Netflix Earning, Microsoft Ad Deal & Why Microsoft – A Possible Acquisition?

Table of Contents

Introduction

These are busy weeks as big tech companies roll out their earning reports. Netflix rolled theirs on July 19th and for the first time in history they lost subscribers for two consecutive quarters. They talked about the gain of approximately 1.3M subscribers in the Asia region and reiterated their mission to bring in ad-supported tiers to increase revenue options by providing cheaper subscription options in front of the customers.

A couple of weeks ago I wrote about “Netflix Ad Partnerships and “Stranger Thing” Effect“. It is interesting to follow a company during the stages of its transformation and understand how companies strategies with changing environments and landscapes. This provides a great learning opportunity for all of us to see how successful or unsuccessful this transformation is for Netflix. What are the lessons we can absorb and implement in our work from the Netflix story?

Today’s essay will focus on the latest Netflix earnings, the Partnership with Microsoft and How will ads work on Netflix.

Netflix earnings – Highlights and Commentary

Here is the video link to Netflix earnings – https://www.youtube.com/user/NetflixIR/videos

Q2 revenue grew by 9% driven by a 6% increase in membership and a 2% increase in ARM (Avg revenue per membership). Excluding foreign exchange, Asia Pacific revenue grew by 23%, as Netflix added 1.1M subscribers. EMEA revenue grew by 13%, while Netflix lost 800k subscribers in this region. Latin America revenue grew 19%, with no impact on paid memberships. US and Canada revenue increased by 19% with a net loss of 1M in membership count. Most of the increase in revenue is attributed to an increase in the ARM in all regions.

Netflix in the June quarter lost 1.3 million subscribers in the U.S./Canada region, and another 800,000 in Europe, while Latin America was flat. The losses in more mature markets were offset in part by 1.1 million subscribers adds in Asia. As Reed Hastings put it, “We’re talking about losing 1 million instead of losing 2 million, so our excitement is tempered by the less-bad results. Losing a million and calling it a success is tough. But really, we’re set up very well for the next year”. Here is the snapshot of the subscriber count over the last five quarters for Netflix.

Low expectations are a boon sometimes. If you fare better than those expectations you are treated as a hero. That is what Market did to Netflix. Less bad results were celebrated as Netflix shares rose 8%. What we missed was an important distinction that NA and EU subscribers are more important than Asian subscribers, where subscription prices are very low. You can see from the chart below that ARM for the USCAN region is almost double that of the APAC and LATAM regions. The net increase in revenue will be lower than expected. Especially considering the strong dollar value against other currencies.

Average Revenue by Membership (by Region). Source: Company Data

Netflix stressed its goal to curb password sharing. Netflix has launched two different approaches to control password sharing. One is adding a member and the other is adding a home. Depending on your plan members will be able to control who gets access to their Netflix account. Netflix has started testing both options on a trial basis in Latin America. They plan to roll out to the entire population sometime in 2023.

Additional Commentary

Two things I want to add here, (1) the impact of the recession and (2) Price sensitivity around Netflix tiers.

Impact of recession on Netflix business

In-home entertainment has proved to be recession-proof, at least in the US. In fact, most forms of entertainment have been resilient to downturns. There is a level of escapism that entertainment providers. During recessions, you try to cut out expenditure on goods and services outside the house. In-home entertainment keeps you alive.

The big question is, with so many in-home entertainment options which one will customers stick to. As I have said in the past essays “3 problems faced by OTT/entertainment industry and why gaming is a potential solution“, the use case here is not to build a better product that competes with other services. But to build a product that catches users’ attention and gets you the most of their 24 hours in a day.

We all know subscription pruning is real, during the recession will cut down expenses on goods and services, cut down on travel, and will do a staycation. Entertainment will be the primary driver to keep everyone busy. Cable TV survived subscriptions in the 2008 crisis, although they were hit hard by poor ad revenue. In today’s world, it will all be about user acquisition. With so many services it’s always going to be an option for the customers to keep switching subscriptions based on their viewing needs.

Price Sensitivity around Netflix tiers and ads

Netflix knows there is price sensitivity around their product. Review this statement first from Greg Peters from the Netflix earning Q&A session.

