Would Advertising Work for Netflix?

Management has good reason to continue resisting an ad-supported subscription option to its video-on-demand service.

Adam Levy
Adam Levy
Jul 10, 2019 at 8:00AM
Consumer Goods

Over the last few years, there's been growing speculation that Netflix (NASDAQ:NFLX) will have to introduce an advertising-supported option in order to grow its subscriber base. As Netflix's monthly subscription prices rise throughout the world (it most recently raised prices as much as 20% in the U.K.), a less-expensive, ad-supported option might be more appealing to consumers who haven't yet signed up for the subscription video-on-demand service.

But Netflix can't simply flip a switch and turn on ads. And current subscribers will likely get upset if they're soon faced with the option of either paying more for their service or watching ads in the middle of their Stranger Things binge session. Roughly a quarter (23%) of U.S. subscribers said they would cancel Netflix if the company introduced ads without lowering prices, according to a recent survey from Hub Entertainment Research. Most importantly, the countries where a lower-priced, ad-supported option would best boost subscriptions are the same markets that are least practical for Netflix to sell and incorporate ads.

A woman sitting at a reception desk at Netflix's office.

Image source: Netflix.

What's it worth?

Advertising could create a huge amount of revenue for Netflix. Hulu generated about $1.5 billion in ad revenue from its 25 million subscribers last year. Ad sales could grow quickly under Disney's (NYSE:DIS) control, too.

About 60% of Hulu subscribers are on an ad-supported plan, and all of them are based in the United States. That enables Hulu to generate an average of $9 per month in ad revenue per subscriber.

Hulu didn't start off making that much per subscriber. It developed relationships through its ad sales team and grew out an advertising technology stack. That became easier as it scaled. After years of improved monetization, it actually lowered the subscription price of its ad-supported service.

Netflix would effectively be starting from scratch. The discount it could offer subscribers willing to watch ads wouldn't be significant, and it could hurt its existing subscriber base if the company doesn't price things right. Netflix would have to be willing to generate less revenue from ad-supported subscribers than from its paid subscribers -- at least in the short term.

That might be worth it if Netflix was really struggling to grow its subscriber base. It added 5 million U.S. subscribers last year, despite its price increases. Management forecast 20% domestic revenue growth for the second quarter.

In the markets where Netflix isn't growing as quickly as it wants, like India, advertising revenue would be considerably smaller. Netflix is looking for other ways to convince subscribers to sign up for its premium service through partnerships with wireless carriers or offering more limited streaming plans.

Placing ads to offset further price increases isn't a good solution to improve subscriber growth. Nor is it even necessary for Netflix right now.

Better options for increasing revenue per subscriber

Netflix has had a lot of success increasing its prices over the last few years, but it's also starting to experiment with other ways to capitalize on its viewership. One example is the company expanding its merchandising and licensing agreements for Stranger Things. The series is one of Netflix's first in-house productions, and the company has made it a pillar of its merchandising strategy, licensing the series' characters and plotlines for numerous products, including toys, figurines, apparel, and video games.

Merchandising is a key part of Disney's business. Its consumer products and interactive media generated $4.7 billion in revenue last year. And that business segment produced a higher operating margin than any other segment at Disney.

As Netflix brings more of its original productions in-house, it'll have more licensing opportunities. What's more, licensing its intellectual property for other products can produce a virtuous cycle where consumers become more engaged with the Netflix brand and the characters from its series and films. That makes customers more likely to subscribe and stay subscribed.

Finding ways to monetize its viewership outside of its own service is a better path for Netflix than trying to push ads on its viewers.