Hulu is popular, but that wasn’t the goal

Pioneering Internet television service Hulu recently celebrated its third anniversary in a fitting locale: under the roller coaster at the Santa Monica Pier.

Hulu has reached a dizzying level of popularity among users by offering easy and free online access to episodes of hit TV programs. But the site’s soaring success has induced stomach-churning paroxysms for its owners, Walt Disney Co., News Corp. and NBCUniversal.

Now the website faces changes that could curtail its trove of offerings or require users to pay for episodes they currently watch for free. Once hailed as the networks’ solution in taming the Internet, Hulu’s stunning success is now undermining the very system it was designed to protect, forcing the site’s owners to reconsider what Hulu should be.

“Technology is changing so fast, and, as a direct result, so is consumers’ behavior,” said Jordan Levin, chief executive of the TV and Internet studio Generate. “One of Hulu’s problems was that it accelerated changes in behavior faster than the companies were prepared for.”

As a result, Hulu’s media owners — the corporate parents of ABC, Fox and NBC — are tussling with the site’s entrepreneurial managers over opposing visions for the venture. The companies originally crafted the service as a way to control online distribution of their content. But by offering popular shows such as “Glee” and “Modern Family” online at no charge, the media companies fear they may be encouraging consumers to drop cable and satellite TV services, one of their chief sources of revenue.

Hulu’s management, on the other hand, contends that the current strategy of reaching the widest possible audience on the free site will ultimately generate higher advertising revenue. They say revenue is expected to top $500 million this year, proof that its current emphasis is paying off.

In a short time, Hulu has exploded into one of the top Internet video destinations, defying skeptics who predicted that a service backed by such an unwieldy joint venture would never work. It now attracts some 27 million users every month, according to ComScore Video Metrix.

Jason Kilar, a former top executive at Amazon.com Inc. who was recruited to be CEO of Hulu because of his Internet know-how, has been chafing under the old-media company owners. He has proposed a restructuring that would give him greater autonomy, according to people familiar with the situation, who were not authorized to speak publicly about it.

According to these people, Kilar has been resisting efforts by Hulu’s owners to institute fundamental changes, such as squeezing in additional commercials. A large part of Hulu’s appeal has been its modest reliance upon commercials — only 3 1/2 minutes in a half-hour prime-time show, compared with eight minutes on TV. Advertisers like the lighter load because it makes their messages stand out. In the first quarter, Hulu attracted 289 advertisers, up about 50% from a year earlier.

The crux of the problem is that Hulu’s ad sales are still dwarfed by some $30 billion annually in programming fees that pours into the media giants from cable, satellite and telecom providers. Those fees support the cost of producing content, and undercutting them by steering viewers away from TV and to the Internet would jeopardize the sturdiest financial leg of the TV industry.

Despite Hulu’s ad surge, it’s not enough to satisfy its media owners. The three entertainment companies each received less than $100 million in revenue from the service last year.

The issue, said Chris Allen, director of video innovation for ad agency Starcom, is whether Hulu is “generating enough revenue to make it a sustainable model.”

To boost revenue and in a bid to capture the iPad and portable device market, Hulu began encouraging people last year to sign up for the $7.99-a-month subscription service Hulu Plus. The company recently said it was “on pace” to reach 1 million subscribers by the end of the year.

The media company owners, in another move to keep viewers choosing TV over the Internet for watching shows, have proposed delaying the availability of free episodes. At present, users can go to Hulu to watch episodes that aired the previous night on TV. But viewers may eventually have to wait weeks after the network airing to see the episode on Hulu.

Another decision looms. This summer, Hulu’s exclusive rights to distribute ABC, Fox and NBC programming online begin to expire. The media companies have been dragging their feet on renewals until they resolve the questions surrounding the next iteration of Hulu.

Tensions between Kilar and key Hulu board members spilled over in February when Kilar laid out his vision for the future in a lengthy blog post. One entertainment industry veteran dubbed the missive Kilar’s “Jerry Maguire letter,” referring to the fictional sports agent played by Tom Cruise whose memo called on colleagues to stop being greedy and consider the welfare of clients.

“History has shown that incumbents tend to fight trends that challenge established ways and, in the process, lose focus on what matters most: customers,” Kilar wrote. “Hulu is not burdened by that legacy.”

The memo blindsided Hulu’s directors, including Disney CEO Robert Iger and News Corp. President Chase Carey. People close to the executives said they were displeased about being taken to task so publicly.

Kilar, Iger and Carey declined to comment.

Much has changed since Hulu launched in 2008. The two executives who hired Kilar — former News Corp. President Peter Chernin and former NBCUniversal CEO Jeff Zucker — have exited their companies, leaving Kilar without his influential advocates. NBCUniversal has also been sidelined, forced to give up its voting rights in Hulu as a condition imposed by the government when it approved cable giant Comcast’s takeover of NBC.

The recession also intervened by forcing advertisers to pull back, sending the networks scurrying to find new sources of revenue. The networks didn’t have to go far: They began demanding that cable and satellite TV operators pay fees to carry the broadcast programming they previously were getting for free. Giving away those same shows for free on Hulu created a double standard.

Currently, ABC, Fox and NBC provide their shows to Hulu in exchange for 70% of the advertising, forgoing a cash fee for carriage. The media companies have discussed levying a programming fee on Hulu just as they do with cable operators.

“The rights given to Hulu were intended to be a head start, to get them on their feet,” said one executive with knowledge of the situation, who was not authorized to speak on the record. “Now, the content owners feel that it’s time to take the training wheels off and start to compete on another level.”

The Hulu board has considered raising money to pay for more content, including original productions. But plans for an initial public offering were scuttled last fall because none of the owners were ready to cede control.

The disagreements suggest the site is in limbo.

“Jason Kilar has been trying to telegraph to the investment community that this pause in their business is not going to sink their business,” Forrester Research analyst James McQuivey said. “But the delays could become fatal if the owners let things stall for another year or so. You can only keep people motivated for so long. Talented people will find another pasture to graze in.”

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