By SAM SCHECHNER And JESSICA E. VASCELLARO
Just as the digital wave transforms the television industry, Hulu, a pioneer of Internet TV, is in internal discussions to dramatically transform itself.
The free online television service has become one of the most-watched online video properties in the U.S. and a top earner of web-video ad dollars since its 2008 launch.
But its owners—industry powerhouses NBC Universal, News Corp. and Walt Disney Co.—are increasingly at odds over Hulu's business model. Worried that free Web versions of their biggest TV shows are eating into their traditional business, the owners disagree among themselves, and with Hulu management, on how much of their content should be free.
Fox Broadcasting owner News Corp. and ABC owner Disney are contemplating pulling some free content from Hulu, say people familiar with the matter. The media companies are also moving to sell more programs to Hulu competitors that deliver television over the Internet, including Netflix Inc., Microsoft Corp. and Apple Inc.
And in what would be a major shift in direction, Hulu management has discussed recasting Hulu as an online cable operator that would use the Web to send live TV channels and video-on-demand content to subscribers, say people familiar with the talks. The new service, which is still under discussion, would mimic the bundles of channels now sold by cable and satellite operators, the people said.
Hulu's managers say tumult is natural in such a fast-changing industry. "When we blaze trails, which is what Hulu is about, it takes time," said Jason Kilar, Hulu's chief executive, in an interview. "That is not for the faint of heart, and we understand that."
When it launched three years ago, Hulu was the networks' answer to Google Inc.'s video-sharing site YouTube. It provided an easy—and legal—way for viewers to watch new TV shows online whenever they wanted for free. It now offers more than 30,000 television episodes, and its new Hulu Plus subscription service lets users watch on Internet-connected TVs and portable devices like the iPad.
But the digital landscape is changing so fast that Hulu's future is unclear. The networks are grappling with a dilemma facing all entertainment companies: how soon to release movies or shows online without destroying their value in other lucrative "windows" such as DVDS or reruns on cable TV—and at what price.
After upending the music and publishing industries, the digital revolution is poised to shake up TV in earnest this year. As more viewers watch TV and movies on the Internet, industry executives say a generation of TV watchers may never sign up for cable or satellite television, turning off the spigot of monthly fees that have helped support TV for over 30 years. Broadcasters such as those behind Hulu, cable TV operators, and even TV hardware makers such as Sony Electronics are scrambling to figure out their role in the new Internet television universe.
The number of U.S. households that pay for TV service from cable, satellite or phone companies dipped for the first time last year after decades of growth, with 335,000 fewer households paying for service between the first and the third quarters, according to research firm SNL Kagan.
Hulu's owners are worried that free Web versions of their biggest TV shows are eating into their traditional business. Hulu has launched a new paid service, Hulu Plus.
In last year's fourth quarter, the number of people between ages 18 and 49 watching any kind of TV on a traditional set was down about 1.3% from the previous fall, according to Nielsen Co, the biggest decline in at least four years.
At the same time, Internet viewing has increased. U.S. consumers watched about three billion videos on websites offering TV shows in December, up 96% from a year earlier, according to comScore Inc. Hulu alone saw the number of videos it showed double in that period.
Hulu's owners all agree that "consumer behavior is changing" toward more time on Internet-connected devices, said Mr. Kilar. "If you're a content owner, you're at risk of being left behind."
But they can't agree on the best way to capture the new audience.
"It remains unclear what the business model is" for Hulu, said Bruce Rosenblum, head of the television arm of Time Warner Inc.'s Warner Bros. studio. "At some point, if enough people turn off cable, then you've got a complete disruption of the business model," he said.
When Hulu was created in 2007, NBC Universal and News Corp.—which also owns The Wall Street Journal—were concerned about the growing influence of YouTube and pirated copies of their programs showing up on the Internet. Hulu aggregated the networks' TV shows online and made money by selling advertising.
The partners hired Mr. Kilar, former general manager of Amazon.com Inc.'s North American media business, giving him autonomy to chart a new course. Mr. Kilar, 39, was determined to create an independent corporate culture closer to the tech world than the tradition-bound television business.
The company built a Silicon Valley-inspired startup in a low-slung office park in Santa Monica, a few miles west of its Hollywood owners. In the break room, engineers modified a refrigerator to house a beer keg, cutting a hole in it to fit a special tap in the shape of Hulu's logo.
Mr. Kilar gave new hires a culture manifesto, an 1,100-word document that paints Hulu as a frugal meritocracy where "Fruity Snacks boxes hold up our monitors," but where everyone has a "neurotic focus on quality."
In an office expansion, Mr. Kilar and senior managers gave up their offices to sit at desks in an open floor plan among hundreds of employees, underscoring Hulu's egalitarian approach.
It wasn't long before the new venture clashed with owners' established ways.
Hulu competitor Netflix also charges a monthly fee.
In 2008, ad-sales executives at both Fox and NBC complained to their bosses that Hulu was cutting into sales on the networks' own websites like Fox.com or NBC.com.
The protests fell on deaf ears. News Corp.'s then-president and chief operating officer, Peter Chernin, and NBC Universal's Chief Executive Jeffrey Zucker defended Hulu as part of a larger strategy to build their online business.
The strategy drew viewers. A slick commercial in the February 2009 Super Bowl jokingly revealed Hulu as an extra-terrestrial plot to turn human brains to mush from excessive TV consumption. Hulu's traffic skyrocketed, reaching 397 million U.S. video views in April, up 58% from January, according to comScore.
