On the Hulu Auction - There's something happening here, what it is ain't exactly clear.
"There's something happening here, what it is ain't exactly clear." - Stephen Stills in Buffalo Springfield's For What It's Worth.
There’s a media business. It earned $695mm in gross revenue at 30% gross margins with 75% top-line growth in 2012. It is a market leader with a brand that is recognizable to savvy consumers and leading-edge brand advertisers who associate it with quality. The space in which it plays is expected to grow at a 13% CAGR globally between today and 2017.
And it could be yours for the low, low price of . . . $800mm?! 1.15x gross revenues?! 4.1x net revenue?! Sign me up!
If only it were that simple.
I was delighted to hear last week that the Hulu bids are in and there are some exciting strategic (DIRECTV, Time Warner Cable, Yahoo) and financial/operational (Chernin, Guggenheim, KKR, WME/Silverlake) bids for a business that is near and dear to my heart both as a rabid consumer of SNL clips and as a former NBC-er who worked in the very, very, very early days of the Hulu transition (I left NBC for Google in June of 2007) before Jason Kilar and team stepped in and turned what was then ClownCo into the beautiful product that Hulu is today.
As a fan and a believer, I’m surprised by the low numbers attached to the bids. When the current partners (NBC, Fox and DisneyABC) purchased Providence Equity Partners's stake back in 2012, Hulu was valued at $2B. Today, the two public bids have Hulu valued at $500mm (Chernin) and $600-$800mm (Yahoo). What gives?
The low bids reflect the uncertain future for Hulu and for what it will be like under new ownership. Three uncertainties exist (1) what future content will exist on the platform; (2) the future of Hulu’s ad sales, specifically in relation to its current owners and (3) the threat retransmission fees pose to the Hulu.com (as opposed to the Hulu Plus) business model.
First, I want to understand Hulu’s revenues and costs. (Unless otherwise noted, all data comes from Jason Kilar's excellent December 2012 letter posted on Hulu's blog).
The revenue part of the Hulu business is pretty simple. In 2012, Hulu did $695 million in revenue from three distinct segments: (1) Hulu.com, Hulu’s ad-supported PC-only destination site and syndication network (Yahoo, MSN, AOL etc.); (2) Hulu Plus, Hulu’s subscription multi-platform (TV, Phone, Desktop) site and; (3) Hulu Japan, Hulu’s subscription-only Japanese site.
Of these three, Hulu Plus has the easiest revenue to understand. At the end of 2012, Hulu Plus had 3 million subscribers each paying $7.99/month for the service = est. $288mm in 2012 revenue.
Hulu Japan is similarly straightforward, but there is no public information about its subscriber number. It launched in Q3 2011, charges ~$10/month and 15 months later (December 2012), it has tripled in subs. Hulu Plus (an analogue) started at 250K subscribers in its first quarter. I’ll assume that Hulu Japan’s launch subscriber number was similar to that of Hulu Plus and scale it down to a Japan-sized population. Then, I’ll triple it for the growth through 2012. That gives Hulu Japan 100K subs at launch and 300K at the end of 2012, each paying $10/month = est. $36mm in 2012 revenue.
That leaves $371mm in ad revenue for Hulu.com. Quick sanity check: it is safe to assume that Hulu is attracting premium video CPMs (~$40) and from personal experience (those SNL clips), it tends to show ads on about 50% of its streams for an RPM of $20. Generating $371mm on a $20 RPM requires Hulu to deliver 18.6 billion views annually. Sounds like a lot, but when we consider that in January of 2012, YouTube was delivering 4 billion views a DAY, it also sounds achievable.
Kilar’s letter says that Hulu spent over $500mm on content in 2012. That investment likely takes the form of advertising rev share back to its partners and licensing fees for original programs like Battleground. It’s roughly 72% of the total revenue. That matches what early reports said about Hulu’s arrangement with its content providers, calling for it to send back at least 70% to its premium partners.
That still leaves a chunky $195mm for Hulu to pay its staff, its real estate and its streaming costs. Hulu's cost structure (outside of content costs) is incredibly opaque and although it was once profitable the overall business is currently in the red. Still, I don't think Hulu's current unprofitability is the reason these bids are coming in low. Rather, I think it lies in the uncertain answer to these three questions:
(1) WHAT CONTENT WILL BE AVAILABLE?
