Netflix and advertising - build, buy or partner?

Post Netflix’s announcement that it would be entering the world of ad supported streaming via a new pricing tier, there has been significant chatter around just how Netflix will bring this product to market.

Ultimately the options come down to 3 scenarios – build the technology required, buy the technology required by acquiring a company with suitable ad tech infrastructure, or partner with an existing player with the scale and credentials to adequately deliver on the revenue opportunity.

Which leads us to the first question. How big is the revenue opportunity?

Analysts are somewhat torn, but the belief is Netflix should be able to generate between $1.2b and $3b USD in advertising revenue in year 1.

Where you sit on that figure is dependent on two factors – how many customers you believe Netflix can attract to the ad supported tier, multiplied by the ARPU per subscriber from advertising sales.

$1.2b in revenue at an annual ad funded ARPU of around $100 per year requires between 12m subscribers. $3b would require around 30m ad funded subscribers. Let’s be conservative and assume $1.2b is where it will land.

The connecting questions are trickier. What ratio of these ad funded subs are incremental, and what ratio are current subscribers who trade down to the ad model? Secondly, what is the margin Netflix can expect to generate from ad sales?

Option 1: Build

Netflix is on record in saying it will have an ad funded tier by years end. Given that, there is no real chance Netflix can launch with a proprietary advertising offering built from the ground up. The technical resource required would be too great. A cursory glance of the Netflix careers page shows there are no advertising specific engineering roles being advertised at present.

So, let’s draw a line through build for the time being. Time consuming, resource heavy, high risk and people dependent.

Option 2: Buy

This has been a highly discussed area, with a one common target identified … Roku. I don’t think Netflix buying Roku is likely or sensible and I’ll explain why.

Roku is currently valued at $12.4b, with a 52-week high of $64b USD. Whilst it’s unlikely Roku could sell at its 52-week high; it would be at a significant premium to its current valuation. For reference, Netflix is valued right now at $79.4b. It’s hard to see them acquiring a company valued at 25% of the acquirer.

The other complication is the revenue makeup of Roku. Roku generates most of its revenue from platform revenue, which is primarily charging SVOD and BVOD services for distribution on its platform. Roku generally takes a clip of advertising revenue sold by services on the platform or takes a chunk of inventory and sells it via its ad sales force. Either way this revenue is dependent on Netflix direct competitors.

The other revenue stream is via hardware sales. This wouldn’t be an interesting area for Netflix given it is a software business. The other complication is the hardware business cannot self-sustain – the model of Roku is hardware provides distribution and this is monetised monthly via ad sales.

Paying $20b plus for a business given this feels like a significant overinvestment.

The more sensible target is Magnite. It’s currently valued at $1.3b USD, with a 52-week high around $4b. Magnite is focused on connected video ad technology and has acquired a bunch of kit around this area. It is very much capable of doing the job Netflix requires – creation of a system that can control the purchase and delivery of video advertising, complete with requisite intelligence around analytics, targeting and yield management.

Magnite has relations with advertisers and agencies and has valuable IP and domain expertise. At $2-3b purchase price it feels like a sensible investment given the likely revenue profile of the ad supported tier. Magnite is likely an asset that can be purchased at 10% of the price of Roku, with a pretty equivalent potential application value for Netflix.

Another potential option is Innovid or Tremor. But Magnite feels like the smart approach if acquiring the capability is the preferred path.

Option 3: Partner

If Netflix feels acquiring at this stage is too risky, it could partner with a third party who could handle the heavy lifting of establishing the pipes and help selling the inventory to market.

There are 3 main options here. Google, The Trade Desk and Freewheel. All 3 could provide the requisite plumbing to setup an ad product and connect these to demand side platforms to allow advertisers and agencies to buy them.

All 3 offer benefits. Google is the leader in this area and has the largest video service in YouTube. My belief is YouTube and Netflix would be complimentary assets and appealing to buyers. The Trade Desk is a focused offering and is very good in the space it plays in. It has wide distribution and is highly regarded. Freewheel was built primarily for the use case Netflix has, but it’s owned by Comcast (who owns Peacock, and owns NBC Universal).

It’s worth pointing out that Disney is all in on building out its own integrated stack, the DRAX (Disney Real Time Ad Exchange).

So, what’s the likely scenario

My view is Netflix needs to acquire an existing piece of tech and spend the time and resource to tailor it to deliver a Netflix worthy ad product. As a business it’s highly considered around the user experience, and it’s sensible to suggest it will be extremely careful with the advertising experience. This requires full control and full focus. It won’t want to be a ‘customer’ of another business that has other focus areas. Magnite as a target is a sensible one in my view.

The ambitious timeline is the challenge. Any investment requires due diligence, especially technical due diligence. And this is time consuming when the stakes are this high (both financially in terms of purchase price and in terms of customer impact). Once a deal is done, integration is complex and resource heavy. Doing this in 6 months is ambitious. But hey – commissioning ‘House of Cards’ was ambitious too, and they did it, and it paid off.