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What Would Commercials Do to Netflix?

By Stephen Lovely - Sep 24, 2018 at 9:00PM

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Netflix's decision to test ads for original content on its platform invites questions about the company's priorities and its subscribers' tolerance for commercials.

Netflix ( NFLX -3.76% ) has been streaming TV and movies over the internet since way back in 2007. A lot has changed since then, and a lot of competitors have joined Netflix in the streaming space. Some companies have used commercials to drive profits and promote content on their platforms. But as Netflix has gained competitors, it has never gained ads -- at least, not yet.

Change may be in the works, though. Netflix is testing ads on its platform, showing a small portion of users trailers for its own original content. If all goes well, the ads will roll out to all users at some point in the future. That's not quite the same thing as breaking up movie streams with ads for Tide, but it's still a huge step for Netflix to consider -- and one that users are not, by all accounts, eager to see. What will this mean for Netflix?

To advertise or not to advertise?

It's worth looking at the larger world of streaming advertising, where there's a lot to consider, and more than a few things to wonder about.

Hulu, Netflix's longtime competitor in the streaming video on demand (SVOD) space, has always shown commercials in its streams. The commercials are from third parties, not just from Hulu itself, and they act as a source of revenue. They also make it possible for Hulu to offer an ad-free option to subscribers -- for a few extra bucks, of course. The ads and higher-priced ad-free option both generate income, but it stands to reason that ads depress subscriber numbers. Streaming companies are more than a little reluctant to reveal any data about commercials upsetting customers, but the fact that ad-free options available from services like Hulu get subscribers to pay more for ad-free content shows that advertisements matter to some streamers.

Cable has ads. Netflix doesn't. Will that change?

Image source: Getty

Netflix has dominated Hulu for years, but there are plenty of reasons for that: Hulu came along later, has a smaller library, and has a different appeal (Hulu emphasizes new TV content, including episodes from seasons in progress), so there's not a clear way of evaluating how much commercials have cost Hulu. It may be that commercials are a big part of the reason that Netflix still dominates; or it may be that Hulu would always have been second (or third, or fourth) fiddle, and that ads have helped it profit more with the resources it has.

Advertising is even more integral in the world of ad-supported video on demand (AVOD) services. Sony's Crackle, as well as the independent Tubi TV and PopcornFlix, offer on-demand content for free and make their money entirely from advertising. Such services almost can be said to not be in conflict with Netflix at all;  their small libraries make them more likely to supplement, rather than replace, a user's SVOD options.

Netflix's ad-free SVOD model is familiar due to Netflix's dominance, but it's not as common as it may sometimes feel. In fact, there's really no service quite like Netflix in this respect: Amazon's Prime Video, Hulu, and HBO all air ads of some kind.

Netflix's users don't want commercials

There's one thing that we know for sure about Netflix and advertisements: users don't want the two together. Pollsand articles show that, when asked directly, Netflix users come down hard against ads of any kind of Netflix. 

 It is unlikely that users would abandon Netflix completely if ads were included in the service, but it is certain that Netflix's subscriber count would be negatively affected. Netflix would keep growing, of course, but a user exodus could point out a disconnect between Netflix's expected and actual growth, like the one that briefly tanked Netflix's stock earlier this year.

Will Netflix's customers remain happy if ads arrive?

Image source: Getty

Netflix presumably has plenty of its own market research in hand. Perhaps they have reason to believe that opposition to advertising is overstated. Or perhaps they have found that users react much less angrily when the advertisements in question are for content they can stream on the platform, rather than for Doritos or Hondas.

This doesn't mean that Netflix expects no fallout from its commercials. It just means that Netflix thinks the pros may outweigh the cons. 

Netflix's originals and priorities

Keeping users happy is paramount for Netflix. It's also expensive. Maintaining its streaming library is a pricey proposition , which is part of why it makes sense for Netflix to invest in originals. The more popular originals Netflix can offer, the more breathing room it has when deciding how to spend on pricey syndication deals, which periodically expire and must be renewed.

When Netflix airs an ad for an original series on its platform, there are two parts to the calculation. The first is the potential for the advertisement to put off subscribers, leading to cancellations, lower growth, and less income. However, the other is the potential power of the advertisement to increase the value of Netflix's original series. The more people Netflix can get to stream its original series, the more self-sustaining and cost-effective Netflix's model becomes in the long run (while initially expensive, original series let Netflix save on syndication expenses that would otherwise last indefinitely). Successful originals give Netflix quality content hours and subscriber draws at an affordable price. This allows Netflix to cut costs, and cutting costs is just as valid a way to increase profits as increasing income is.

Just as a TV channel would advertise its own shows during commercial breaks, Netflix wants to use its platform to promote its own content. Netflix users don't have to love advertisements for Netflix's gambit to be a success: if users tolerate advertisements that end up helping the Netflix originals, then that may more than offset potential downsides.

None of this means that Netflix will consider "real" ads, external ads; while cash is nice, Netflix is pursuing ads because Netflix's originals are so important to its overall strategy.

Watching Netflix's next move

Investors should keep an eye on the ad pilot program. If Netflix moves forward with it, that may be a good sign. Yes, basic data shows users hate this, but that's only one dimension of the issue. Evaluating the intensity of user dissatisfaction is presumably the main reason that Netflix is doing a pilot program instead of a full rollout in the first place. If they move forward, that won't mean that Netflix users have suddenly learned to love ads, but it will mean that Netflix believes that the ill effects mild enough that they're worth weathering in exchange for a boost to its originals.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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