Ad-supported plan likely to be profitable for Netflix (NASDAQ:NFLX)

Marvin Samuel Tolentino Pineda

Why do I see an opportunity here?

I value Netflix (NASDAQ:NFLX) a cautious purchase. The ad-supported plan has the makings of one of the few moves that could revive Netflix’s prospects. It is the announcement of October 13, 2022 detailing the plan revealed some different traits of a masterful and potentially revolutionary pricing strategy. Because economics will be important to the business and pricing strategy is critical to the company’s success or failure with this move, this meets my criteria for the rare situations where I will offer a view. Furthermore, this is a masterful example of the use of “pricing power” that does not lie in forceful price increases. Rather, the pricing power here is to bring Netflix’s underutilized assets into “offer design” and monetize them accordingly.

While the stock is up ~35% or more from its lows, largely in anticipation of this move, at 21.5x P/E and 3.2x EV/sales, the stock is no longer a scary value if a rally materializes of growth. It’s cheaper than PayPal (PYPL), but has a higher margin/higher return on almost all metrics. And PayPal isn’t without doubts about growth, either. Although these names are found in different industries, these two have some notable similarities.

Basic math adds up to amazing earning potential

We will see in turn what Netflix “gives up” in this “cheaper” plan and what it gets in return. In short, we found that Netflix would be giving up $3-$13/month in potential subscription revenue to get 15 hours of ad viewing per household. The 15 hours of ad viewing should be worth at least $50/month in ad revenue, making for a delicious ROI.

According to compiled statistics, the average Netflix subscriber watches its content for 3.2 hours a day. (We will round to 3 hours to simplify the math.) The ad-supported plan, according to the ad, will come with ~5 minutes/hour of ads. For the previous 3 hours, that’s ~15 minutes of ads/day (per person). Assuming two users per subscriber household, that’s 30 minutes or 0.5 hours per day. For a 30-day month, this adds up to 15 hours/month of subscription ads.

Even compared to Netflix’s most expensive $19.99/mo plan, the new $6.99 ad-supported price point “saves” at most $13/mo, while forgoing other premium plan benefits. Let’s assume that the ads are generous 30 seconds/ad, which means that one hour of ad viewing would mean seeing 120 ads. Let’s further assume a CPM of $30 (Hulu’s CPM is reported around $30, ranging from $20 to $60 depending on the ad). CPM stands for cost per thousand impressions, which means that each ad viewed would generate around $0.03 in revenue for Netflix. Those 120 ads per hour of ad viewing would generate around $3.60 per hour viewed. And we estimate about 15 of those hours per subscription on the ad-supported plan, which brings in about $54/month in ad revenue.

Here’s one thing to note: Hulu is two-thirds owned by arch-rival Disney (DIS) and it looks like a particularly apt comparable. However, I am not an ad rate expert, and the assumption that Hulu/Netflix CPM rates would be an “apples to apples” comparison could be open to question.

Netflix itself sheepishly admitted that it does not plan to lose money on the “downgrade” of subscribers. according to The Wall Street Journal:

[Netflix COO Greg] Peters declined to say how much of Netflix’s existing subscribers he expects the company to switch to the ad-supported tier, but said he expected revenue from ad-supported tier subscribers to be equal to or greater than that of the comparable ad-free plan.

If the above math is half correct, then Peters is seriously underestimating the case. This is not surprising. For one thing, executives don’t get paid to over-promise, so sandbaging is common. More importantly, as discussed in the section on behavioral economics biases below, the likelihood that Netflix will achieve wide adoption of this revenue-generating plan benefits from keeping the focus on what users earn (a lowest price) and make Netflix’s own profits (by “charging” users in time/ad impressions) as forgettable as possible.

Two types of “adopters” of the ad-supported plan would be immensely enriching. First, users downgrading from the $9.99 “basic” plan would “cost” Netflix just $3/month in lost subscription revenue, versus $50+ in ad revenue. That’s one hell of a trade. And, two, new subscribers “upgraded” by sharing passwords or feeling the service was too expensive and making the jump would generate $6.99 in new signup revenue and hefty ad revenue.

How many buyers will Netflix find?

