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For Netflix, advertising is the elephant in the room
The company has an opportunity to unlock significant innovation
With its enviable subscriber model and market share, Netflix has been one of the mass-media industry’s biggest advertising holdouts. On one of its investor pages, it clearly states, “We don't offer pay-per-view or free ad-supported content. Those are fine business models that other firms do well. We are about flat-fee unlimited viewing commercial-free.”
That’s why tongues were wagging wildly this week when Chief Financial Officer Spencer Neumann seemed to suggest that Netflix had not completely closed the door on advertising. Disney had just announced that it would begin offering an ad-supported video-on-demand (AVOD) tier later in 2022, which the company hopes will help it reach 230-260 million subscribers by 2024. That move left many wondering if Netflix would — ever — follow suit, and the topic unsurprisingly came up at Morgan Stanley’s 2022 Technology, Media & Telecom Conference.
“It’s not like we have religion against advertising, to be clear,” Neumann said at the event. “But that’s not something that’s in our plans right now … We have a really nice scalable subscription model, and again, never say never, but it’s not in our plan.”
This may be the first time that a Netflix executive has broken ranks on the advertising question. CEO Reed Hastings has seemed pretty adamant that Netflix wouldn’t pursue this route, despite its estimated $16 billion in debt and the billions of dollars it spends on content creation every year. In 2021, Netflix poured $17 billion into content, and that is expected to grow to $19 billion in 2022.
Netflix has 221.8 million global subscribers, and it is the No. 1 streaming service in the US with 25 percent market share in Q4 2021. However, that’s a 2 percent drop in share compared to the previou quarter, and global demand for its digital original series fell below 50 percent for the first time in 2021. Its subscriber growth appears to be slowing. Netflix gained 8.28 million subscribers in Q4 2021, just shy of Wall Street expectations of 8.3 million, and even lower than the company’s own forecast of 8.5 million. Netflix only expects 2.5 million “net subscriber adds” in Q1 2022, far lower than the 7.25 million subscribers forecast by analysts, which recently sent its stock stumbling. Part of the calculus in that lower subscriber forecast: a price hike in the US and Canada. The company also stated that streaming competition “may be affecting our marginal growth some.”
Any company with a sizable audience — which today typically means several million people — has to think about its advertising options at some point, even Netflix. Advertising is why the concept of retail media even works in the first place, because retailers with large audiences realized, “Wait a minute. Why aren't we monetizing all of these people?” Advertising is the elephant in the room: If you have a big audience, you need to/owe it to your investors to at least game out what an advertising offering for your platform should look like sooner or later.
In Netflix’s case, the business case for advertising would seem to only be getting stronger, especially as its competitors, including HBO Max and Disney+, continue to mature and present compelling ad-free and ad-supported offerings. When it comes to the number of subscription services consumers will have, we always look to the Rule of Threes approach, which we’ve previously written about. We expect that consumers will have a clear preference for about three subscription services that they are willing to pay for, with the rest being long-tail. Among weekly Netflix users, more than half subscribe to three or more video streaming services, according to Civic Science. The company's subscribers also tend to be using Netflix less frequently, but US adults are more likely to say that Netflix has the best selection of original content.
For a company like Netflix, which has been very successful with global customer acquisition, the question becomes whether it has hit its ceiling on subscriptions but could potentially grow in other subsidized ways of account expansion, particularly overseas where Netflix has penetrated roughly half of European households that have high-speed internet access, and about 15 percent of Asian homes. Outside the US, interest in streaming has different driving factors and isn’t necessarily fueled by cord-cutting to the same extent as it is in the US market.
Why we think advertising could be a hit on Netflix
When we picture ad-supported streaming, industry professionals readily gravitate to imagining all of the ad-supported tiers being the same TV-like experience (because we know that that’s where sizable advertising budgets still are). Everyone pictures pre-roll, midroll, and end-roll ads of some kind — the usual AVOD garbage.
When Facebook launched its advertising offering not that long ago, it didn't settle for standard-size IAB display banners — it created an in-feed unit that made sense for the platform. For AVOD, Netflix may have a similar type of opportunity to redefine the category.
What we find intriguing are the new innovations that Netflix could bring to advertising. Its subscribers are always authenticated, and Netflix is investing in more interactive content, including its recently announced “Trivia Quest,” an interactive daily quiz show. Maybe it has an opportunity to invent a relatively passive way of consuming ads on video and television content that doesn’t alienate its subscribers.
What if Netflix takes this opportunity to reimagine the advertising experience on its platform and use its vaunted recommendation algorithm to match subscribers with advertisements for which they have a higher likelihood of converting? For example, Netflix could use its recommendation algorithm to surface strong advertising that is personalized for subscribers, and the more ads they watch and interact with, the more content they could unlock. If you're not a subscriber but you want to watch “Extraction 2” in the week that it premieres, for instance, you could earn your screening by watching a certain number of ads from advertisers that want to pitch to you. We think that type of scenario makes more sense for a Netflix-like environment rather than a bunch of AVOD car ads that are landing on the screen because car OEMs are the only advertisers spending money at a given time.
Netflix controls the experience from end to end, since it is commissioning and producing so much content that it can weave in everything from product placement to quizzes on how many bottles of Coke were shown in a particular episode, which could gamify the experience and unlock new content for subscribers of an ad-supported tier.
