Netflix Is Scrambling to Learn the Ad Business It Long Disdained

By spring, after announcing its plans publicly, Netflix had fostered a bidding war that included

Alphabet Inc.’s

Google,

Comcast Corp.’s

NBCUniversal and a dark horse,

Microsoft Corp.

One of Netflix’s goals was to secure a big “minimum guarantee”—a promise that it would get a large influx of ad revenue to limit its financial risk, say people familiar with the discussions.

Netflix also hunted for a senior leader with advertising expertise, mindful that it knew little about the business of selling ads. The company approached at least two top Comcast executives for a senior role while the partnership negotiations were continuing with their employer, angering the top brass at the cable giant, some of the people said.

Netflix’s urgent move into the ad market, with a lower-cost tier that will be available early next year, is its most dramatic pivot since shifting from DVD-by-mail to streaming. The U-turn reflects the company’s desire for a course correction as it encounters its most difficult stretch in over a decade.

After years of looking invincible, Netflix has suffered two consecutive quarters of subscriber losses in the face of tougher competition, and its stock has lost roughly two-thirds of its value this year.

“They’re shifting gears and fast,” said Raman Gambhir, an associate portfolio manager at money manager Neuberger Berman, who invests in Netflix within funds he helps manage. “This is the first time they’ve really pivoted from a position of weakness,” he said, adding that he remains supportive of the company’s management team and bullish on the stock.

Netflix’s turn is a reminder of the challenges facing industry disrupters as competitors emerge in their wake. Now Mr. Hastings is in the uncomfortable position of playing catch-up with rivals that have already taken the lead in weaving advertising into their business models.

“They have quality competition. Massive amounts of it,” said

Wenda Harris Millard,

former vice chair of MediaLink, an ad and media consulting firm, referring to an increasingly crowded subscription-streaming arena that includes

Disney

+, Hulu, Paramount+, HBO Max, Amazon Prime Video and Apple TV+. While Netflix management was wise to focus on a subscriber business and doing so helped grow its customer base for years, she said, “these are different days now.”

Mr. Hastings has set lofty financial ambitions for the ad business. He and other company executives have told investors and ad industry executives privately in recent months that Netflix will eventually be able to charge advertisers about $80 for every 1,000 views of an ad by helping them target specific audience segments, people familiar with the discussions said. That would put Netflix among the most expensive destinations for ads, alongside top NFL television programming.

The company hasn’t spelled out what customers would pay for the ad-supported tier, but is expected to be less than the $9.99 cost to today’s least-expensive option.

Creating an advertising-supported tier isn’t the only about-face the company is making in its quest to revive growth. After years of treating password-sharing by customers as a marginal problem—Mr. Hastings said in 2016 he loved the practice—Netflix plans to begin charging households a sharing fee sometime in 2023.

While Netflix’s subscriber base has grown, the ratio of paying members to password-borrowers has remained relatively consistent in recent years, a person familiar with the metric said. That suggests sharers are not necessarily converting to paying users after trying out the service, some analysts say.

While the rate of Netflix’s service cancellations has slowed from an all-time peak in April, fewer of the company’s new customers are sticking around past their first month, according to research firm Antenna.

Of the new subscribers who joined Netflix in May, 22% canceled within one month, up from 17% at the same time last year, according to Antenna. Netflix has said a price increase in the U.S. early this year contributed to higher customer defections, but that the level is coming back down to where it was before the change.

Though Netflix says it remains committed to a “binging model” where episodes of shows are released all at once, it has begun spacing out the episode releases of some high-profile programs such as its latest “Stranger Things” installment, moving closer to the staggered releases of traditional networks such as AMC and HBO. Some analysts say that practice can help keep people from canceling subscriptions or cycling in and out of them.

The challenge for Mr. Hastings and his co-chief executive,

Ted Sarandos,

is to find ways to drum up new revenue without losing what made Netflix appealing enough to attract an audience of about 220 million subscribers. Offering a less expensive, ad-supported tier and cracking down on password-sharing could turn off some existing customers.

“If I am paying for a service then I don’t want to see ads,” said Miguel Carvalho, 23, who lives in Toronto and shares a premium Netflix subscription with his parents and sister, even though they live in different households. He has been frustrated by Netflix’s price increases in recent years, and said he doesn’t want to see ads or pay more to share his account, particularly given rising inflation. Netflix has said it will continue to offer ad-free plans.

Despite its back-to-back subscriber losses, Netflix still sees enormous growth potential from people coming online across the globe. Internally, the company was trying to beef up its infrastructure to accommodate as many as 500 million members in the next three years, according to a person familiar with the matter.

Netflix expects to rebound in the third quarter and gain subscribers, and has said it will continue to have an advantage as a pure-play streaming company.

Project ‘Crickle’

Netflix has kicked around the idea of entering the ad business for years. Roughly a decade ago, a group of senior Netflix finance and content strategy executives explored the idea.

They considered how many customers might choose the lower-cost option, what content the company had the rights to run ads next to and how it might affect users’ experiences, the people said. Code-named “Crickle,” a play on an existing ad-supported service called Crackle, the secret project analyzed how much it would cost to renegotiate licensing rights and plotted an initial launch in Canada, people familiar with the discussions said.

It never got off the ground. Netflix at the time was aggressively expanding overseas in Western Europe, Japan and other Asian markets, and Mr. Hastings saw global expansion as a goal the company needed to be entirely focused on to win, the people said. Building an ad-supported tier would create a distraction and disrupt the relative sanctuary Netflix had created in a media landscape littered with ads, Mr. Hastings told staffers.

