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Netflix And The Advertising Conundrum

|About: Netflix, Inc. (NFLX)
Summary

Netflix currently does not show advertising before, during, or after its content.

The company has tens of millions of viewers for some of its shows and could charge very substantial sums to advertisers to reach the Netflix audience.

The "conundrum" for Netflix is how many subscribers would be turned off by a few ads and quit watching as much, or cancel their subscription, versus the potential of advertising-revenue.

It is only a matter of time before Netflix (NFLX) monetizes its huge content portfolio by selling advertising.  No one really knows how long one will have to wait before Netflix cashes in on its potential advertising goldmine, because management has stated multiple times that they are committed to not selling advertising on Netflix, not now, not ever.  But at some point someone running Netflix may pull the lever and start selling ads.  There is simply too much money involved to resist advertising forever.

Some think Netflix is right not to offer advertising because it would turn off their viewers, who would then turn off their subscriptions.  A recent survey by Hub Entertainment Research found that up to 23% of Netflix subscribers may cancel their subscription if advertising were offered unless the company significantly lowered their subscription fees.  Obviously their is a balance that would need to be achieved if Netflix offered advertising.  The fact that this survey was just conducted is an indication the company is acquiring research to help weigh its advertising options.  It doesn't mean advertising on Netflix is imminent.  

Netflix currently has three different pricing options. A Basic plan costs $9 and is for older standard definition televisions.  The Standard plan costs $13 and enables the user to view content in full high definition.  Finally, the premium plan is for the early adopters of the newer 4K Ultra HD technology.  The content access is very similar for all of the plans.  Although obviously most of the content is not available in 4K Ultra HD.  If Netflix started showing advertising, then I imagine they may lower their subscription prices to show goodwill to their customers.  They could also show some content advertising free.  Or, they could limit the number of ads to limit the annoyance.

If I were paying hundreds of dollars a month for premium content on Netflix because I was promised no advertising, then I would cancel my subscription and look for another service if they started advertising.  But everyone is only paying a few dollars a month to access the content they want to see.  And most subscribers really want to see it, whether or not some ads are being shown.  The flip side is the survey showed 77% would keep Netflix even if there were some ads run and the company didn't lower its subscription prices.

I am currently hooked on four different original series on Netflix.  The first one is a fun supernatural heroine based adventure named The Chilling Adventures Of Sabrina (The Teenage Witch).  The second one is a brilliant dark comedy called GLOW (Glorious Ladies Of Wrestling).  I just watched, and highly recommend, the first season of a murder mystery told from a different perspective named Dead To Me.  And finally, I am currently binge watching the horror/drama juggernaut Stranger Things.   

It is Stranger Things that is really highlighting Netflix's advertising "conundrum."  The company just released data that showed 40.7 million households have already watched an episode of Stranger Things Season 3.  Incredibly, 18 million households have already watched all eight episodes and completed the season.  Stranger Things was only released on July 4 of this month.

So how do those numbers compare to global viewership of the most recent Super Bowl?  Fortune reported Super Bowl LIII (53) had a decline in viewership to 98.2 "viewers," and 2.6 million digital subscribers. Netflix is reporting a non apples to apples comparison with 40.7 million households.  I am one of those households, and both I and my spouse have watched two episodes of Stranger Things so far.  The point here is that 40.7 million households is more than 40.7 million "viewers."  And the show has only been out for a few days.  More households can be expected to view Stranger Things in the coming months and more households can also be expected to finish all eight episodes of Season 3. 

Including both pre-game and post-game programming, CBS (which broadcast Super Bowl LIII) offered seven hours of total Super Bowl LIII programming.  The company sold the average 30 second ad for $5.1 to $5.3 million dollars.  In all the network made approximately $500 million in advertising revenue from Super Bowl LIII.  The Super Bowl is the premier advertising event and Netflix probably couldn't charge as much per 30 second ad for Stranger Things as CBS charged for the Super Bowl.  Additionally, they probably wouldn't want to show as many commercials.