Ryan Lawler wrote a great post over at TechCrunch about the uncertainty over what content will be available and for how long. It's a real concern and well articulated.
(2) HOW MUCH AD SALES SUPPORT WILL “NEW HULU” GET?
A significant chunk of ad sales revenue on Hulu has always come from the current owners. Hulu has its own strong ad sales team, but its relationship with NBC, Fox and ABC enables it to effectively outsource a significant part of sales to three of the most experienced video ad sales teams in the world. It is unclear if that tight relationship will continue with new ownership. There are two concerns here. First, aligning incentives across sales forces with the same ownership is always tricky. It's going to be even harder with cross-ownership. Second, great detail from Brian Steinberg over at Variety on how NBC, Fox and ABC are now taking as much as 90% of that ad inventory and taking “lead” on it. If this leadership position includes setting value for the ads, a bundling concern arises. If Hulu inventory is effectively bundled with television and other online video inventory and the new owners do not negotiate a price-setting mechanism that recognize full and fair value Hulu inventory, it could rapidly deplete the value of the Hulu.com ad units.
(3) WILL RETRANS DEPLETE HULU.COM OF CONTENT?
Since Hulu’s founding in 2006, NBC, Fox and ABC have opened a second revenue stream by collecting retransmission (“retrans”) fees from cable, satellite and telco, both through their own owned and operated stations (“O&O’s") and through their affiliates around the country.
Retrans creates a problem for Hulu. In 2006, the broadcast window (the current season) of Saturday Night Live was entirely ad-supported on-air and online. SNL’s distributors (NBC nationally and its stations (e.g. WNBC/KNTV) locally) were free to make as much money as they could during the broadcast window by selling the show to advertisers. They did this through first-run and in-season repeats on-air and by digitally playing the content on NBC.com and Hulu.
In 2013, things have changed. Now that cable subscribers (me) are paying MVPDs (FiOS) who then pay stations (WNBC/KNTV) who kick something back to the network (NBC) to fund the programming (Saturday Night Live), all of a sudden there is less of a willingness to just let the content be monetized on the internet for free. The MVPDs can rightfully ask the stations - “Why are we paying you fees for what viewers can get for free online?”
Fast Company’s Nicole Laporte wrote a great article on Hulu and Jason Kilar last year discussing how this issue came to a head in a 2009 board meeting in an animated discussion between Kilar News Corp President Chase Carey. It’s great reading and sounds like wonderful media theater. It also sounds like retrans fees and the resultant availability of the content for “free” has become the most important battleground in a potential Hulu sale. If that 2009 meeting was a shadow of what’s happening today, it occurs to me that the “free” over-the-web ad-supported business that is Hulu.com (as opposed to Hulu Plus) may not exist for much longer.
It is my belief that even if Hulu.com goes away and all that is left is Hulu Plus, Hulu still can be a great business. Even with all the restrictions, a savvy buyer can make strong returns with Hulu if it is run efficiently and effectively by a strong leadership team. The Hulu Plus business is a $288mm revenue business and growing (100% growth between 2011 and 2012).
This is definitely an odd auction with a strange variation of the principal-agent problem. The current owners of Hulu are not only looking for a high bid, but they are also looking for an accomodating partner. A partner that will pay top-dollar for the content, that won’t complain when ads are given away for free to keep on-air advertisers happy and that will be willing to keep much of the content behind the Hulu Plus paywall to keep the MVPDs happy.
Some critics will call that buyer a stooge. I believe that if that buyer is savvy in its negotiations, while keeping these threats in mind, and if it staffs Hulu with a management team (or keeps the current one) that understands these issues core to Hulu's prosperity, it will own a strong and unique web property that will be well positioned to take advantage of the impending incredible growth in online video. If well negotiated and well managed, there is no reason why Hulu can't deliver outsized returns for years to come.
In the coming days, I’m going to do some thinking about each of the bidders and what their potential angle and value add could be. If there is enough material for a post, I’ll make one. If you have any thoughts - reach out on Twitter (@saroff_nyc) - I’d love to hear what others are thinking about this.
tangentwithtanner
