Hulu's Biggest Advantage Over Netflix

Hulu can benefit from its close relationship with networks ... as can the networks. Source: Hulu.

Hulu and Netflix aren't exactly rivals, but the relationship between Hulu's parent companies -- Twenty-First Century Fox , Walt Disney's ABC, and Comcast's NBCUniversal -- and the competing streaming service is becoming increasingly tense.

That relationship is exemplified in the recent negotiations around FX's content. Owned by Fox, FX is a cable station that produces shows such as Sons of Anarchy and American Horror Story. In its most recent negotiations, the network wanted to retain the right to brand its content with its logos and stack full seasons of the current season in on-demand services from cable operators.

Netflix doesn't offer flexibility like that, but Hulu is happy to provide its parent companies with a little extra advertising. The relationship with its parent companies gives Hulu a nice advantage over Netflix and other streaming services and could put Netflix in a bad negotiating position.

An unfair advantageHulu is the ace up the sleeve of the major broadcast networks. While Hulu operates independently of the broadcasters, it works on the framework that its best interests and those of the content owners are usually tied to one another. Thus, it's willing to make more concessions, such as allowing networks to offer full seasons of "exclusive" shows on demand via cable operators.

Netflix, on the other hand, is more like a competing network looking to syndicate old shows from other broadcasters. Thus, keeping branding or allowing cable subscribers to view the content through other means works against its efforts to attract a larger audience.

Having Hulu as a buyer and a subsidiary gives Fox, Disney, and Comcast the upper hand in negotiations with Netflix. Even if Hulu itself is unable to turn a profit with higher content costs, those numbers are hidden on the income statements at Fox, Disney, and Comcast, where the revenue from selling the content and the cost of buying the content essentially cancel each other out. That allows Hulu to bid more, since it's not subject to the close scrutiny of investors unlike Netflix.

Of course, there is the opportunity cost of not selling the content to a third party, and any business should be looking to maximize profits. Forgoing revenue from a Netflix deal today suggests that Fox believes the long-term value of having the new FX content on Hulu, being able to offer full seasons on-demand, and place branding in the online videos is greater than Netflix's offered price.

Content costs will keep risingNetflix is stuck in a position of being forced to pay an increasingly large amount for the bulk of its content. This could explain why the company has started producing its own original content and has accelerated the development of new originals.

Still, the bulk of its content is coming from other networks and media companies. Fox, Disney, NBC, and the CW have Hulu to help drive bidding higher. CBS recently launched its own platform that it can fall back on. With Netflix's revenue stream only coming from subscribers, rising content costs will eventually cut into the company's ability to grow profits.

Valuations are out of whackNetflix's earnings growth is expected to slow from a robust 84.9% this year to just 36.8% next year. Long term, analysts expect Netflix to grow earnings an average of 28% over the next five years (including this year), implying EPS of $6.35 in 2018. That means analysts expect an average of just 11% earnings growth per year after 2015.

Those estimates seem reasonable, but the fact that Netflix trades for nearly 73 times next year's earnings estimate does not. The potential earnings growth simply doesn't justify paying such a high multiple. If you consider that the company is heavily reliant on content from other companies and has less leverage in negotiations, it's hard to see Netflix producing enough profit expansion to grow into its valuation in the long run.

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Adam Levy owns shares of Apple. The Motley Fool recommends and owns shares of Apple, Google (A and C shares), Netflix, and Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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