Back in July, I said Netflix (NASDAQ: NFLX) stock would benefit if the company added advertising to its platform. Now that Walt Disney (NYSE: DIS) has successfully launched Disney+, Netflix really needs those ads.

NFLX stock is down 15% since that column was published. Netflix can’t compete with Disney and other services on price. And NFLX is paying too much for content to give it away so cheaply. Unless Netflix adds a free or cheap ad-supported tier soon, Netflix stock could be in trouble.

Why NFLX Stock Needs Ads

Needham analyst Laura Martin recently took a deep dive into Netflix’s 2020 outlook, based on its current prices. Martin estimated that Netflix would lose 4 million U.S. subscribers next year unless it makes changes to its subscription pricing. Martin says there is simply too much viable competition in the $5 to $7 per month range. Netflix’s standard tier costs $13 per month. Disney, Apple (NASDAQ: AAPL), Hulu, ViacomCBS (NASDAQ: VIAC) and NBC all have streaming services that cost $7 or less per month.

“Since NFLX’s balance sheet cannot withstand lower revenue (in our view), we recommend a 6-8 minute/hour ad load to supplement a $5-$7/month consumer fee,” Martin says.

NFLX stock bulls may believe Netflix can replace those lost domestic subscribers with international ones. Unfortunately, not all subscribers are created equal. Martin estimates U.S. subscribers are three times more profitable than overseas ones. Many new international subscribers are choosing Netflix’s $3 monthly mobile plan.

In other words, Netflix has two choices. Its first choice is to  add four international subscribers for every domestic one lost. That trade off would allow it to merely maintain its current revenue.

Budget Tier

The other option would be to add a lower-priced tier that is partially supported by ads. Martin estimates it would need to cost around $5 to $7 per month. Six ads per hour times two hours of average viewing time per day would result in about $6 per month in ad revenue from each U.S. subscriber.

Investors seem to understand how valuable domestic subscribers are. In the second quarter, Netflix reported a 126,000 decline in U.S. subscribers. Netflix stock immediately dropped 10%. Martin says Netflix can’t suffer U.S. subscriber losses and expect NFLX stock to maintain its current valuation.

Martin estimates NFLX stock is currently trading at a 2020 enterprise value-to-revenue multiple of above 7.2. That type of valuation is only reserved for the hottest growth stocks.

“If U.S. subs fall and/or rev growth decelerates, NFLX would be revalued downward…, in our view,” Martin says.

The Valuation of Netflix Stock

Today NFLX stock trades at an enterprise multiple of 64. DIS stock trades at an enterprise multiple of 19.8. If NFLX stock traded at Disney’s enterprise multiple, its share price would be around $110.

Martin has an “underperform” rating and no price target on Netflix stock. However, she says NFLX stock would look “more attractive” at around $260, or about 22% below its current price.

Of course, NFLX’s outlook would change dramatically if it launched an ad-supported tier. Unfortunately, management has insisted it is not open to ads.

Some analysts strongly believe Netflix doesn’t need ads. Pivotal Research analyst Jeffrey Wlodarczak says Netflix will add 2 million net new U.S. subscribers in 2020 without ads. He also says both Netflix and Disney+ can coexist in the U.S. market, since Disney is targeting families with kids under 13. Wlodarczak has a “buy” rating and a $425 price target on NFLX stock.

Looking Ahead

As I’ve said before, I’m skeptical about the notion that a significant number of U.S. subscribers will immediately cancel their Netflix subscription in favor of Disney+. For now, Americans are happy carrying a $13 Netflix subscription, a $7 Disney+ subscription and a $13 Amazon Prime subscription. The economy is booming, and people have money.

When the next economic downturn comes, which of those three services will Americans cut first? They aren’t giving up their Prime Delivery. Are they going to  eliminate the $7 Disney+ subscription and make their kids throw a tantrum? Or are they going to cancel their $13 Netflix subscription and get by with Prime Video and Star Wars?

If Netflix wants to avoid losing market share (and market cap) to Disney when times get tough, it may need to give its subscribers a lower-cost alternative.

For now, Netflix stock is doing just fine. It’s trading at a nosebleed valuation, but it’s putting up the growth numbers to justify it. However, if Netflix’s lack of a budget-tier subscription starts costing it subscribers when the economy sinks, the valuation of NFLX stock will move closer to that of DIS stock.

As of this writing, Wayne Duggan did not hold a position in any of the aforementioned securities.