Hulu Rolls in Video Ads, but It's Not Enough Revenue

If delivering online video ads is a positive sign, then TV and movie streaming site Hulu rocks. It presented a fourth of all online video ads in March. Only problem is, appearances can be deceiving. Even though Hulu's popularity helps drive the number of video ads, there's another reason for the volume that could eventually undercut the business.

The company, co-owned by NBC Universal, News Corp (NWS), and Disney (DIS), delivers programming with a frequency of advertising interruptions that could make you long for traditional network TV -- especially when you pay for a Hulu Plus subscription. But don't assume Netflix becomes the winner. No, it doesn't run ads ... yet. But the streaming industry is starting to learn that new ways of doing business doesn't necessarily change fundamentals, which can drive costs and the need for more revenue, however companies can get it.

You don't want ads? We still got 'em.
It's not that Hulu runs more minutes of ads. An hour program on network television is about 42 minutes long, meaning that advertising takes up 30 percent of the time. But people are used to that and will often do something during a commercial break.

Hulu generally slots in between 30 and 45 seconds during a show -- not long enough to go elsewhere, clearly. And at the same time, rather than commercial breaks at the top of the hour and on the quarter- and half-hour marks, it will run commercials at 5 or 6 times during a show. Here's a breakdown from a running a current episode of Glee:

• 4 second network ad (Fox)
• 3 second ad for the show on the network
• approximately 30-second spot
• show interleaved with six commercial spots of about 30 seconds each

Customers running away
One of the assumptions in the video industry is that consumers are cutting back on traditional pay TV services and increasingly using services like Netflix or Hulu as partial or complete replacements.

Cable supposedly lost 2 million viewers last year, but how about Hulu? Here's a graph of global unique users per month according to Quantcast.com, which says that it gets actual traffic reports for Hulu (click to enlarge):

The site saw rapid growth until a peak last fall, after which it has been in decline. Hulu has actually lost more users per month since its peak than cable did last year. One reason is likely that some of the novelty has worn off. But gauging from the reaction of people I've seen watch Hulu programming, part is that the experience of watching stuff is choppy and unpleasant, even if you like the shows.

So why so many ad breaks? Part of the theory, according to online advertising experts I've spoken with over time, is that smaller numbers of shorter spots can be more effective than longer ones. The more effective the ads, the greater a premium a company like Hulu can command. And Hulu needs money.

It costs how much?
Here is where existing industry dynamics come hurtling down. Cable operators say programming costs represent 40 percent of their income. A quick check of the public financials of both Cablevision and Time Warner Cable puts the amount closer to between 42 percent and 48 percent.

That's a lot of money to send out the door, and for first-run programming, don't expect the studios and channels to settle for less. They don't. Last year, Netflix's cost of revenue was almost 63 percent. Granted, there's significant expense that the streaming companies avoid, like expansion and maintenance of infrastructure that runs to the consumer. But, wow, that's a big chunk of revenue to immediately pass on to others.

Even at that, Netflix has still operating income of 13 percent of its gross revenue. However, what happens when it wants more recent programming? The studios and channels get more, which has to come from somewhere, and that will mean consumers' pockets.

Money to cover costs is why Hulu pushes those ads, even when people pay for a subscription for extra programming. It's why Sony pulled programming off Netflix on Friday because the service had hit a ceiling on the amount of streaming it could do.

The same economics that have dogged old pay TV will also hound the new versions. Cable companies don't stick those annoying animated figures at the bottom of a running program just because executives have bad taste. It's economics. Expect Hulu ads only to increase in number, even if not frequency. Don't write off the possibility that Netflix, too, will include advertising in the future. Eventually, someone has to pay the programming bill. One way or another, you know who that will be.

Related:

• Why Netflix Users Cut the Cord: Cable Isn't Worth What It Wants
• Why Traditional TV Companies Will Fail: Consumers Hate Them
• Tuning Out: TV Ownership Drops, and Advertisers Have to Get Smarter -- Fast
• Time Warner Cable and Viacom Fight Over Who Gets to Snuggle With Consumers
• Consumers Won't Cut Cable -- Because They'll Find that They Can't