If Netflix Wants to Offer a Less Expensive Service, It Should Test Advertising

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Netflix (NASDAQ: NFLX  ) is reportedly testing a downmarket plan. New subscribers that don't need to stream movies on multiple devices at once and don't care about high-definition can save a whopping $1 a month. I guess Netflix is testing to see if $1 off will convince more people to sign up. My guess is that it won't.

The diminutive discount for the severely limited service seems to imply that Netflix can't afford to offer much less, with the cost of content rising with the added bidding power from (NASDAQ: AMZN  ) , Hulu (owned by Walt Disney (NYSE: DIS  ) , Twenty-First Century Fox (NASDAQ: FOXA  ) , and Comcast (NASDAQ: CMCSA  ) ). If Netflix really wants to accelerate adoption, it needs to diversify its revenue as Amazon and Hulu have done.

How Amazon pays for Prime Instant Video
Amazon Prime subscribers are profitable for Amazon because, on average, they buy more stuff. The additional sales are enough to cover shipping costs, video content rights, and e-book lending rights associated with a Prime subscription, and leave a $78 profit, on average. In other words, the average Amazon Prime subscription fee falls straight down to Amazon's bottom line over the course of the year.

Because Amazon doesn't rely on a single revenue stream, it won't feel pressure to grow Prime subscriptions in order to afford new content and renew old content. As e-commerce expands, Amazon is leading the charge, and it can use that huge revenue stream to support its Instant Video service.

How Hulu pays for content
Hulu has two revenue streams: subscription fees and advertisements. Besides competing with Amazon and Netflix for previous seasons of popular television shows, it also pays a premium for the rights to current season episodes. As Hulu points out in its FAQ, it shows ads so that the service is more affordable. Even though its parent companies make a lot of the content, the subsidiary still has to pay for them.

In 2013, Hulu expects to generate $1 billion in revenue. I estimate the company made slightly less than 40%* of that from subscriptions. The rest was from advertisements.

Hulu is really good at getting people to watch ads. It serves more ads per minute of video and more ads overall than any other website. It's also able to charge a premium for advertising compared to its competition. The Wall Street Journal reported that top-tier video sites charged $15 to $20 per thousand views in 2012. Hulu, however, charges around $35 per thousand impressions, applying a conservative estimate. At that rate, Hulu is bringing in an extra $3 per viewer in profit.

Could Netflix go to advertising?
It will be interesting to see how people respond to Netflix's newest offer. As mentioned, I have my doubts that $1 will really sway people to sign up. If Netflix really wants to move downmarket, which this test seems to imply, it might be better off offering an ad-supported version of the service.

Even if the low-rate subscribers watched less content than the average Netflix subscriber -- say 20 hours -- Netflix could charge $4 per month, show just 4 minutes of ads per hour, and see its average revenue per user, or ARPU, increase***. In other words, Netflix could generate more revenue from its low-end, ad-supported subscribers than it does from its typical $7.99 per month subscribers. 

There are other benefits to advertising besides revenue. Netflix could use ads to reduce churn by pointing its subscribers toward series they might be interested in watching. Its recommendation engine does a very good job of this already, but an ad may give users that extra push, or it may inform them that the content is exclusive to Netflix, which ought to keep them around.

Why is Netflix moving downmarket in the first place?
With subscription rates starting at $7.99 per month, Netflix is already very affordable. I suppose the low-rate test may give some insight into the price elasticity of the service, but Netflix likely can't afford to decrease its rates significantly without diversifying its revenue. Even if the test shows an uptick in subscription rates, it may never see a full-fledged rollout. Investors want Netflix to increase its ARPU, not decrease it.

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*Hulu started the year with 3 million subscribers and ended it with 5 million. The mid-point, 4 million, provides annual revenue of $383.5 million. That might be on the high end considering free-trial users and the timing of sign-ups.

**Approximately 1.4 billion ads per month. 16.8 billion ads total. Approximately $600 million in ad revenue ($1 billion-$400 million). ($600 million/16.8 billion ads)*1000 ads  = $35.71

***8 ads per hour. 20 hours per month. $0.035 per ad ($35 CPM). (8 ads/hour)*(20 hours)*($0.035/ad) = $5.60. $5.60+$4 = $9.60 > $7.99

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 06, 2014, at 3:33 PM, AceInMySleeve wrote:

    It seems fairly clear that if you are a 1 stream household you are either more constrained by budget or you have fewer people than if you are a 2 stream household, and so basic economics does dictate that the price demand should be different. This is a perfectly logical market segmentation for Netflix.

    Price increases in the future can be selectively targeted as well. For instance, I would wager the 4 stream price goes up first. This also lets Netflix measure the elasticity without risking the farm, and gives customers a choice.

    I think advertising may have a role in the future, but I think susbstantial product elaboration comes after Netflix has more or less exhausted it's current business model in terms of customer counts.

  • Report this Comment On January 06, 2014, at 5:26 PM, adamlevy wrote:

    @AceInMySleeve You're right in terms of the economic argument.

    The counter-argument is that $1 off won't meaningfully impact subscriber counts. Netflix might see a small bump in subscriber numbers, but its revenue might not change as much, and ARPU could decline if the service went mainstream and 2 stream subscribers could downgrade if they wanted.

    I'll be awaiting to see if Netflix releases any information about the test in a few months, but I really don't expect this to go anywhere. I think it's more likely the company offers an ad-supported version in the future.

    As far as price elasticity it could face trouble as Amazon Prime already undercuts it and obviously doesn't mind low margins.

  • Report this Comment On January 06, 2014, at 7:14 PM, duuude1 wrote:

    Hey Adam,

    I'm trying to figure out the logic of your statement here:

    "Amazon Prime subscribers are profitable for Amazon because, on average, they buy more stuff. The additional sales are enough to cover shipping costs, video content rights, and e-book lending rights associated with a Prime subscription, and leave a $78 profit, on average. In other words, the average Amazon Prime subscription fee falls straight down to Amazon's bottom line over the course of the year."

    Gross margins on purchases are gross margins - whether you buy $5 or $50. If gross margins on $5 won't cover shipping, how would the same gross margins on $50 be any better?

    Gross margins for physical product are probably similar between AMZN and WMT, right? Somewhere around 20%? AMZN's increasing gross margins are due to more digital products and products like AWS, right? But for physical product it is probably pretty constant around 20%.

    Here are some approx and guestimated numbers to chew on - you can put in your own numbers...

    Per member subscriber price = $79/yr

    Approx subscriber numbers = 20M

    Approx Prime membership rev = $1.6B/yr

    Approx Prime purchases = $1500/sub/yr

    Approx Prime purchase rev = $30B/yr

    Gross margin = 20%

    Approx gross profit = $6B/yr

    Guesstimate average Prime purchase = $50/purchase

    Guesstimate average shipping cost = $5/purchase

    Total shipped pkgs = 30/sub/yr

    Shipping costs per sub = $150/yr

    Total shipping costs = $3B/yr

    That leaves $3B/yr out of gross profits to pay for licensing of video and e-books?


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Adam Levy

Adam has been writing for The Motley Fool since 2012 covering consumer goods and technology companies. He spends about as much time thinking about Facebook and Twitter's businesses as he does using their products. For some lighthearted stock commentary and occasional St. Louis Cardinal mania

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