Netflix's decision to explore an advertising-supported subscription model in the face of customer losses did not come as a huge surprise. Though the streaming giant has been resisting the idea for years, it's been slowly backed into that corner, finally forced to follow the lead of premium competitors, including Hulu, HBO Max, Peacock, Paramount+ and Disney+, which already offer ad-supported, lower-cost streaming subscriptions.

Netflix has yet to formalize how it will pursue an ad-supported model, but analysts are already starting to weight in and speculate on what it all might mean. While it's clear that a less expensive, ad-supported offering could expand its addressable market, there are concerns that Netflix also runs the risk of cannibalizing its existing base.

Figure 1: Netflix is exploring an ad-based model, but has not yet said how such an option might undercut the prices of its existing, ad-free tiers.
(Source: Netflix)

Netflix's "throwaway line" about advertising during this week's earnings call was likely meant to grab attention, MoffettNathanson analyst Michael Nathanson surmised in a research note (registration required). That it did. Nathanson this week cut his price target on Netflix to $245 (down from $350) and kept his "neutral" rating on the stock. He now expects Netflix to add 11.7 million net new subs in full-year 2022, down from a previous estimate of 20 million, and dropped his 2023 subscriber estimate (from 20-25 million to 15-15.5 million).

"Now comes the tricky part," explained Nathanson, who is somewhat baffled that Netflix didn't jump into the ad game earlier if only to limit the revenue growth of its competitors. "How will the company introduce an ad tier without cannibalizing their subscription revenues? How and where will they go to market? What are the costs of building out this endeavor?"

Build or buy?

Netflix has left those questions unanswered. For starters, it's not clear if Netflix, which will undoubtedly have to build out an ad team, will build or buy its advertising infrastructure.

Colin Dixon, founder and chief analyst at nScreenMedia, said Netflix has already implied it will likely work with partners for both the ad-tech infrastructure as well as the ad sales component.

Brett Sappington, vice president at media, entertainment and technology research and analysis firm Interpret, speculates that Netflix could jump-start the effort by acquiring an ad-tech company and perhaps pursue deeper ties with global brands, such as Samsung and LG Electronics – TV-makers that already have a working relationship with Netflix from a platform standpoint.

And it's unlikely that Netflix will blanket the global market right away, given that ad networks are not consistent region by region and sometimes country by country. Plus, the company tends to test or phase-in new capabilities and technologies in individual markets first before broadening rollouts, Sappington points out.

Dixon isn't super concerned about the cannibalization risk Netflix faces with the addition of ad-supported tiers, noting that Hulu has had success using ads to make up for subscription revenues it loses when customers shift from the ad-free tier to the ad-supported tier. "If they [Netflix] do it right, you should actually see revenue go up," he said.

Late, but perhaps not too late to the ad party

Though Netflix will be in the uncharacteristic position of being late to the party when it comes to advertising, Dixon believes the company can make a strong go of it. And he advises that Netflix, which has full control of its platform, should strive to get something stood up within a year.

"I don't think it's too little, too late," he said. "If I'm an advertiser, I totally want to reach that audience."

But he does acknowledge that Netflix will be getting into the ad-supported model in some markets that are already subscriber-saturated. "In developed markets like the US and UK ... everybody who wants Netflix pretty much has got it," Dixon said. "It was inevitable that we'd reach this day in the US and some other markets. You've got to do something to alter the deal. That's all they're doing."

Still to be determined is how many Netflix existing customers might downgrade to a less expensive ad-supported tier, and how many non-Netflix subs (including the tens of millions who are accessing the service through password/account sharing) will find a new ad-based offering attractive enough to finally buy in.

"It's risky in terms of how many people actually switch over to a lower cost option. And it's risky if they calculate wrong," Sappington said.

Though some big questions about Netflix's ad strategy are still being ironed out, Sappington also believes Netflix already has some favorable pieces of the puzzle in place. One is a deep library of original content that stands to get some fresh legs with customers who opt for an ad-supported tier that are also brand new to Netflix.

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— Jeff Baumgartner, Senior Editor, Light Reading