He also told investors and Netflix executives that he didn’t want to have to compete for ad dollars against behemoths Google and

Facebook.

“No advertising coming onto Netflix. Period,” Mr. Hastings wrote in a 2015 Facebook post.

His change of heart in recent months was spurred in part by the reality of the company’s growth challenges, but also by market research on rival streaming services such as Hulu and HBO Max, people familiar with Netflix’s advertising plans said. The research showed that customer satisfaction hadn’t dipped for users of their advertising-supported plans, the people said.

In March, Netflix Chief Financial Officer

Spencer Neumann

said at a conference that the company would “never say never” to advertising, the first public signal that the company was reconsidering its stance. On an earnings conference call the following month, Mr. Hastings said the company was exploring an ad-supported tier.

Top Netflix executives, including its co-CEOs and finance chief, and COO

Greg Peters,

blanketed the ad industry, talking to potential ad buyers and other executives as it plotted its approach, people familiar with the discussions said. Netflix officials got advice on things ranging from how many ads to show in programming to what ads should look like. Netflix hasn’t said publicly what formats its ads will take. Internally, it has discussed ideas including running video ads from major brands before programming, plus some static ads within the app, according to people with knowledge of internal discussions.

Mr. Hastings’ comments on the earnings call set off a competition over who could partner with Netflix and supply the advertising technology—and, possibly, manpower—needed to launch the service quickly. Among Netflix’s asks was that the partner would guarantee a certain amount of ad revenue from markets around the world, people familiar with the company’s requests said.

Netflix wasn’t looking to outsource ad operations for the long term: The company sought a three-year deal to give it space to create its own ad infrastructure, some of the people said.

Netflix’s intention in the early going was to launch an ad product in the fourth quarter of this year, say people familiar with its plans—a timeline that would slip. It said on its latest earnings call that it would launch an ad-backed tier in early 2023.

Calamari in Cannes

Some of the biggest players in the media and technology industries entered the race. Google could offer vast digital advertising infrastructure as well as expertise in video advertising and brand partnerships from YouTube.

Comcast’s NBCUniversal developed its pitch for Netflix under the code-name “Calamari,” people familiar with the matter said, an allusion to the streaming service’s hit “Squid Game.” The company offered up its ability to provide ad-serving technology from its FreeWheel video ad unit and draw on NBCUniversal’s sales team.

Microsoft, meanwhile, came to the table early in Netflix’s hunt for a partner with a much smaller ad business than Google and Comcast. Unlike those firms, however, it lacked a competing streaming business. Executives stressed the word “agnostic” in their pitches and their willingness to be a partner as Netflix eventually stood up its own ad-selling business.

Netflix’s negotiations with potential partners were heating up as the advertising industry descended on the French Riviera in June for the Cannes Lions advertising festival, where tech and media executives, sipping rosé on yachts, woo big-spending advertisers.

While Cannes was teeming, as usual, with celebrities—among them, Ryan Reynolds, Lupita Nyong’o and Dua Lipa—in the ad world the star attraction was Mr. Sarandos of Netflix. He used the event to hold discussions with several large advertisers and high-ranking ad agency executives, said people familiar with the situation. He also attended a Google dinner that featured

Mark Read,

the CEO of ad-giant

WPP

Plc, and Snap CEO

Evan Spiegel,

among others.

During the festivities in Cannes, NBCUniversal tried to drop out of the mix, deciding that the bidding—and Netflix’s asks—had reached a level where the media company couldn’t envision a profitable partnership, people close to the discussions said. Netflix eventually persuaded NBCUniversal to re-engage. Google sensed by the end of June its chances were dimming, a person familiar with the matter said.

In the background, the Netflix talks with Microsoft had quietly advanced.

Netflix and Microsoft announced their ad partnership on July 13, shortly after the annual gathering of tech and media moguls in Sun Valley, Idaho. Some Comcast NBCUniversal executives were upset when they discovered Netflix’s attempts to poach its top talent during the partnership talks, which they viewed as unprofessional, people close to the company said. Netflix also made hiring inquiries at Google, according to a person familiar with the talks.

The tension with Comcast could spill into Netflix’s separate negotiations to secure rights to show NBCUniversal content in the ad-supported tier—part of wider discussions the streaming giant is having across Hollywood—and could cause NBCUniversal to drive up its asking price, the people said.

Mr. Sarandos said on Netflix’s second quarter earnings call that the company already has the rights to air “the vast majority of what people watch on Netflix” in an ad-supported tier.

Many advertisers are already plotting how to use Netflix as a marketing platform.

One thing they will want to know: how many people they are reaching through Netflix ads.

Netflix said for years that it didn’t need to publish ratings for its content because it wasn’t selling ads. More recently, the company has begun providing some viewership information, such as a look at the top 10 programs on the service. Netflix will have to be even more transparent after launching an ad-supported plan, since advertisers will be looking to pay based on the quality of that data, said Ms. Millard, the former MediaLink executive.

Netflix will have a strong hand to play as the biggest name in streaming, but advertisers also will be able to reach many of its customers on other services. “They are going to get somewhat of a premium because of their brand. They will not get a premium because of a differentiated audience,” Ms. Millard said.

Write to Sarah Krouse at sarah.krouse+1@wsj.com, Suzanne Vranica at suzanne.vranica@wsj.com and Jessica Toonkel at Jessica.Toonkel@wsj.com