Again, even if we cut our math by 50%, the number of adopters of the ad-supported plan becomes one of the, if not the, the most important KPIs for Netflix profitability almost overnight. Unless, that is, the acceptance isn’t material enough to matter. So, we looked at why we think Netflix will find enough takers in this plan to deliver a significant profit improvement.

Behavioral economics: tailwinds for adoption

It turns out that a surprising number of consumer choices come down to behavioral economics: the subconscious biases that entice us all, largely unconsciously, to make decisions in predictable (and often irrational) ways. Netflix’s move here harnesses some of the strongest insights from behavioral economics to present an option that will look appealing to significant segments of consumers.

First, Netflix is ​​masterfully rolling out a framing effect. Framing takes advantage of consumers’ propensity to make decisions based on comparisons framed as gains or losses. Here, the most obvious comparison every consumer will make is to previous Netflix plan options, and in particular for current subscribers, to the plan they’re already on. The main price differential will be perceived as a substantial gain in favor of the new plan. This will be particularly true for very price-sensitive consumers, the ones who are probably considering going without a Netflix plan altogether (shaken). Wouldn’t it be a stroke of genius to turn what could have been a turnover not just into retention, but into a plan that is dramatically more profitable?

Second, another well-documented bias from Behavioral Economics 101 will also be activated: the availability bias. This will ensure that all the “losses” (having to watch ads, not having access to the full content library, etc.) are easily outweighed by the much easier to remember and cognitively assess “gain” of the price differential. Let’s face it, few Netflix users will do the math on ad viewing that we did here. It is cognitively “slow” (as described in Daniel Kahneman’s Nobel-worthy book Thinking Fast and Slow). It’s also tiring, as is remembering the ways the new plan is “feature deprived,” or checking to see if your favorite shows are in the excluded content. Although many users will in fact do the latter, this is highly correlated with perceived high value of specific programs, which should drive willingness to pay and a renewed appreciation of existing plans.

Third, another bias in psychology that can have a tailwind effect for Netflix is ​​reciprocity, based on price-sensitive consumers who are not yet subscribers feeling that Netflix is ​​finally “finding them in the middle.” on the way” with its “most affordable” plan. In one of the most influential books on sales and marketing, Influence: The Psychology of Persuasion, Robert Cialdini uncovered the extraordinary power of reciprocity to drive behavior and influence. Users in the more price-sensitive market segments might well perceive this plan as a “gesture” to them from a beloved brand. These segments could also, all things being equal, feel less taxed for time spent watching ads.

Similarly, those password sharers who have already felt a bit guilty about the phenomenon in the press, and who are worried about Netflix’s stated goal of cracking down, may also feel it’s time to reciprocate for all years. of freeloading, and for Netflix to finally get in their way too. These may be optimistic versions of human nature, but every ounce of hope in the new battle for subscriber growth helps Netflix.

Why caution is still warranted

The fact is that pricing, masterful as it may be, cannot replace value creation through superior products and services. Netflix must continue to deliver great content at a rate equal to or greater than that of its formidable competitors.

Furthermore, if the economy continues to slide into a recession, or if inflation continues to eat into the budgets of the price-sensitive consumers who are the blind target of this shift in pricing strategy, Netflix and others could feel the collective belt of consumers. squeezing the new plan will help, but it can’t make up for long if existing Netflix subscribers continue to shrink.

Last but not least, the cost of acquiring or producing top-tier content could well adjust and scale with the success of Netflix (witness the ever-increasing prices of sports TV rights elsewhere). A portion of the profits Netflix makes here will have to be spread across its cost structure.

conclusion

I would consider diving into Netflix stock and writing covered calls here, especially if the stock falls back to $200. Moves in price strategy like this usually take a bit of time to work their way through a company’s trades. , and there is a possibility of some cutbacks now that the news finally breaks and the recent rise needs to consolidate.

In upcoming news or earnings, any comments about faster or slower-than-expected adoption, or the real economics of this plan, could become a major catalyst in either direction. But there’s too much to like about this move not to think that the odds are tilted in Netflix’s favor for this plan to be a success.

Finally, when writing about biases that influence behavior, it’s a good habit to make other people aware that no one is immune, including me. Therefore, any reader should consider that helping companies win with prices is what I do, so when I see what I think is a winning price move, I might be predisposed to like it more than the average investor.

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