Before we dive into Netflix (NFLX) Q3 2024 earnings, and especially the new ad server, we’d like to refer you to the recent video/show notes we did on AppLovin. Digital ads have taken to the AI phenomena, and we will probably have some updates regarding this on Netflix in 2025. We can’t imagine Netflix won’t put new AI to work as it builds its new revenue driver. 1 Stock Up 1,200% Investors NEED to Know About – The Absolute Best Use of AI So Far?

For now, let’s get up to speed on the new Netflix, and what all this ad server stuff is about.

Marketing – the lifeblood of consumerism

With a global audience of over 600 million (based on 283 million paid memberships as of the end of Q3 2024), Netflix making the move into the digital ads industry makes total sense – at least from a financial perspective. The lower cost ad-supported membership option isn’t just about continuing to acquire more subscribers. Global marketing is a massive industry hurtling towards $1 trillion a year in spending. 

And digital ads, with all its power to fine-tune marketing campaigns based on audience demographics and interest, is far-and-away the most valuable marketing outlet ever devised. This is becoming the driving force of the multi-trillion-dollar per-year “products and services” sales top of the funnel in the global economy (see the above chart).

Netflix operates streaming services in many dozens of countries around the world, often implementing its software and data close to end users by tapping into “edge network servers” operated by local internet service providers (ISPs). Given this situation, as Netflix progressively launches its adtech into more markets (starting with Canada next year, and gradually everywhere else it offers an ad-supported tier), this could become a massive, complex, and incredibly lucrative digital ads business. Marketers could be rubbing their hand together in eagerness to tap into buyer interest on a very granular country-by-country basis.

Hold up, what’s an ad server?

Since Netflix runs on Amazon AWS infrastructure (and perhaps, maybe, the digital ad server will run on AWS too, or maybe a combination of AWS and other colocation data centers around the world), let’s allow AWS to help explain what an ad server is. https://advertising.amazon.com/library/guides/ad-server 

In a nutshell, an ad server is a collection of servers (powerful enterprise computers that slide onto racks) installed in a data center. These computers are the workhorse of cloud computing and have handled much of big organizations’ computing needs for decades. With Nvidia’s hot accelerated computing tech run, perhaps you’ve seen pictures of these new types of servers popping up all over the place.

In Netflix’s case, it will probably be categorized as an SSP (supply-side platform), an ad server run by a publisher of content that has ad listings for sale that can be purchased by marketers. Marketing firms and their customers (brands) use a DSP (demand-side platform). Nearly everyone in big tech owns a DSP server. The Trade Desk is another example. DSPs are tasked with finding the best publisher ad listings for sale after a marketer has set a budget for their ad campaign.

An ad server runs complex algorithms that programmatically (meaning, the buying and selling of ad slots is automated) match ad supply with demand. Marketers set their budgets, tap into SSP audience metrics to find the right potential customers, and measure the effectiveness of their campaigns on these ad servers. This is why Netflix said it will keep its ad server open to various DSPs (including The Trade Desk, Google, etc.) so it can maximize its take from selling ads. We can assume it may offer some sort of analytics software package to marketers too.

Here are some further definitions used in adtech, as explained by Microsoft:

Netflix makes rapid progress, and ditches Microsoft

Let’s talk about Netflix’s digital ad server, which it announced early this year, not long after making the foray into lower-cost ad-supported membership tiers with the help of Microsoft.

Is Netflix ditching Microsoft because the software giant’s adtech is rubbish? No, probably not. Yes Microsoft isn’t exactly known for its adtech prowess, and it lags far behind leaders like Google, Meta (Facebook and Instagram), and Amazon. Fun little timeline of events, Microsoft greatly expanded its ad server business with the purchase of Xandr in 2022 from AT&T, which itself had made the acquisition (at the time, Xandr was called AppNexus) in 2018 for likely a sizable chunk of change for more than it sold to Microsoft for.

We doubt Alexander Graham Bell (AT&T’s founder, from which the name Xandr was derived) would have liked how that panned out.

But that’s not the real reason Netflix is moving to in-house adtech development.

Rather, we see this switch as two-fold. MSFT probably offered competitive pricing for Netflix when they started rolling out ad-supported memberships last year. But with the ad subscribers very quickly ramping up (over 40 million members reported in spring 2024), Netflix probably sees a significant amount of value in developing its own ad server over the long-term, versus paying someone else to manage an ad server.

Indeed, in the Q3 shareholder letter, management said its ad-supported sign-ups are reaching “critical subscriber scale.” That’s another way of saying marketer interest is up, and Netflix could quickly turn a profit on its own in-house development.