And while we talk about more performance-oriented offerings, there could also be upper-funnel formats and metrics. “Extraction” was an extremely well-received movie with99 million viewers. What if a brand could buy the 15 seconds before “Extraction 2” loads in English-speaking regions around the world for the first three days after it’s released? That's a new type of ad inventory that really doesn't exist anywhere. It's also a conversation piece and a new level of scale and concurrency that we haven't seen before outside of the Super Bowl. What else could reliably command ~100 million viewers over a short period of time?
A change in marketing strategy
The CFO’s comments about advertising come at an interesting time for Netflix. It has a new CMO, Marian Lee, who will clearly need to mount some aggressive audience acquisition efforts immediately. Netflix and the streaming landscape look very different than when its previous CMO, Bozoma Saint John, joined the company in 2020. At the time, it appeared that the marketing strategy would be a very brand-focused push to highlight all of its award-winning movies and spectacular content.
But with the entry of HBO Max, Disney+, and Apple TV, a laundry list of competitors are spending tons of money and building up portfolios of sufficiently good content. As a result, Netflix is no longer the clear winner in the streaming game, although the user experience on Netflix continues to be superior relative to other offerings such as HBO Max (*cough* please fix your player, it’s buggy on every device *cough*).
That’s a readjustment from being the clear market leader and essentially personifying the entire streaming segment to now competing with three or four other leaders that are also carving out their own content paths. Netflix must also contend with customer attention spans, pressured share of wallet, and the ease of canceling a subscription and signing up for something else when a show you really want to watch is premiering on a competing platform.
As a result, branding gives way to proving, in a block-and-tackle way, the value of subscribing to Netflix versus competitors. If someone is price-comparison shopping, Netflix must ensure that would-be subscribers understand what they’d be receiving versus other services. It's less about brand awareness and back to its original performance-oriented go-to-market strategy with a focus of driving customer acquisition.
It’s also important to note that consumers are also refining their viewing habits. As Hastings has said, Netflix’s No. 1 competitor is sleep. People only have so much time to spend on entertainment, which today includes gaming, live streaming, podcasting, and other subcategories that are consumed through the same set of devices. We also have so much good content at our fingertips that consumers no longer have FOMO, even for shows that they have enjoyed. It’s hard to keep up with all the good content and new seasons. It’s an interesting yet fundamental challenge of this transition from content scarcity to content abundance, where there is always something new to discover. That creates less of an impetus for loyalty even among those who were previously reliably loyal.
That’s the key: Netflix's real path is understanding how and why loyalty may be changing for its customers so that it doesn’t have to reacquire the same customer every few months.
Designing the right advertising experience
If advertising were native to the Netflix platform, what form would it look like? As we said, the answer is probably not the standard units that can be bought programmatically in an open auction. We see more of an integrated native experience with custom units and more production work, which inherently focuses on advertisers that can execute on that type of approach. That's typically larger advertisers with bigger budgets, such as blue-chip brands, and their agencies that are managing their media spend.
What does that look like from a product perspective? And how do you articulate the results and value of this kind of advertising? This is an area where other platforms have struggled. We've written about Facebook's measurement challenges, for example, and how it has shared flawed results that advertisers use to make business decisions. If Netflix were to pursue an advertising route, it needs to ensure that it isn’t making the same mistakes since, by virtue of being a platform, it would also be checking its own homework. Netflix already has a history of creating metrics for its production partners, and it famously has a set of internal metrics it uses when it's courting people with content it wants to buy; it would need to design a set of metrics that it could share with its advertisers to demonstrate efficacy of spend. There is clearly expertise in the organization around metrics, which is crucial: If you're inventing a new advertising format, you must also invent the metrics to measure performance, which are ideally analogous to some existing measurement metrics, so that it's easier for brand partners to work across their existing media plans, rather than creating a separate budget for this new format and take on greater risk.
At the same time, when we talk about an addressable platform like Netflix, there is a natural desire to immediately talk about advertising performance, but maybe performance in a cost-per-action kind of way isn’t what we should be focusing on. Maybe it's more about matching the algorithm to understand that someone who's watched art house movies and the “Formula 1: Drive to Survive” series would be the right candidate for Volvo ads versus Hyundai ads. Maybe it should be more about whether the overall advertising experience can be better based on what Netflix knows about content, subscribers, and viewing habits and how that information can supercharge the strategy chosen by a given advertiser.
Since Netflix has a global audience, it would also run into the challenge where different advertising environments have varying restrictions and jurisdictions. We’re sure pharma companies would love to run ads in a brand-safe Netflix environment, which would be OK in the US but pretty much nowhere else.
But Netflix’s global customer footprint also represents target-right ad opportunities, especially with current technologies that can retool what is visible in the background in a given show, such as subtly promoting a beer that’s only available in Japan or North America. It already offers some product placement opportunities, and tailoring product placement to the local viewing experience using insertion solutions is an interesting advertising offering at Netflix's scale. Many Netflix subscribers are rabidly anti-ad, and some of the company’s experiments with promotional content of its own shows haven’t sat well with some segments. Still, more than a third of non-Netflix subscribers say they would be more likely to sign up for a free or lower-priced version, according to Civic Science. And other regions may be even more receptive to an ad-supported tier rather than paying for the service at full price. The consideration may be different, for example, in places that have excellent free TV options or cheap and ample cable offerings.
It's all about understanding where the next tranche of subscribers is located — and how Netflix can keep them entertained once they’ve subscribed.
Thanks for reading,
Ana, Maja, and the Sparrow team
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