When Netflix (US: NFLX) Launched in 1997, it was an e-commerce platform for DVD rentals. In 1999, it moved to a subscription service where customers could pay for a flat rate in exchange for unlimited rentals. It wasn’t until 2007 that CEO Reed Hastings launched the online streaming service we know today. Initially, Netflix only aired other people’s shows, but in 2013, it started creating its own content upon release. Card castle.
Since then, the goal has been to produce massive amounts of content and attract as many people as possible to the platform. In 2013, cash on hand was $43.7m (£37.9m), but when the cost of production started to rise, cash was taken out of the business. In 2016, cash outflows were $1.58 billion and in 2019 they peaked at $3.14 billion. That wasn’t a problem, however, as interest rates meant capital was cheap and Netflix was adding more than 20 million customers a year.
The growth is now halted. In the second quarter (Q2), Netflix lost 1 million subscribers and the company expects to have fewer subscribers in the third quarter of 2022 than in the fourth quarter of 2021. Rising interest rates mean that investors are not value more growth at all costs. Cake now is better than cake later, and Netflix’s share price is down 63% for the year.
To appease investors, management promised to focus on free cash flow. The objective is to generate $1 billion of free cash flow in 2022 plus or minus a few hundred million fluctuations due to changes in exchange rates. Netflix believes its “multi-year evolution of its content model” is poised to deliver solid profitability and says it’s the most cash-intensive part of this transition.
It seems convenient that he’s been through the most cash-intensive part of the transition, just as the market turns sour. However, if we give Netflix the benefit of the doubt and assume everything goes according to plan, what will the new content model look like and how successful will it be?
Advertising is very profitable
After the disappointing first quarter results, Netflix announced that it would start selling advertising. The ad-supported subscription lets users pay less but then they have to watch ads. The ad platform was set to launch in 2023. However, The Wall Street Journal announced it was going to be moved to November 1, 2022, possibly to get ahead of Disney Plus, which is launching its own ad-supported platform in the US in December.
Netflix has partnered with Microsoft (US: MSFT), which will contribute to the technological and marketing aspect of the platform. Netflix’s ad-supported service would cost between $7 and $9 per month, down from the current subscription of $15.49. This means that Netflix expects to earn at least around an additional $7 per user from advertising per month – and on the face of it, that seems doable.
Sky, which belongs to Comcast (US: CMSCA), made $556 million in advertising revenue in the second quarter of last year and drew 22.7 million viewers. For every viewer every month, that equals $8.16. Netflix would likely be able to generate more than Sky as it will have more granular data on its viewers. When you watch Sky, the adverts you see are the same for everyone. Netflix may personalize advertisements based on historical viewing habits.
Hulu already offers an ad-supported service, which costs $6 a month, half the price of the normal offering. Determining the amount of ad revenue generated per customer from accounts is tricky. However, a New York Times A 2019 article stated that it reportedly brought in $15 in revenue per subscriber per month. This is almost double the number of Sky and shows how much more effective targeted advertising on streaming platforms is compared to traditional live TV. If Netflix could shift half of its customers (about 100 million) to an ad-supported subscription, it would increase revenue by about $900 million per month, a 34% jump from Q2 2022 numbers.
It is probably wise to revise this figure slightly downwards from 34%. To think that Netflix would earn as much as Hulu in 2019 is wishful thinking. First, demand for advertising space is expected to fall as businesses and consumers are squeezed by the cost of living crisis and recessions are expected in the US and UK. Second, the supply of ad space is growing as more companies look for ways to monetize people’s attention. With fewer ads for more commercials, the basics of supply and demand suggest that prices will come down.
As already mentioned, Disney Plus is launching its ad-supported platform in the United States in December. Meanwhile, the sports news site Athleticismwhich was acquired by the New York Times at the beginning of the year for 550 million dollars, launches announcements. Athleticism, with the backing of private equity, spent huge sums of money to hire the best sportswriters and offered endless discounts to increase subscriber numbers. It would have lost $55 million in 2021. Like all platforms, it was evolving but now it is monetized.
Even if we have to revise the 34% revenue growth down, there is still the possibility of a significant increase in Netflix revenue over the next few years. These estimates also assume that there will be no increase in subscriber numbers. The cheaper service could attract more customers and reverse last year’s decline.
Most people don’t give TV their full attention when watching it. Many keep an eye on their phone, either while gaming or texting their friends – the industry calls this “multi-screen”. Over 40% of Netflix viewers play games on their phones every month, according to Midia Research. Given this, commercial breaks won’t be as prohibitively expensive for customers. When the TV tries to sell them something they don’t care about, they can go back to playing whatever’s on the phone.
It’s a depressing situation, but the reality is that most people need constant stimulation. We are addicted to dopamine. Multi-screen allows viewers to be entertained at all times, regardless of the content on the main screen. This shift in media consumption habits means that people may be more inclined to accept advertisements than they were before, particularly if their budgets are squeezed by gas prices.
The game is not expensive and sustainable
The large crossover between Netflix watchers and mobile gamers is also part of the reason for the foray into gaming. If you want to charge your customers more money or suffer from annoying ads, you need to offer them more content . Ubisoft partnership announced this week allows Netflix customers to play Assassin’s Creed – Ubisoft’s most successful game to date – at no extra cost. For avid gamers, this is a big advantage.
So far, Netflix has struggled to get its game product off the ground. In the past year, Netflix has acquired three game studios and released 28 games, including one based on the popular show Stranger Things. Unfortunately, so far only about 1.7 million (or 1%) of Netflix customers have played it, according to Apptopia (via CNBC). However, the franchises that Ubisoft brings to the Netflix platform significantly enhance this offering.
The big advantage of games over video streaming is that they keep users interested much longer. Remember Tiger King from the first lockdown in 2020? Everyone was talking about it, but the hype soon died. animal crossing, a game made by Nintendo, also saw a huge surge in interest during the lockdown. However, as you can see from the Google Trends chart, it kept the American public interested for much longer.
This means that production costs per hour of user consumption are lower for games than for video. On top of that, games also generate more revenue from users than video. The average revenue per hour for games was $0.56 compared to $0.43 for online subscription video, according to Ampere Analysis. Gaming is a higher-margin business than constantly having to produce expensive shows that consumers then binge on over a weekend.
Moving away from paid-only video streaming is a good idea for Netflix. Advertising and games are much more effective ways to monetize user attention. The problem is execution. If Reed Hastings is successful, then the 63% drop in share price this year is a great buying opportunity for investors.
The concern is that the sudden announcement of ads right after Q1 results smacks of panic. You would prefer management to be proactive rather than reactionary. However, any writer will tell you, pressure is needed to sharpen the wit. At this price, it’s worth betting that a dose of panic is exactly what Netflix needed.