Netflix Cut Its Ad Revenue Forecast by $300 Million. Does That Matter More Than Its Earnings Beat?

Netflix (NASDAQ:NFLX) released third-quarter earnings after hours on Tuesday, and it was another disappointment for investors. The stock was trading down 6% after hours.

While its headline numbers were slightly ahead of expectations, Netflix's engagement remained weak, and its trend of slowing growth continued. In fact, the company reported its slowest top-line growth in three years, and it expects it to continue to moderate in the fourth quarter.

Overall revenue rose 11.8% to $12.87 billion, which matched expectations, while its operating margin came in at 34% due to the timing of its content spend. On the bottom line, earnings per share improved from $0.59 to $0.87, beating estimates of $0.82.

However, beyond the existing concerns about engagement and its weak original content slate, one number underscored Netflix's troubles. The company cut its ad revenue guidance for the year from $3 billion to $2.7 billion, indicating weakness in what's supposed to be a key growth market for the streamer.

What the ad biz means to Netflix

Netflix was late to launch its advertising business, finally pulling the trigger in 2022 after years of resistance. The decision has turned out to be a success, giving customers a lower-priced option and allowing advertisers to meet audiences where they are, on streaming. The two-tiered advertising model has become the norm in the streaming industry, and all of Netflix's rivals offer some version of a higher-priced ad-free tier and a lower-priced tier with ads.

Advertising was also supposed to give Netflix an avenue for growth at a time when its subscription business is believed to be maturing, especially in core markets like the U.S. Netflix no longer reports quarterly subscriber numbers, so investors don't have much insight into subscriber growth anymore.

Netflix cut its ad revenue forecast due to a "slightly slower than expected rollout of some ad product capabilities," which places the blame for the shortfall on a technical issue rather than a business issue like weak demand from advertisers or poor engagement. That's a good sign for investors, but still a disappointment, nonetheless.

Is it a red flag?

Advertising still makes up a small fraction of Netflix's revenue. The streamer expects to bring in $51.1 billion in revenue this year, meaning that advertising makes up less than 6% of its revenue. The subscription business still dominates.

However, advertising is a key part of the growth story, and it could face increased scrutiny from Wall Street, especially given the disappointing engagement trends.

The advertising weakness isn't a red flag, but Netflix has become a "show-me story" this year, meaning it needs to prove to investors that it can stop its growth slowdown and improve engagement, or it will continue to face skepticism, which is likely to push the stock lower. The advertising weakness, whether it's due to a one-off technical issue or something else, only adds to those concerns.

What it means for investors

Netflix's guidance for the fourth quarter called for revenue growth of 11.5% to $13.44 billion, and earnings per share of $0.67, both of which were below the analyst consensus of $13.52 billion in revenue and $0.73 in earnings per share.

That's still decent top-line growth, but the company desperately needs to show Wall Street that something is going right for the business, or the stock slide looks likely to continue. At one point, advertising looked like that bright spot, but unless management tells us something different in the fourth-quarter report, investors may count that as another one of many disappointments from the company over the last year.

Jeremy Bowman has positions in Netflix. The Motley Fool has positions in and recommends Netflix. The Motley Fool has a disclosure policy.