Is Netflix’s Ad Strategy a Danger for Investors?

As Netflix (NASDAQ:NFLX) looks for new ways to grow earnings and revenue after a disastrous loss of subscribers earlier this year, the company has turned to the legacy model of inserting ads into movies and TV shows.

 

Investors are split on whether this strategy could help the stock regain lost ground or cause it to fall even further. Is the strategy a danger or a genius revenue growth lever?

 

Netflix’s plan to create an ad-supported tier comes in response to rising competition from other streaming providers and a troubling loss of subscribers this year.

 

Under the plan, Netflix will create a cheaper subscription tier that will cost $7-9 per month and generate additional revenue from advertisements.

 

This tier will not include the entire Netflix catalog, though the company has yet to release full details on what content will be available.

According to Netflix’s estimates, the ad-supported tier will add about half a million subscribers from its planned debut in November through the end of the year.

 

In episodic series, the ads will run throughout the content at a rate of about four advertising minutes in each hour of watch time. For films, the ads will play as a preroll before the beginning of the movie.

 

Although supporting a cheaper membership tier with ad revenue seems like a good idea on paper, it could present several problems for the already embattled company.

 

To begin with, there seems to be a substantial gulf between the planned cost for ads and what the market is likely to bear. Netflix intends to charge $65 per thousand views and require a $10 million minimum spending commitment. This puts Netflix’s pricing at a much higher point than most of its competitors.

 

Netflix’s ad strategy also doesn’t include the ability for advertisers to target their ads based on geography or demographics. This could put it at a substantial disadvantage to other streaming services exploring ad-supported models. Disney+, for instance, plans to sell untargeted ads at around $50 per thousand views and upcharge for better targeting.

 

Another serious impediment to the plan’s success is the lower level of service subscribers can expect with the ad-supported plan.

 

As noted above, those using the ad-based tier will only have access to some of Netflix’s content. Users who subscribe to these plans also won’t be able to download content to their devices. As such, these users won’t have the option to watch Netflix offline.

 

Finally, there’s the question of pricing when compared to other streaming services. At $7-9 per month, Netflix’s new plan won’t be appreciably cheaper than the introductory plans offered by other streaming services. As such, it’s an open question as to how many new subscribers the company will gain by offering an ad-based plan.

 

Investors disagree widely on the effects that the new ad strategy will have on Netflix stock.

 

On the bull side, Netflix believers argue that the company will produce strong growth in earnings, revenue and subscribers with the ad-supported tier. If the company’s projections regarding adding new subscribers with this plan prove accurate, there could be some merit to this argument.

 

On the bearish side, some argue that ads could turn viewers away from Netflix and fail to generate appreciable revenue. There is, of course, good reason to believe this view.

 

Streaming customers now have many options, and the high pricing Netflix has suggested could make it less likely to attract advertising partners. To some extent, Netflix itself seems to believe that viewers won’t be receptive to ads. The lack of targeting and the 4-minute limit per hour of content are clearly calibrated to reduce negative reactions from subscribers.

 

Ultimately, the truth is probably somewhere in the middle. It appears unlikely that Netflix’s shift toward ad-based revenue will not be actively dangerous to investors. With that said, it also doesn’t seem as though it will be particularly helpful in getting the company back on track.

 

Supporting this view is the fact that the median analyst price target for Netflix over the next year is up just 3.8 percent over the current price. Even taking ad revenue from the lower subscription tier into account, analysts don’t appear to believe that Netflix will advance to higher prices this year.

 

There’s also a possibility that subscriber losses could continue as competition in the streaming industry becomes ever more intense. In this scenario, Netflix would likely continue to lose value irrespective of advertising revenues.

 

So, while ads probably aren’t dangerous to Netflix, there’s also little guarantee that they will solve the company’s problems.

 

Netflix’s challenges aside, there is a value argument to consider when deciding whether to buy or hold Netflix.

 

Today, the company trades at about 22 times expected earnings. While fairly high, this multiple is nothing compared to the ratio’s historical average. Netflix is currently trading at the lowest earnings multiples since the early 2010s, suggesting that there could be an opportunity in the stock.

 

Needless to say, slower growth is baked into these prices. In the next five years, analysts expect Netflix to grow at just over 9 percent annually. Though it doesn’t fully justify the stock’s current valuation, this growth rate could prove to be too low if Netflix can find ways to improve subscriber retention.

 

Overall, Netflix looks like a stock to hold, but it probably isn’t a buy at current prices. While it is trading at much lower multiples than usual, growth has also slowed down significantly.

 

Investors who already hold the stock may be rewarded with better prices if Netflix’s attempts to improve its business succeed. With stocks rapidly selling off, however, investors who are holding cash and looking for buys will likely have better opportunities than Netflix during this period of heightened volatility.

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