And second, Netflix runs the bulk of its services on Amazon AWS cloud infrastructure. Now that Netflix’s ad business is scaling, maybe AWS came in with a secondary bid to host a Netflix ad server that beat out what MSFT could offer. 

At any rate, cloud service competition is a win for Netflix. It’s probably getting great pricing on computing hardware rent as it builds out a new lucrative line of business, one management hopes can keep the overall business growing in the double-digit percentage range for years to come. This bodes well for further profit margin expansion.

Netflix ads, the greatest thing since TikTok influencer marketing?

All of the above is more than Netflix piling into an already crowded digital adtech industry. What we really like to see is management taking a thoughtful approach to ads, one that will be different from what is already out there. 

Rather than plastering its content with ad banners and frequent ad breaks (at least, not yet, God help us all when the day comes when EVERYTHING has ads slapped on it), Netflix wants to keep telling stories to its viewers with its ad campaigns.

What does that mean, exactly? Time will reveal what this looks like. But given the data Netflix has on its viewers interest, it can approach marketers with legitimate customer buying interest data in hand. And then, it can help those marketers tell a story that integrates with the specific content being viewed.

Does this sound a bit like influencer marketing, like what TikTok has been pushing? It sure does to us.

Storytelling to an audience you know has a likelihood of making a purchase is a marketing firm’s dream. Trying to decipher what will capture audience interest gets easier, which means the marketer can instead focus their time on pumping the story, and desire to buy. Marketers will pay top dollar for this type of campaign.

Let’s say a consumer goods company that sells cooking supplies and kitchen appliances wants to push new baking products. A new season of The Great British Bake Off is airing, and you approach Netflix about viewership ratings. Awesome, so you know how many people are interested in baking. Now can you integrate a line of products into the storyline, complete with fan-favorite hosts or contestants talking about the product (hopefully in a natural way). One step further, because this is based on a digital ad server, you probably will also get very specific audience demographic metrics from this ad server too. Is there a way to curate which specific product ad is pushed based on the specific viewer, based on Netflix’s analytics? Perhaps…

That’s just one example we dreamt up. But the opportunity for tailor-made influencer-like ad revenue is there, in a myriad of different ways based on Netflix content and viewer favorites. With a global audience of 600 million and counting, Netflix could be sitting on pay dirt it can mine for years to come. More topics like this were shared back in May during the Netflix Upfront event, including the company making moves in sports (like NFL games on Christmas Day this year) and other live events that draw in many millions of viewers. Read more on it here: https://about.netflix.com/en/news/netflix-upfront-2024-the-year-of-growth-and-momentum 

A brief note on NFLX stock valuation

If you’ve been following Nick’s writing that predates our work on Chip Stock Investor, you may remember that back in the day (2017-19, we had a bit of an aversion to owning Netflix. The reason? The company actually operated in negative free cash flow (FCF) and funded its own content curation and production by taking out high-yield (junk bond) debt. Those days are long gone. Netflix is profitable on all counts, and is expected to remain so even as it now uses up operating profit to build out its own ad server.

The stock has had quite a 2024, and the valuation is a bit high. But on a forward basis, it looks a bit more reasonable – albeit still on the rich side. Per usual, we admonish a dollar-cost average or gradual buying in batches approach, if you don’t own any NFLX already. We expect volatility to strike to the downside at some point, and fully expect a no-less-than 20% drawdown when that happens. But if the progress remains unchanged, we’d be a buyer again in such an event.

Nevertheless, Wall St.’s lofty expectation is for Netflix to continue growing its profitability at an average 20% or more pace for a number of years to come. An acceleration in revenue and higher profit margins lay at the heart of this expectation, and the ad server is a big part of that anticipation. We are optimistic this will work as well. Here’s one scenario that gets us to a fair value today (stock price of ~$755 on October 25, 2024).

We see Netflix homing in on a billion viewers within this decade, with many of the new subs on the ad plan. With that kind of scale and data on its hands, this really could be a TikTok-like “influencer marketing” juggernaut if it can incorporate storytelling into its ads. We’re all for less annoying ad campaigns, at the very least. 

Perhaps it’s time to start talking about Netflix as a legit “tech giant” again, like back in the FAANG stock days (Facebook, Apple, Amazon, Netflix, and Google, pre-dating the current “Magnificent 7” moniker). Let’s go ahead and do it. Add Netflix in there, and let’s make it the “Ottima Otto,” or simply, “The Ocho.”

Video link: https://youtu.be/re8FOz58x1k 

If you’d like to create your own finance and investing visuals, you can use our referral link to get a 15% discount on a subscription to Finchat.io: https://finchat.io/csi/