Mr. Kilar needed more content to show all his new customers. Hulu turned to Disney, offering the entertainment giant an equity stake in return for access to ABC programming. After months of wooing by Messrs. Chernin, Zucker and Kilar, Disney came on board in the summer of 2009. The company provided two years of exclusive access to TV shows—including "Grey's Anatomy" and "Lost"—on the Web free with advertisements.
Soon, the stage was set for a showdown. News Corp. had announced that Mr. Chernin, an original creator of Hulu, would leave the company at the end of June. News Corp. named Chase Carey to be its new president and chief operating officer.
Mr. Carey had a very different vision for Hulu, according to people familiar with the matter. The former head of satellite operator DirecTV, Mr. Carey was a big believer in the subscription-TV business. He worried that online video would train a generation of people to expect entertainment for free with advertising. He thought Hulu should be supported by both subscriptions and ads, those people said.
The strategy conflicted with Hulu's initial business model. While Mr. Kilar had talked about adding subscriptions since Hulu's launch, people close to him say he thought the best way to build the business was to increase the audience by keeping much of the content free, supported by advertising.
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Among broadcast networks, pressure was building to increase revenue. Having seen their audience migrate to cable for years, the networks were becoming increasingly insistent about seeking monthly fees from cable and satellite operators who used their broadcast signals. The networks needed the fees to help pay for soaring production and sports-rights costs. But in tense negotiations, the cable and satellite operators had a big objection: Why would we pay you for content you make available free on the Web?
In 2009, Mr. Kilar hashed out a subscription model that would become Hulu Plus. The idea was a compromise: New TV shows would remain free with ads. Paying subscribers would be offered additional content, as well as the ability to watch Hulu on devices other than their computers.
At a meeting of Hulu owners at News Corp.'s Manhattan headquarters last April, Hulu's management said it wanted Hulu Plus to offer access on multiple devices to full seasons of shows like ABC's "Desperate Housewives," leaving the most-recent episodes free with ads.
Some attendees said that didn't go far enough. At one point, Peter Levinsohn, head of digital distribution for Fox Filmed Entertainment, contended the new paid service was not differentiated enough from the existing free one, according to people familiar with the meeting.
Andy Forssell, Hulu's head of content acquisition and distribution, replied that Hulu would lose advertising if it restricted access to free new episodes.
Despite its privileged access to content, Hulu's revenue is still small compared to the bigger TV ecosystem and emerging competitors such as Netflix. In 2010, Hulu reported revenue of more than $260 million, up from $108 million in 2009. Netflix, which also rents out DVDs, had revenue of $2.16 billion last year.
Hulu's management prevailed that time. But owners and management would continue to differ on strategy.
In April, Disney unveiled software for Apple's new iPad tablet computer, offering free access to some ABC television shows with advertisements. The service raised a conflict: Hulu already was planning to offer the paid Hulu Plus service on the iPad.
Some Hulu board members and staffers were stunned. Mr. Kilar called Disney's chief executive, Robert Iger, to express concern, say people briefed on the call.
By last summer, eager to raise money to secure more content, Hulu management began discussing the idea of an initial public offering.
Hulu managers flew to New York in August to talk to investment bankers, some of whom estimated the company could go public at a valuation of around $2 billion. But to get such a handsome number, Hulu would need to lock up long-term access to its owners' programming.
The owners, however, wanted to first nail down their own new license deals with Hulu, which are set to expire this summer. They didn't want to conduct those negotiations while Hulu was under pressure to impress markets.
Board members, including Mr. Kilar, tabled the IPO in the fall and are now discussing raising capital through other methods. Hulu has asked the owners to invest more themselves, say people familiar with the matter, although it's unclear whether they will do so.
By October, as Hulu Plus was about to launch to a wide audience, Mr. Kilar clashed again with the owners.
Hulu's CEO worried that rival video service Netflix was gaining traction with a feature that allowed subscribers to stream movies and TV shows online on demand. Mr. Kilar proposed dropping Hulu Plus's monthly subscription rate to $4.99 from $9.99.
In a conference call, Mr. Kilar told the media executives how critical his proposals were: He indicated he was prepared to leave when his contract expired if owners didn't follow his recommendations, according to people familiar with the matter.
Both sides eventually compromised, and the owners agreed to a smaller 20% cut to $7.99 a month.
Hulu's owners are now preparing to start negotiations for their new licenses. Discussions have included such concerns as whether giving Hulu exclusive content restricts the owners unnecessarily. News Corp. and Disney are also each mulling whether to wait two weeks or more after a TV episode airs before making it available free online, according to people familiar with the matter.
Meanwhile, the media companies have all struck deals to license TV shows to Hulu's competitor, Netflix.
When NBC Universal recently gave new episodes of "Saturday Night Live" to Netflix, Mr. Kilar complained in a phone call with NBC's Mr. Zucker, people briefed on the conversation said.
NBC Universal is being forced to relinquish its Hulu management rights as part of government conditions on its takeover by Comcast Corp. NBC Universal may be obliged to start making more deals with Hulu competitors as part of those conditions.
ABC, for its part, has quietly built a potential subscription-based service that could mirror the selection of ABC shows in Hulu's subscription offering, according to people familiar with the plans. It remains unclear if it will launch the service.
Hulu's owners are now considering management's proposal to create a "virtual cable operator," according to people familiar with the talks. If they decide to move forward, some form of Hulu's free service would likely remain under such a plan. It is possible Hulu Plus could be folded into the new service, one of the people said.