The Truth Behind Netflix Inc.'s Advertising Controversy

Streaming video fans went a little crazy last week at the idea that Netflix was considering adding commercials to its content broadcasts. Like most Internet controversies, this one started with a small nugget of truth and quickly grew into something preposterous.

The truth is that Netflix is looking for ways to market its original content to subscribers. But it's crazy to think that means third-party commercials are headed to the service.

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Source: Netflix.

The rumor mill The advertising freak-out began when some Netflix users reported seeing trailers for original content such asHouse of Cards and Orange Is the New Black that ran automatically after they finished streaming a show. Cord Cutters News called it a test of "post-roll ads" that could grow beyond Netflix's original content in the future. Motherboard also reported on the news under the headline "What's New on Netflix: Advertisements."

Subscribers responded negatively to the posts. The following is a sampling of the comments for the above-linked articles:

This is no "Qwikster"Sure, Netflix has made tone-deaf moves in the past that angered its user base. The most notable example was the doomed plan to separate out its DVD service in 2011 under the "Qwikster" brand. Thousands of users complained and threatened to cancel their subscriptions, forcing the company to abandon the idea.

Source: Netflix.

But this isn't another Qwikster move. Instead, as Netflix explained in a statement, the company is showing trailers only for its original content. "We are not planning to test or implement third-party advertising on the Netflix service," the company told Mashable.

CEO Reed Hastings made the point more directly with a Facebookposton June 1: "No advertising coming onto Netflix. Period. Just adding relevant cool trailers for other Netflix content you are likely to love."

Yes, it starts with trailers, some might say. But that's a slippery slope that can easily grow into short advertisements and eventually a deluge of commercials on par with the 15 minutes per hour we have to watch on cable TV.

Why it won't happenNot a chance. I see two reasons why Netflix won't be selling ads anytime soon. Branding is the big one. After all, advertising-free streaming is a core part of the Netflix identity. Management's long-term business outlookmakes clear the company knows what differentiates its offering in the market. "We don't offer pay-per-view or ad-supported content," according to Netflix. "Those are fine business models that other firms do well.We are about flat fee unlimited viewing commercial-free."

Second, Netflix doesn't need the money. Contribution margin for its domestic user base spiked to 32% of sales last quarter, and the company expects to ramp that up to 40% by 2020.

It's also true that Netflix's original content and foreign expansion strategies are hugely expensive. Those moves have pushed Netflix's free cash flow dramatically lower over the last few quarters.

But that's why the company took out $1.5 billion of debt earlier this year. Management plans to use its domestic profits to fund its international expansion, while paying for more original content with debt. And by the end of next year the expansion will be over, leaving all the U.S. profits available to flow directly to the bottom line. Subscribers can relax: Netflix has no reason to switch to an advertising business model.

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Demitrios Kalogeropoulos owns shares of Apple, Facebook, and Netflix. The Motley Fool recommends Apple, Facebook, and Netflix. The Motley Fool owns shares of Apple, Facebook, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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