Microsoft just scored a huge win for its ad business

Microsoft (MSFT 1.04%) was the surprise winner among those vying for control Netflix‘c (NFLX 8.20%) future advertising business. The streaming company plans to launch an ad-supported tier of its service in the near future. The SVOD leader was in talks with companies more related to digital video advertising such as Alphabet‘c (GOOG 1.19%) (GOOGL 1.28%) Google and Comcast‘c (CMCSA 3.33%) NBCUniversal, which operates Freewheel.

While Microsoft’s choice has some advantages for Netflix, it could provide a more significant boost to Microsoft.

Building a digital video advertising business

One important reason why Netflix is ​​likely to choose Microsoft is that there is no major conflict of interest. Unlike Google and Comcast, which have their own video streaming businesses, Microsoft does not operate a direct competitor to Netflix.

Importantly, this gives Netflix and Microsoft a cleaner starting point for building a digital video ad business. In a blog post announcing the deal, Netflix COO Greg Peters said, “Microsoft offered the flexibility to innovate over time on both the technology and sales sides.”

Indeed, Microsoft will build on the back of its existing advertising business anchored by its Bing search engine and MSN portal. The addition of Xandr from which it was taken AT&T recently provided some important ad technologies for connected TV that will serve video ads and link targeting and measurement data across platforms.

Microsoft already runs a sizeable advertising business, generating $10 billion in revenue last year. But that pales in comparison to giants like Google, which saw $209 billion in ad revenue in 2021. And while Google’s YouTube generated more than $28 billion last year on top of Google’s other streaming and connected TV ad efforts, Microsoft doesn’t generate a lot of video.

In other words, Microsoft has a pretty big ad business with a lot of established technology, but it should be more willing to work closely with Netflix to develop new technologies and services around video. This could benefit Microsoft just as much as Netflix.

With Netflix, Microsoft has been able to build technology and sales teams with a guaranteed customer—and a significant customer at that. This is the advantage Google has in building its video ad services because it has all the search built into YouTube. Likewise, Comcast can keep Freewheel because it won’t lose NBCUniversal as a customer.

As Microsoft develops technology and business practices to support Netflix, it could become a bigger force in the fast-growing digital video advertising market. That makes the deal far more valuable than just the potential revenue it could generate directly through Netflix.

A win-win for Microsoft and Netflix

Netflix probably got a very good deal from Microsoft compared to what more established competitors can offer. In return, Netflix will help establish Microsoft as a major player in connected TV advertising. The streaming service could generate more than $1 billion in ad sales worldwide in just a few years, analysts at MoffettNathanson estimate.

However, investors in either company should not expect an immediate payoff.

Netflix now has 220 million subscribers worldwide. As such, it will take some time before the ad-supported tier becomes a significant contributor to Netflix’s subscriber base. The company may see some customers migrate from ad-free to ad-supported tiers and may be able to improve churn by giving existing customers a cheaper option to stay. Still, it will take some time for Netflix to roll out the ad service globally, get its marketing message across, and drive subscriber growth through the new offering.

But as Netflix and Microsoft repeat their practices over the next few years, the business could become an important part of both companies. Netflix could see improved subscription rates as Microsoft expands its advertising business in a growing market.

Suzanne Frey, CEO of Alphabet, is a member of The Motley Fool’s board of directors. Adam Levy has positions in Alphabet (C stock), Microsoft and Netflix. The Motley Fool has positions in and recommends Alphabet (A Share), Alphabet (C Share), Microsoft and Netflix. The Motley Fool recommends Comcast. The Motley Fool has a disclosure policy.

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