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

Both of Netflix's biggest competitors, Amazon and Hulu, have multiple revenue streams. Netflix should too.

Jan 6, 2014 at 3:00PM

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 Amazon.com (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

Adam Levy owns shares of Amazon.com and Walt Disney. The Motley Fool recommends Amazon.com, Netflix, and Walt Disney. The Motley Fool owns shares of Amazon.com, Netflix, and Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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