Yes. I would say, in general, we know that there’s price sensitivity around consumers. And that — some of those consumers are folks that have never actually ever signed up for Netflix. Some of them are folks that were members for us for a period of time and they decided to cancel for a variety of reasons. Some of those are folks that are currently watching Netflix, but they’re using another paying member’s account credentials, right? So those all, I think, represent opportunities for us because we’re bringing a wider range of prices through the ad-supported offering, a lower consumer-facing price to be able to attract a broader set of members. So that’s sort of very consistent with our wide range of pricing and our general goals there. We think that’s great for consumers. It’s good for us, obviously.

And when we run the models and talking to brands, advertisers to Microsoft, we look at the monetization that is the complement to that sort of subscription part of the ad-supported offering, and we’re quite optimistic that the sort of unit economics work to make that monetization sort of equal or maybe even better than what we would see on the comparable side for the non-ad, subscription-only kind of plans. So we think that this is, again, expansive from a member reach perspective but also neutral to positive on the unit economics and monetization. So that’s great for us for — obviously from a business perspective.

With both providing a better solution for password curbing (such as adding home or member) and ad-support which does not disrupt the end members’ value I believe Netflix may be able to provide a solution that may help retain members. An enormous library of content and access to millions of user data points provides Netflix with an edge to start experimentation with their ad-supported model, which they set to bring out in 2023.

In my previous essay “Netflix Ad Partnerships and “Stranger Thing” Effect” I outlined how the Long Tail effect and how Long Tail has positioned Netflix for the ad-supported model. I had stated:
Netflix is an aggregator. It sells access to content. It has long-tail content (as Netflix keeps adding to its inventory and specific niche items in regional languages, or for specific geographies). Netflix has reached a stage where it has sufficient content to scale on advertisements. This is the opportunity for Netflix to do what its competitors are doing, sell ads.

How will ads work on Netflix?

Netflix has not quite laid out detailed plans on how its ad system will work. They did mention that there will be a lot of experimentation and a very slow ramp-up. Netflix is looking to build both a brand and consumer-centric model from my understanding. Netflix wants to control the brands it adds to the content and let Microsoft build a tech platform that will control the advertisers.

Based on my guess, the ad tier model will be cheaper than the current base model of $9.99, similar to Hulu’s $5.99. I am also guessing that Netflix will add HD to their base ad plan. When reading between the lines of what Greg Peters said in the earnings press conference, it looks like there will be a few ad-supported options for users. For example, 30 sec of ads every 30 mins of viewing to let’s say 30 sec of ads every 2 hours of viewing. Users will pay more for fewer ads.

Some of the ad-tiered options will be expensive and will be closer to non-ad models in terms of pricing. This is where Netflix will try to upsell the customer to a non-ad viewing option. See below from Peters during the earnings press conference.

Greg Peters states:
I would say, over a period of time, we think that this is sort of one of the dimensions that will inform sort of our plan structure. And I would say, generally, our thinking of going from our Good, Better, Best model that has been sort of the core offering that we’ve had into making that slightly more complicated because we’re going to have more sort of discrimination features that would inform what offering consumers ultimately choose to get to. So there’ll be a little bit more complexity there in ads. No ads will be one of those dimensions. But we want to work into that model. And obviously, while we’re thinking about the right pricing model there, we also want to keep it as simple as we can from a consumer-facing perspective. So in terms of the on-ramp, the planned selection, how upsells happen, we want to sort of work those flows iteratively over time, so we build into that complexity without making overwhelming for consumers.

WSJ reports:
Netflix has said it is trying to create an ad experience that is less disruptive than ads on traditional TV but it hasn’t specified how many ads per hour of content the new service will feature or what format they may take. The company is appealing to advertisers because of its reach and how engaged its viewers are on the platform.

Why Microsoft

Microsoft has long been a player in online advertisements due to its search engine Bing. But it really gained the technology after the purchase of Xandr from AT&T. Microsoft reported $8.7 billion in revenue from search and news advertising revenue in the nine months ending March 31, up from $6.7 billion during the same period a year earlier.

