Netflix’s advertising strategy is undervalued

When Netflix (US: NFLX) started in 1997 as an e-commerce platform for DVD rentals. In 1999, it moved to a subscription service where customers could pay a fixed fee in exchange for unlimited rentals. It wasn’t until 2007 that CEO Reed Hastings launched the online streaming service we know today. Netflix initially only streamed other people’s shows, but in 2013 it started creating its own content when it launched house of cards.

Since then, the goal has been to produce large amounts of content and attract as many people as possible to the platform. In 2013, free cash was $43.7m (£37.9m), but as the cost of production began to rise, cash flowed out of the business. In 2016, cash outflow was $1.58 billion and in 2019 it peaked at $3.14 billion. However, this was not a problem, because interest rates meant capital was cheap, and Netflix was adding more than 20 million customers a year.

The growth has now stopped. In the second quarter (Q2), Netflix lost 1 million subscribers and the company expects to have fewer subscribers in the third quarter of 2022 than in the fourth quarter of 2021. The increase in interest rates means that investors no longer value the growth at all costs. Pie now is better than pie later, and Netflix’s stock price is down 63 percent for the year.

To appease investors, management has promised to focus on free cash flow. The expectation is to generate $1 billion of free cash flow in 2022 plus or minus a few hundred million fluctuations from changes in the exchange rate. Netflix believes the “multi-year evolution of its content model” is poised to deliver solid profitability and says it is undergoing the most cash-intensive part of that transition.

It seems convenient that you are past the most cash-intensive part of the transition just as the market turns sour. However, if we give Netflix the benefit of the doubt and assume everything goes according to plan, what will the new content model look like and how successful will it be?

advertising is very profitable

After disappointing first quarter results, Netflix announced that it would start selling advertising. Ad-supported subscription allows users to pay less, but then they have to watch the ads. The advertising platform was supposed to launch in 2023. However, The Wall Street Journal announced that it would be moving to November 1, 2022, possibly to preempt Disney Plus, which will launch its own ad-supported platform in the US in December.

Netflix has partnered with Microsoft (US: MSFT), which will help with the technological and marketing aspect of the platform. Netflix’s ad-supported service will reportedly cost between $7 and $9 per month, down from the current $15.49 subscription. This means that Netflix plans to earn at least around an additional $7 per user from advertising per month, and at first glance, this seems doable.

Sky, owned by Comcast (US: CMSCA), earned $556 million in ad revenue in the second quarter of last year and had 22.7 million viewers. For each viewer each month that is equal to $8.16. Netflix could probably make more than Sky as it will have more granular data on its viewers. When you watch Sky, the ads you see are the same for everyone. Netflix may personalize ads based on viewers’ historical habits.

Hulu already offers an ad-supported service, which costs $6 a month, half the price of the regular offering. Determining how much ad revenue you generate per customer from accounts is tricky. However, a New York Times The 2019 article said that he reportedly made $15 in revenue per subscriber per month. This is almost double the number for Sky and shows how much more effective targeted advertising is on streaming platforms compared to traditional live TV. If Netflix were able to transfer half of its customers (about 100 million) to an ad-supported subscription, then it would increase its revenue by around $900 million per month, which is equivalent to a 34 percent increase compared to the figures of the second quarter of 2022.

It is probably sensible to revise this 34 percent figure slightly downwards. To think that Netflix would earn as much as Hulu in 2019 is wishful thinking. Firstly, demand for advertising space should fall as businesses and consumers come under pressure from the cost of living crisis and recessions are expected in both the US and the UK. Second, the supply of ad space is increasing as more companies look for ways to monetize people’s attention. With fewer ads chasing more ad space, the basics of supply and demand suggest that prices will fall.

As already mentioned, Disney Plus will launch its ad-supported platform in the US in December. Meanwhile, the sports news website the athleticwhich was acquired by New York Times at the beginning of the year for $550mn, it is launching ads. the athletic, through the backing of private equity, spent a lot of money hiring the best sportswriters and offered countless discounts to increase subscribers. It reportedly lost $55 million in 2021. Like all platforms, it was scaling, but now it’s monetizing.

Even if we have to revise down the 34 percent revenue growth, there is still a chance for significant revenue growth for Netflix in the coming years. These estimates also assume that there will be no increase in subscribers. The cheaper service could attract more customers and reverse last year’s decline.

Most people don’t give their full attention to television when they watch it. Many keep an eye on their phone, whether playing games or texting friends; the industry calls this “multi-screen”. More than 40 percent of Netflix viewers play games on their phones each month, according to Midia Research. Given this, ad breaks are not going to be that prohibitively expensive for customers. When the TV tries to sell them something they don’t care about, they can go back to playing whatever is on the phone.

It’s a depressing situation, but the reality is that most people need constant stimulation. We are addicted to dopamine. Multi-viewing allows viewers to always stay entertained, regardless of what’s on the main screen. This development in media consumption habits means that people may be more willing to accept ads than before, especially if their budgets are squeezed by gasoline prices.

the game is cheap and durable

The heavy crossover between Netflix viewers and mobile gamers is also part of the reason for the foray into gaming. If you want to ask your customers for more money or suffer from boring ads, you need to offer them more content. Ubisoft partnership announced this week allows Netflix customers to play assassin’s Creed – Ubisoft’s most successful game to date, at no additional cost. For avid gamers, this is a huge advantage.

So far, Netflix has struggled to get its gaming product off the ground. Last year, Netflix acquired three game studios and released 28 games, including one based on the popular show Stranger Things. Unfortunately, so far only about 1.7 million (or 1 percent) of Netflix customers have played them, according to Apptopia (via CNBC). However, the franchises that Ubisoft offers to the Netflix platform significantly improve this offer.

The great benefit of gaming over streaming video is that it keeps users engaged for much longer. Do you remember Tiger King from the first closing in 2020? Everyone was talking about it, but the hype soon died. animal crossing, a game created by Nintendo, also saw a huge spike in interest during the lockdown. However, as you can see from the Google Trends graph, it held the interest of the American public for much longer.

This means that the production costs per hour of user consumption are lower for games than for video. In addition to this, games also generate more revenue from users than videos. Average hourly revenue for gaming was $0.56 versus $0.43 for online subscription video, according to Ampere Analysis. Gaming is a higher-margin business than constantly having to produce expensive shows that consumers then binge on over the weekend.

Moving away from paid video streaming is a good idea for Netflix. Advertising and games are much more effective ways to monetize user attention. The problem is the execution. If Reed Hastings gets it right, then the 63 percent share price drop this year is a huge buying opportunity for investors.

The concern is that the sudden announcement of announcements right after the first quarter results smacks of panic. I would prefer management to be proactive rather than reactionary. However, any writer will tell you that it takes pressure to sharpen your mind. At this price, it’s worth betting that a dose of panic is just what Netflix needed.

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