After nearly a decade of avoiding the ad business, Netflix (NFLX 2.72%) is starting an ad business.

Co-CEO Reed Hastings had long dismissed the idea, arguing that the simplicity of Netflix's ad-free subscription model was an advantage, but the market finally forced his hand.

Netflix stock is down 64%, with much of that decline coming after the company reported a surprise decline in total subscribers in the first quarter and lost another net 1 million members in the second quarter.

The most obvious conclusion based on those numbers is that Netflix has reached maturity sooner than expected, especially in its core North American market, where it lost a net 1.9 million subscribers over the last two quarters.

Since the service already counts more than half of broadband households in North America among its subscribers, its growth potential is limited. If it can't grow its subscriber base, its only real options for increasing revenue in North America are to raise prices (which it has done several times in recent years) or sell ads. The company is also starting to give customers the option of "paid sharing," or paying to add extra users to a household account in an attempt to cut down on password sharing, but advertising is its best idea for growing the top line. 

Why advertising could be huge

Hastings is correct that Netflix's simplicity has historically been a strength that helped attract subscribers. In fact, its straightforward subscription model dates back to its days as a DVD-by-mail company, when it promised a simple flat monthly charge and no late fees. 

By now, though, it has become clear that sticking with it would mean leaving a lot of money on the table.

In its Q2 shareholder letter, Netflix disclosed that its viewing hours, according to Nielsen, were far ahead of any of its competitors, including broadcast television networks. In the 2021-22 TV season, viewers watched 1.3 trillion minutes of Netflix content. CBS was a distant second at 753 billion, and NBC was in third place with 597 million. Even combined, those two legacy broadcast networks had only slightly more hours of viewing than Netflix. Among streamers, Disney+ came in second at 245 million minutes, meaning people spent more than five times as much time watching Netflix as they spent with its closest streaming competitor.

Given the enormous size of its content budget, it may not be a surprise that Netflix gets more viewing time than any of its peers. The problem is that Netflix isn't monetizing its audience at five times the rate of competitors because that all-you-can-watch model offers the business no incremental benefits from extra time spent with the service.

Advertising can fix this. With an ad-based tier, Netflix will earn revenue based on viewing times rather than just per subscription, leveraging that high level of engagement.

Ad tiers work

Probably the best example of a streaming service that offers a choice between an ad-based tier and an ad-free option is Hulu, which is now owned by Disney. Hulu currently prices its ad-supported service at $6.99 a month, while viewers who want an ad-free experience pay $12.99 a month. Hulu's average monthly revenue per subscriber was $12.77 in its most recent quarter, meaning it makes about the same in revenue from customers in both categories. At times, it's made more money from ad-supported customers than ad-free.

In 2019, Hulu said that 70% of its viewers were on the ad-supported tier, showing that streaming subscribers -- at least in that case -- prefer an ad-based tier with lower out-of-pocket costs. Hulu originally launched as an ad-based service, only debuting its ad-free tier in 2015. Netflix is unlikely to see its subscriber base shift to the kind of mix that Hulu has, but the share of its users who have chosen the option with commercials is still revealing. 

What it means for Netflix

In addition to the demand from viewers, there should also be ample demand among advertisers. After all, Netflix is a primary reason why the once highly profitable linear TV ecosystem has been leveled, and with it, the huge TV advertising industry. Advertisers are hungry to replace those eyeballs. Connected TV allows for better ad targeting than linear TV, as Netflix has detailed data on household and individual viewing habits. More broadly, digital advertising has already become a huge industry delivering mountains of profits to leaders like Meta Platforms and Alphabet (which owns YouTube).

Netflix will offer advertisers another platform with massive global reach. The streamer still needs to execute on its new business, but all the pieces are there for it to be a success.