April 2022 was a month of reckoning for streaming service provider Netflix, Inc. (NASDAQ: NFLX).
For the first time in over a decade, Netflix reported a loss in subscriber count.
Mercilessly, investors immediately sent the stock price plunging by 35.1%.
It was during this same quarter that CEO Reed Hastings announced the launch of advertising on its lower-priced plans.
This ad-supported tier functions as a new business model known as Advertising-based Video on Demand (AVOD) as opposed to its previous ad-free Subscription Video on Demand (SVOD).
AVOD, otherwise termed by Netflix as Basic with Ads, was officially rolled out in November last year in 12 countries along with substantial advertising spend.
To stay competitive, Netflix pegged many aspects of its ad-supported tier such as price and advertising duration closely against its competitors.
We attempt to evaluate whether advertising will bolster the company’s subscriber count and revenues amid rising competition and in the absence of COVID-19 tailwinds.
Basic with Ads looks expensive
Netflix expects its advertising business to eventually comprise at least 10% of total revenues.
Given its market leadership, the streaming giant has an aggressive asking price of US$65 per thousand viewers (cost per thousand or CPM) which is significantly higher than what its competitors are asking for.
Advertisers can expect the CPM to eventually increase to US$80.
Furthermore, Netflix has been relatively restrictive on its suite of offerings to advertisers.
For instance, advertisers are afforded very limited targeting and measurement options.
This makes it harder for marketers to determine if their return on advertising is positive, potentially encouraging advertisers to choose another streaming platform that allows for ad curation and feedback at a lower CPM.
The drawback of choosing other AVODs is the lower subscription numbers of alternative platforms, which is becoming less important to companies as there are other metrics beyond impression or reach when devising a marketing plan.
Conflicting value proposition for advertisers
Apart from CPM and features such as targeting and measurement, marketers should ensure that their messages reach the right demographic.
This is where Netflix’s outreach to advertisers may demonstrate inconsistencies.
Early sponsors of Netflix’s foray into AVOD include luxury brands such as LVMH Moet Hennessy Louis Vuitton SE (EPA: MC).
However, subscribers who opt for AVODs are typically price conscious.
Faced with rising global inflation and economic uncertainty, it remains to be seen if this segment of audience will eventually level up to become consumers of premium goods and services.
As such, initial interest from these luxury brands in Netflix’s ad inventory may fade over time if their ads do not gain traction.
What investors may look out for
Introducing AVOD may lead to the cannibalisation of Netflix’s other plans – a concern among many investors.
In particular, the Basic tier is most susceptible to cannibalisation.
There have been attempts to minimise this cannibalisation by limiting resolution and library size, which have paid off thus far.
Since Basic with Ads was released in November 2022, we look at this tier’s operating metrics for the fourth quarter of 2022 (4Q 2022).
The number of paid net membership additions grew far more aggressively in 4Q 2022 than in 4Q 2021, which may be proof of low cannibalisation rates.
This growth may also imply the budding success of AVOD in attracting new subscribers.
On balance, the average revenue per membership (ARM) fell quarter-on-quarter (3Q 2022 vs 4Q 2022) across all four regions.
In comparison, a 3Q 2021 versus 4Q 2021 comparison revealed that ARM had only decreased for two of Netflix’s four regions.
This is within expectation since the new Basic with Ads tier is the cheapest streaming option.
The movement of existing customers and addition of new customers to this lowest tier naturally weigh on ARM.
Hence, the addition of AVOD to the streaming titan’s business model may change the way we analyse the company.
Paid net membership additions may become a less valuable metric because of lower ARM which will, in time, lead to a lower contribution to overall revenue.
That said, it still boils down to whether AVOD can grow the business’ profit margins and free cash flow to be reinvested into creating new content, which is undoubtedly the largest value proposition of any streaming platform.
A mixed outlook
Netflix has cleverly built itself new growth levers by first restricting the options available to marketers and subsequently rolling them out with built-in enhancements.
Doing so provides Netflix with headroom to offer a better selling proposition to entice advertisers and justify higher CPMs over the longer term.
This is on the back of a huge advertising market worth over US$180 billion.
At the same time, there are also headwinds to grapple with.
Competition remains the largest challenge.
Not only is Netflix fighting against the likes of media giant Disney+, other entertainment sources such as linear TV, YouTube, and TikTok also vie for consumers’ attention.
The stiff competition impacts its AVOD business as advertisers assess audience overlaps among various marketing channels and whether promotional budgets should be focused elsewhere.
Get Smart: Still early days
It is still early days for Basic with Ads.
Regardless of whether one is supportive or critical of AVOD, it is imperative to remember that Netflix contains other moving parts.
Paid sharing is the other major initiative that the company is working on.
This initiative allows subscribers to share their accounts with people outside their household by paying an extra fee.
In time, it will be harder to discern if subscription numbers change due to AVOD, the launch of paid sharing, or reasons such as alternative entertainment sources.
For now, investors can try to put themselves in the shoes of both a subscriber and an advertiser.
Doing so makes it easier to weigh both perspectives, possibly arriving at a conclusion of whether adoption will outpace churn rates.
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Disclosure: Tan Ke Xuan does not own shares in any of the companies mentioned.