Microsoft has not proven its metal in the ad world yet. Yes, they acquired Xandr which provides them with a capability but the platform is still unproven. Xandr is more display focused with minimal CTV exposure. The same video ads run on Netflix could also be shown on a variety of SVOD/AVOD services from Disney+ to Hulu, so why does Netflix want to become a walled garden by partnering with Microsoft?

I understand the reasons for not going with Google or Comcast as they offer competing services and in the future may pose challenges for Netflix. But there are other proven companies that could have built a great ad platform for Netflix with minimum tech lift. Netflix did not consider the likes of Trade Desk, PubMatic, Roku, and Magnite.

On 7/12, Trade Desk reached a deal with Disney to allow advertisers to launch targeted ads on Disney’s properties such as Hulu, ESPN+, and ABC. This means campaign managers on the Trade Desk platform will have access to linear and CTV inventory from Disney’s portfolio when running programmatic ads. Disney+ is expected to launch an ad-supported tier in the US later this year, with international access coming in 2023.

If you ask me, why did Disney choose Trade Desk over other players in the market, my answer is Trade Desk is a neutral ad tech platform without the desire of being in an entertainment/content space. Google’s DV360 has YouTube, and Roku’s OneView has the Roku Channel.

Netflix in their blog also cited member privacy as a major reason for selecting Microsoft. Netflix perceives Microsoft as having better privacy policies than its competitors. I do not buy this argument to select Microsoft.

Is Netflix looking for an exit?

I am pretty sure there is much more to this deal than just ad tech sharing. I am speculating that if things go south and Ad tech does not work, Microsoft will acquire Netflix. There is a high probability that Google or Comcast will face a lot of congressional scrutiny if they pursue the acquisition of Netflix owing to their existing content/entertainment businesses. Amazon and Disney would face similar headwinds.

Putting it all together, Microsoft is the only tech giant that has nothing in the entertainment/content industry and is more likely to see the acquisition through. This will be a huge win for Netflix investors.

Microsft is a winner here

Microsoft is working with authorities to see through the $68B acquisition of Activision Blizzard. Activision Blizzard gave Microsoft access to 370M MAUs. Netflix has 220M, active subscribers. Microsoft will get tons of user data and user preferences while building the ad-tiered platform for Netflix. Microsoft has a complementary XBOX offering that will enable the monetization of the user data from Netflix in some way or form.

I have always talked about building IP around Netflix, Possible partnership with Microsft will enable Netflix to use Microsoft’s gaming engine and build games around its content. Microsoft then gets proprietary rights to sell these games on Xbox which is a huge boost for its gaming services.

Another win for Microsoft could be switching Netflix from AWS to Azure. Netflix still runs on AWS, switching over to Azure will be a mammoth task but Microsoft has the resources to do it. Microsoft had positioned itself really well with the Xandr acquisition and played the Netflix game really well.

WSJ reports:
Work on the project inside Microsoft started with a small team and Mr. Nadella has personally been involved for more than a month, people familiar with the matter said. Among the Microsoft executives heavily involved were Mikhail Parakhin, president of web experiences at Microsoft, Chris Young, executive vice president of business development, strategy, and ventures and Rob Wilk, corporate vice president of advertising, the people said.

Conclusion

Acquisition or no acquisition, Microsoft does protect Netflix from potential anti-trust issues it would have to face with Google or Comcast, or Roku. But one thing is clear. Big tech companies are always a threat as they enter new businesses. Especially big companies with a lot of free cash flow. Microsoft did not invent its ad platform they just went and acquired one. It saved them from the hassle of integrating with multiple platforms. Microsoft has the scale to make the ad business a behemoth. Startups are great at building products as their environment allows them to be agile and flexible to build a competing product. Big tech uses such opportunities to buy such startups to integrate and scale really well.

I am sure Netflix wants to make the ad-tiered model very simple for the user. Too many pricing options always confuse the user and result in attrition and in the end, I won’t be super surprised if Microsoft absorbs Netflix.

Next week, Microsoft will release its results and I will be covering it in the next week’s essay. Subscribe to these insightful essays in your inbox.

Cheers