Netflix (NASDAQ:NFLX) has had a rough year after reporting she lost nearly a million subscribers in the second quarter, the first time she’s lost subscribers in more than a decade. The stock fell more than 49% in April 2022 alone. The only other time the stock did was in 2011, when the Qwikster debacle nearly bankrupted the company. death.
In response, Netflix announced that it would go into advertising in a bid to re-accelerate its growth. A business that they previously said on many occasions that they would not continue. Media coverage seemed to gloat over Netflix succumbing to ads, with this headline, for example, saying the company bowed to advertising reality. The reality facing Netflix, according to media coverage, was that this was a new world in streaming, one where Netflix couldn’t raise prices without losing subscribers to the competition. As a result, adding an ad-supported tier was an important component in combating customer churn.
But what if that wasn’t reality at all? What if the move to advertising was actually calculated?
Why Netflix Never Sold Ads
Netflix had a very compelling reason not to sell ads; he just couldn’t compete. Here’s Reed Hastings in Q4 2019:
Google, Facebook, and Amazon are tremendously powerful in online advertising because they’re integrating so much data from so many sources. And that comes at a business cost, but it makes advertising more targeted and effective. So I think those 3 will get most of the online advertising business. And then to grow a $5 billion or $10 billion ad business, you have to wrest it away from other advertisers. In this case, let’s say, or other providers, Amazon, Google and Facebook, which is quite challenging. So don’t think of it as… in the long run, there’s no easy money there.
So Netflix was at a competitive disadvantage in the ad market. It simply couldn’t compete with companies like 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 thing to do was position the company as the premium brand without advertising.
However, that situation has changed considerably since 2019.
Apple can help Netflix build a massive ad business
Apple’s introduction of ATT (Application Tracking Transparency) has removed much of the armor-piercing ammo from 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 that Apple’s move to limit customer tracking is causing a repositioning in digital advertising. The crucial point about ATT is that many digital advertising 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 of 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 on the entire advertising ecosystem. CTV leaders will help shape the future of identity… It’s where advertisers now have premium content alternatives on a global scale to user-generated content. And because CTV has a massive authenticated registered user base, advertisers and publishers will innovate new ways to create personalized experiences while improving consumer privacy and better explaining the Internet’s quid pro quo.
So Netflix can use the audience data to segment its customers. Customers can be segmented based on age or gender based on viewing habits. It won’t be perfect, but thanks to ATT it will be close enough to what the big 3 ad companies can do. As well as 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 is possible that Netflix management succumbed to the pressure of losing subscribers, one must be mindful of the possibility that business conditions in the ad market coincided with subscriber losses.
Netflix’s ad business may be a big chunk of revenue
Netflix’s ad business won’t be the next Google. But it’s big enough, along with changes in the advertising landscape, to compete with Meta, TikTok and other smaller digital advertisers, who in turn get share from TV advertising. It is also one of the few online media properties that has between 800 million and 1 billion users. The company would generate significant revenue depending on how much of this user base chooses to move up to the ad-supported tier.
So how big can advertising be? It has been reported that Netflix will charge a CPM of $60-80. The same report said that they expect to get 500 thousand subscribers by the end of the year. If those subscribers saw just one ad a day, the company would generate $11 million in ad revenue a year.
Now, the company most likely has its own internal subscribers and revenue goals. With 1 in 3 households watching Netflix through a shared password, let’s assume the company intends to convert half of those households to an ad tier within three years. And let’s assume that the ad level will be a very light ad per day (compared to the usual 3 minutes of ads per hour). That would be (12 million users * $60 ad cost) / 1,000 views * 365 days = $262 million in ad revenue. At $8 in monthly subscription, the total is $1.4 billion in revenue, with significant potential for ad load growth.
But what would the company have to do to generate the $10 billion in ads mentioned by Hastings in the quote above? They would need to register 35 million on their ad tier with an ad load of 12 ad views per day per user (ads are placed per hour, so 12 ad views equals 2 minutes per hour of content, with customers watching a couple of hours a day on average).
Now, what adds to the complexity is that as subscriptions grow at the ad level, the ad business will increase its growth. Because each subscription will normally carry multiple users. So Netflix may not need close to 35 million subscriptions to reach $10 billion. The number could be closer to 14 million if each subscription had 3 users, each of whom sees 12 ads a day. Yes, the $8 per month would be split between those 3 users, but the ad revenue more than makes up for that loss.
The point here is not to predict how much ad business Netflix will generate, it’s too early for that. Rather, it is to help investors be prepared with the big picture, so they can quickly form an opinion on Netflix’s valuation as management shares its views on the business.