slide into Paramount’s spot at the May event. Apparently, Netflix wants to penetrate the quasi-social economic networks, bordering on an old gentleman’s club, that it feels determine advertising spending.

Penetrating those networks appears to be the key to its strategy, because it feels like that’s perhaps the only share of the advertising pie that Amazon and Alphabet won’t penetrate.

Back To Roku

For Roku, if Netflix should in fact prove to be correct, much the same logic would apply to them, and would validate their advertising focus and offer real potential for sustainable advertising profit after all. Unlike Netflix, Roku is already active at the upfronts, with commitments of over $1 billion this year according to management. My thesis has been that those commitments will prove to be more or less equal to content costs since lack of targeting capability will effectively tie Roku ad revenue to the crest of the content cost wave. If in fact, the Big Three can’t crack the window on that side pocket of ad spending, that thesis would require substantial revision.

But is Peters right that YouTube and Amazon Prime can’t get into this market?

Cracking The Door Open

Amazon

To be sure, it’s not impossible. Netflix and Roku are digital companies which can be viewed almost as “TV adjacent,” unlike Alphabet and Meta which have only tangential traditional TV connections. But what about Amazon? Amazon has Fire TV to Roku’s OS, Prime Video and Freevee to Netflix and the Roku Channel. If this Peters theorem is correct, isn’t Amazon the natural winner? Possessing both a vibrant targeting data bloc and a vibrant premium TV ecosystem?

Alphabet/YouTube

I also wouldn’t be so quick to write off YouTube. More specifically, I wouldn’t be so quick to write off YouTube TV, which Alphabet has already used to acquire over 5 million subscribers in a more or less typical linear pay-TV product and which may soon be acquiring a lot more subscribers with its new crown jewel, the NFL Sunday Ticket package. This segregated ad system seems more like a hard shell than a solid rock; hard for newcomers to get their foot in the door, but once they do and start outperforming a veritable tsunami to equalize the efficiency/spending differential may well follow.

Cord-Cutting Collapses The House?

For that matter, will TV advertising even remain segregated in this way to begin with? The continued acceleration of cord-cutting means that this ludicrously imbalanced allocation of ad money is getting harder and harder to defend. Surely there will come a time when the businesses who provide all this money for the ad agencies to allocate will begin to demand a better return on their money? How much longer will the linear TV product that produces this strange effect even still exist? As I’ve argued before elsewhere, there is little reason to believe that cord-cutting will somehow stabilize at a new, lower (50 million is often mooted) level since sports, which is supposed to be what holds the new smaller bundle together, is already defecting to streaming at an accelerating pace.

Investment Summary

After listening to Peters explanation I actually feel I have a much better understanding of why Netflix is doing this. And by extension, what makes Roku so confident as well. But even with that new understanding, I’m not sure I see the grand slam walk-off they seem to.

Roku’s and Netflix’s advertising ambitions seem to center on not just one, but two assumptions: that TV advertising will remain partitioned from the broader, rapidly digitizing market, and that they will be able to shoehorn their own way into that partition despite being digital companies themselves. These two assumptions are not only both questionable, they seem somewhat mutually contradictory.

Actually, I think I agree with the idea that Roku and Netflix will be able to elbow their way in, and perhaps even a little faster than the other companies can. But even if that happens, a short one- or two-year window before the linear/advertising dichotomy collapses seems an odd thing to completely turn product branding and strategy upside down for.

And I just don’t see a long-term future for a partitioned TV linear advertising system to survive.

Positions Summary

I remain bullish on these companies, but for reasons having nothing to do with advertising. Roku and Netflix are platform winners, not advertising winners. Amazon and Alphabet are the advertising winners, perhaps joined by Meta depending on how deep into video it goes.

I am long Netflix, Roku and Amazon.