But with a comparable Super Bowl sized audience for Stranger Things, Netflix could be expected to make hundreds of millions of dollars in advertising revenue from Stranger Things Season 3.  To keep things simple let's assume Netflix could charge $200 million for ads on Stranger Things Season 3 over the next year.  How would that impact the bottom line?

To answer that question let's look at the most recent income statement from Netflix's most recent 10-Q:

Three Months Ended

March 31, 2019

March 31, 2018

Revenues

$

4,520,992

$

3,700,856

Cost of revenues

2,870,614

2,300,579

Marketing

616,578

536,777

Technology and development

372,764

282,310

General and administrative

201,952

134,612

Operating income

459,084

446,578

Other income (expense):

Interest expense

(135,529

)

(81,219

)

Interest and other income (expense)

76,104

(65,743

)

Income before income taxes

399,659

299,616

Provision for income taxes

55,607

9,492

Net income

$

344,052

$

290,124

As can be seen above, Netflix generated $4.5 billion in revenue in the first quarter of 2019.  The company earned just under $400 million in profits before taxes in the first quarter of 2019.  For it to make sense for Netflix to offer some advertising the revenue from advertising would have to be meaningfully greater than any loss of subscription revenue.  Here the company would have to crunch all sorts of data to try and decide whether or not to go forward with advertising.  They would also have to figure out the right combination of either reduced subscription prices versus lost subscribers, and how often to show ads.

I was an early adopter of High Definition Television.  I had this huge TV with a great picture, and almost no programming to watch.  I spent a lot on my equipment easily justifying the $16 a month that the early adopters of 4K Ultra HD subscribers are paying for Netflix.  As a former early adopter I know the vast majority of Premium subscribers for Netflix are not going anywhere, because they have very limited other options available to get quantity and quality 4K Ultra HD content. 

Hence, I don't really believe as many as 23% of Netflix subscribers would actually quit if they saw a few ads per show.  I do believe that 23% of subscribers would answer the question that way and mean it, but when it came time to quit many of them wouldn't.  But no one knows how many.  Therefore, for simplicity sake, let's assume Netflix loses 10% of its subscription revenue if it offers advertising.  So if they lose $450 million in subscription revenue per quarter, then they would have to generate more than $450 million in advertising revenue per quarter to justify making the switch. 

It has already been demonstrated that Stranger Things Season 3 alone could potentially generate $50 million per quarter in advertising revenue based on its huge Super Bowl sized audience ($200 million/4 quarters).  Stranger Things is not the only popular program on Netflix.  I already mentioned I am eagerly watching three additional shows.  Not to mention all of the other content I watch on Netflix.  

Netflix has over 4,000 movies in its library.  Some are popular recent releases and some are obscure.  There are currently over 1,700 TV shows, like Stranger Things, in Netflix's library.  Some are very popular and some are not.  There are currently over 1,100 documentaries in Netflix's library.  Along with stand-up comedies, concerts, etc. Netflix currently is offering around 7,000 different program options.  In order to generate $450 million in advertising revenue, then Netflix would have to average approximately $64,000 per quarter per program.  Many programs have dozens of episodes.  This average would be based on an entire show like The Office, and not on each individual episode of The Office.

Many of these program titles couldn't generate the average of $64,000 in advertising revenue per quarter.  But the most popular shows, like Stranger Things, would easily generate the bulk of the revenue.  In order for Netflix to generate $1 billion in additional advertising revenue, then the average title would have to generate an average of around $143,000 in advertising revenue per quarter.  If Netflix were to be able to average $1 billion in advertising revenue per quarter, then they could more than double their $400 million in profits before taxes.  This would be because Netflix would gain $1 billion in advertising revenues per quarter and lose $450 million in subscription revenues per quarter for a net gain of $550 million in profits per quarter (based on the above assumptions).

Netflix can still offer investors upside versus the market as a whole.  The company is worth buying now even if they never pull the trigger on offering advertising.  If Netflix were to offer advertising, then the stock may be worth much more than it is currently trading for because of its potential enhanced profits.  The opportunity to generate substantial additional revenue from advertising will probably be too much for management to resist in the long run, despite their past statements of never offering advertising.  Investors interested in buying Netflix should do their own due diligence.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.