Up to this point, Netflix (NASDAQ:NFLX) has been a smash hit operating on its paid subscription model. NFLX stock has been one of the best-performing stocks of the bull market, up 136% in the past two years, while the S&P 500 index gained a bit more than 21% in the same 24 months.
However, there’s still plenty of room for the company to improve its business.
Over the years, Netflix management has been adamant that they will not run advertising during their programs. But content costs are skyrocketing, and Netflix already has trouble generating positive cash flow. The company may already be feeling the pressure to run ads. Nomura Instinet analyst Mark Kelley recently took a deep dive into what Netflix advertising would look like and how it could affect the company’s bottom line. In a nutshell, ads may be a win-win for NFLX stock and even for Netflix users.
Hulu’s Ad Business
One of the major selling points for Netflix testing its own ad-supported subscription tier is that it has a template to follow in Hulu. Now controlled by Disney (NYSE:DIS), the platform’s standard ad-free streaming plan costs $11.99 per month. That’s $1 cheaper than the standard $12.99 Netflix plan. Hulu also offers a $5.99 ad-supported subscription tier. Using that pricing as a guide, Netflix could potentially charge $6.99 for its own ad-supported tier. Kelley says Netflix could also choose to offer its ad-supported tier completely free of charge, like network TV.
If Netflix models its ad-supported tier after Hulu, users can anticipate nine minutes of ads per hour. That quantity is about 30% less than the 14 to 16 minutes of advertising typical of linear cable TV. Kelley said Netflix may also start out playing it safe, only incorporating about five minutes of ads per hour.
Massive Opportunity for NFLX Stock
Kelley estimates a free, ad-supported Netflix tier could add nearly 20 million additional U.S. subscribers by 2021. Netflix users watch an average of about 1.2 hours of content per day. Using Hulu’s cost per thousand (CPM) of about $20, Kelley estimates an ad-based Netflix tier could generate $1.3 billion in ad revenue per year. Given the new tier would also come with higher content costs, an advertising sales team and additional bandwidth requirements, the Nomura analyst says the service could add about $700 million in net revenue annually to Netflix’s bottom line.
An extra $700 million in cash flow per year could go a long way in helping Netflix reduce its reliance on debt. The company currently adds about $4 billion in debt annually. In addition, Kelley says an advertising tier could also help shorten the timeline for Netflix to become cash-flow positive. The NFLX cash burn has been troubling investors for years. Heavy investments in global expansion and content will likely keep cash flow negative for at least another couple of years. But advertising could take a $700 million bite out of that annual cash deficit.
Impact Of Advertising
Of course, an ad-supported tier doesn’t come without its risks for Netflix stock. The biggest potential risk to a free ad-supported tier is that paid subscribers would downgrade. Kelley estimates Netflix users most likely to downgrade to a free ad-supported tier are those currently subscribed to the $8.99 basic tier, or about 10% of Netflix’s total current user base. Kelley says losing these paid subscribers to an ad-supported tier isn’t a major concern.
“Our framework results in an average ARPU of ~$7.33/mo for ad-based users in 2021, not drastically lower than the Basic subscription cost of $9/mo,” Kelley wrote recently in a note to clients. In other words, downgrades from the basic tier to the ad-supported tier will mostly pay for themselves.
At the end of the day, Kelley says the positives to advertising outweigh the negatives when it comes to NFLX stock.
“Even though Netflix has been adamant that they will not add an advertising platform, we think this is something they should consider and would be a net benefit to the financials and therefore the stock,” Kelley says.
Netflix’s growth has been impressive, but it won’t go on forever. The company may soon be forced to look for other ways to monetize its user base. Advertising is a natural first step.
As of this writing, Wayne Duggan did not hold a position in any of the aforementioned securities.
