After growing like a weed during the pandemic-induced lockdowns, Netflix (NFLX -3.92%) fell on hard times. The combination of tough year-over-year comparisons and slowing growth, plus an ill-timed price increase, sent the streaming platform's rampant growth into reverse, shedding nearly 1.2 million subscribers during the first six months of 2022.
Yet even as 2.4 million net new subscribers showed up in the third quarter, Netflix stock sat well below its all-time highs, down 55% since late last year. While the bear market and the economic uncertainty are no doubt contributing factors, investors appear to be factoring in much slower future growth for the streaming pioneer. While understandable, this analysis seems to ignore the company's biggest growth opportunity.
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An abrupt about-face
After years of steadfast resolve, Netflix finally relented and launched a cheaper, ad-supported plan in early November. The tier -- dubbed Netflix Basic with Ads, costs $6.99 per month and incorporates an average of four to five minutes of commercials per hour. The plan has additional limitations. Video quality will be limited to standard definition, not all movies and television shows are available on the tier due to Netflix's licensing agreements, and viewers are unable to download programming for later viewing.
Co-CEO Reed Hastings had long believed that advertising wasn't in Netflix's DNA and wouldn't work for the company, but he has since come around. He addressed his change of heart at the New York Times' Dealbook conference last week and seemed to suggest that things were going remarkably well. "I was wrong about that. Hulu proved you could do that at scale and offer customers lower prices," Hastings said. "I wish we had flipped a few years earlier on that."
Hastings' pronouncement suggests that the ad-supported tier's early days are bearing fruit.
It all "ads" up
There are too many unknowns at this point to accurately predict the financial ramifications of the cheaper plan. There's the question of how many of Netflix's existing 223 million premium customers will trade down to the ad-supported tier. We also don't know how much advertising revenue the company will generate per user. Fortunately, one research firm has put pen to paper and come up with estimates that are probably at least directionally accurate.
Over the coming five years, Netflix's ad-supported tier could generate $8.5 billion in annual revenue, according to research firm Ampere Analysis. The company calculates that $3 billion of that sum will come from the new tier's subscription charges, while $5.5 billion will come from advertising fees.
Furthermore, Ampere suggests that Netflix's average revenue per user (ARPU) will see a significant bump in its Europe, Middle East, and Africa (EMEA) region. The increase will be fueled by customers in Western Europe, who don't mind ads, while also having the greatest price sensitivity. This could drive ARPU for the region higher than Netflix currently generates in North America -- its most lucrative market.
The news isn't all good. While Netflix management has steadfastly maintained that it expects minimal defections, as many as 23% of existing customers could trade down to the cheaper tier, according to data analytics company Kantar Research (via Deadline Hollywood).
This is all fun with numbers and doesn't provide any concrete metrics. Still, it suggests that Netflix will increase its subscriber base and boost its revenue with the addition of the ad-supported tier.
A new paradigm
In an appearance at the UBS Global Technology, Media, and Telecom Conference, Netflix co-CEO Ted Sarandos provided some insight into the company's progress thus far. He suggested the company would eventually expand beyond a single, ad-supported tier.
While Sarandos didn't provide any specifics, he cracked a smile when asked about the trajectory of the ad-supported plan, saying, "A lot of people, my son included, are willing to watch ads and take a lower price." Sarandos went on to say that having a tier for price-sensitive customers "opens the market" and isn't likely to drain subscribers from the company's full-priced plan.
Eventually, the company plans to offer additional tiers to support its advertising efforts. "We have multiple tiers today, so it's likely we'll have multiple ad tiers over time, but nothing to talk about yet," Sarandos said. "And the product itself will evolve, I suspect, pretty dramatically, but slowly, gradually."
This all goes to show that Netflix is establishing a firm foundation for its next profit driver. Attracting additional subscribers by way of a full-priced subscription plan or a lower-priced, ad-supported tier will provide the company with a path to future growth. Furthermore, the potential for multiple ad-supported tiers suggests Netflix will have a subscription plan to fit every budget -- something it's currently lacking.
