Value Investing

Hulu: This Velociraptor Faces Extinction

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Madera Technology Master Fund, our concentrated long/short equity strategy, down 2.4% in November and up 14.9% year to date.

Investors love Hulu because it is a semi-private asset that keeps details like revenue and margins out of the sunlight—ignorance can be bliss. Private assets require a little more patience in analyzing. We want to shed some light on Hulu, which is regarded as A+ despite losing its CEO and CTO recently and hiring a new head of programming. A closer look at the financials and ownership structure paint a much different picture.

What Is Hulu?

Hulu is a streaming video provider operating solely in the United States and jointly owned by four (4) major media companies. Hulu provides access to shows from popular networks including ABC, NBC, Fox, and CBS within a day after airing for $8 per month. Customers can pay an additional $4 for commercial-free viewing. The last public subscriber count was about twelve (12) million in June 2016, amassed over nine (9) years.

How Does Hulu Receive Funding?

Disney, Comcast, and Fox each own 30% with Time Warner buying 10% in August 2016. Time Warner contributed $590 million for its 10% stake. Hulu has received $330 million from its owners three times this year in the June quarter, the September quarter, and the December quarter for a total of $990 million in funding for 2017. The owners have collectively contributed $2 billion of funding since 2015 and also guarantee a $338 million five-year term loan due in August 2022.

What Is The Relationship Between The Owners And Hulu?

Hulu serves two main purposes. First, Hulu is a competitor to Netflix in online video distribution. Second, Hulu is a captive buyer of a very large amount of programming from its respective owners. Hulu has inked major deals with ABC, Fox, and NBC for large amounts of programming, presumably outbidding Netflix and Amazon for these rights. Hulu as a buyer keeps programming away from arch enemy Netflix and provides substantial revenue to its owners.

The Owners Recognize 100% Of Program Sales To Hulu

When Fox sells This is Us to Hulu, Hulu pays a license fee (assume $50 million) to Fox upon delivery. This $50 million license fee is then fully recognized by Fox as revenue in the period as a “content sale.” This is generally how all content sales are structured, and the same procedure applies if substituting Netflix for Hulu in our example.

But Only 30% Of Hulu’s Operating Losses

Each major owner owns a minority stake of 30% in Hulu, so they are each only on the hook for 30% of operating losses. These minority losses are recognized below the line in “other income” and do not impact a company’s gross or operating margin. In our previous example, Hulu paid $50 million to Fox for This is Us, but Fox only recognizes 30% of the cost or $15 million.

To review, Fox sells something to a Fox-owned entity, recognizes $50 million in revenue but only $15 million of cost. That’s clever. 

Hulu Is Generating Substantial Operating Losses

Comcast has been reporting operating losses for Hulu consistently for years, and we present Hulu’s operating losses over time in the following exhibit. Comcast’s ownership was adjusted down to 30% in August 2016 when Time Warner acquired a 10% stake. We have estimated December’s losses based on guidance out of Disney CEO Bob Iger on the most recent earnings call. As you can see, Hulu is on track for $(1) billion of operating losses this year, up from $(539) million last year, an 86% increase year/year.

Hulu

One Other Point On Bob Iger Guiding December’s Expected Losses

Hulu’s losses are expected to increase by about $230 million sequentially, which is extremely hard to do in one quarter based on the accounting treatment of content amortization. A $230 million quarterly increase is a $1 billion annual increase, and we have not seen any $1 billion content deals out of Hulu lately. For context, Netflix’s pay one deal with Disney is estimated to be about $300 million per year and the five year deal with Epix was $900 million in total. We have some theories, but we will save those for another time.

Which Is Why The Owners Must Keep Injecting Cash Into Hulu

We believe Hulu will require another $330 million of cash in the March 2018 quarter to remain a viable buyer of content from its owners. We expect the owners to contribute another $1 billion of cash to support Hulu in 2018.

Hulu

Disney Owning 60% Of Hulu Means 60% Of Losses

As a 60% owner with the acquisition of Fox, Disney would be a majority owner and would fully consolidate Hulu’s financials. Disney will be responsible for double the amount of losses if Comcast and Time Warner remain minority investors. If Disney were to buy out Comcast and Time Warner, Disney would be responsible for the full $(1) billion of operating losses generated by Hulu.

DISNEY OWNING 60% LIKELY MEANS COMCAST/NBC AND AT&T/TIME WARNER STOP SUPPORTING HULU

Hulu competes with Comcast Xfinity and AT&T DirecTV/DirecTV Now, so it would make sense for both Comcast and AT&T to withhold content and cash from Hulu to support their own services under Disney majority ownership. Hulu losing its status as a preferred home for content might be an opportunity for Netflix or Amazon to acquire more content. Disney will not control Hulu for over a year, and we expect the pay TV landscape to change dramatically in the interim.

So while Disney gains scale and a yet another streaming video platform in Hulu, it also gains new enemies in Comcast and AT&T Time Warner. This is a significant realignment of competitive interests.

We Are Not Sure Why Anyone Wants To Own More Than 30% Of Hulu

Owning a controlling stake in Hulu destroys the very reason that makes it so wonderful for its owners: receiving 100% of revenue but only 30% of losses. Furthermore, the controlling owner (Disney) is responsible for most of Hulu’s cash needs. With Netflix and HBO getting dibs on the best shows, operating losses significantly increasing, and an unclear corporate strategy, we are not surprised in the slightest to see C-level executive and employee turnover at Hulu. But we are surprised investors are overwhelmingly positive on Hulu as an asset in the context of Disney majority ownership.

With only twelve million subscribers earned over nine years and losses accelerating to $1 billion a year, Hulu may not be the panacea that the majority of investors believe it is.
Feel free to reach out anytime if you'd like to discuss. Thank you,

Kris

212-229-0859

P.S. Velociraptor (commonly shortened to "raptor") is one of the dinosaur genera most familiar to the general public due to its prominent role in the Jurassic Park motion picture series. In real life, however, Velociraptor was roughly the size of a turkey, considerably smaller than the approximately 2 m (7 ft) tall 80 kg (180 lb) reptiles seen in the films.