Microsoft (MSFT 0.34%) was the surprise winner among those vying to manage Netflix's (NFLX +2.67%) future advertising business. The streaming company plans to launch an ad-supported tier of its service in the near future. The SVOD leader had been in talks with companies more associated with digital video advertising like Alphabet's (GOOG +0.53%) (GOOGL +0.37%) Google and Comcast's (CMCSA +1.25%) NBCUniversal, which operates Freewheel.
While the choice of Microsoft has some advantages for Netflix, it could provide a more meaningful boost to Microsoft.
NASDAQ: MSFT
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Building a digital video ad business
One important reason Netflix likely opted for Microsoft is that there's no big conflict of interest. Unlike Google and Comcast, which have their own video streaming businesses, Microsoft doesn't operate a direct competitor to Netflix.
Importantly, that gives Netflix and Microsoft a cleaner starting point for building a digital video ad business. In a blog post announcing the deal, Netflix COO Greg Peters said, "Microsoft offered the flexibility to innovate over time on both the technology and sales side."
Indeed, Microsoft will build on the back of its existing ad business, anchored by its Bing search engine and MSN portal. The addition of Xandr, which it picked up from AT&T recently, provides some important connected-TV ad tech that will serve video ads and link targeting and measurement data across platforms.
Microsoft already operates a sizable advertising business, generating $10 billion in revenue last year. But that pales in comparison to giants like Google, which saw $209 billion in ad revenue in 2021. And while Google's YouTube generated over $28 billion last year in addition to Google's other streaming and connected-TV advertising efforts, Microsoft doesn't generate much from video.
In other words, Microsoft has a fairly big ad business with a lot of established technology, but it should be more will be willing to work closely with Netflix to develop new technology and services around video. That can benefit Microsoft just as much as it benefits Netflix.
With Netflix, Microsoft gets to build technology and sales teams with a guaranteed customer -- and a sizable customer at that. It's the advantage Google has in building its video ad services, because it has all the demand built into YouTube. Likewise, Comcast is able to support Freewheel because it's not going to lose NBCUniversal as a customer.
As Microsoft develops technology and sales practices to support Netflix, it could become a bigger force in the fast-growing digital video advertising market. That makes the contract much more valuable than simply the potential revenue it could generate directly through Netflix.
NASDAQ: NFLX
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A win-win for Microsoft and Netflix
Netflix likely got a very good deal from Microsoft compared to what more established competitors could offer. In exchange, Netflix will help establish Microsoft as a major player in connected-TV advertising. The streaming service could generate over $1 billion in ad sales worldwide in just a couple of years, according to an estimate from analysts at MoffettNathanson.
That said, investors in either company shouldn't expect an immediate payoff.
Netflix already has 220 million subscribers worldwide. As such, it'll take some time before the ad-supported tier becomes a meaningful contributor to Netflix's subscriber base. The company could see some customers migrate from ad-free tiers to the ad-supported tier, and it may be able to improve churn by giving existing customers a less expensive option to stay. Still, it'll take some time for Netflix to roll out the ad service globally, figure out its marketing message, and drive subscriber growth through the new offer.
But as Netflix and Microsoft iterate their practices over the next few years, the business could become an important piece of both companies. Netflix could see improved subscription rates while Microsoft expands its ad business into a growing market.
