Is Hulu Making a Big Mistake?

Image Source: Hulu.

During the last few years, Hulu has been taking steps to play down its free streaming service while encouraging users to sign up for its paid offering. It started by limiting available episodes. Then it started delaying when free viewers could watch them. This week, Hulu announced that it's closing down its free service, and will only license its free content to other video platforms like Comcast's (NASDAQ: CMCSA) Comcast is a co-owner of Hulu.

The idea is to focus its efforts on the paid service, which offers more content and less of a delay between its original airing and when it appears on Hulu. It also allows subscribers to watch Hulu on their connected devices through its apps, not just in the internet browser. That should position Hulu as a premium service along the lines of Netflix (NASDAQ: NFLX), and less of a free-TV-alternative like YouTube, which is owned by Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL)subsidiary Google.

Is it a huge mistake?

Although Hulu has been pushing viewers toward its paid service for some time now, many people still watch the free content it provides. A survey by eMarketer earlier this year found that 30% of Americans watch video using a free-content aggregator like Hulu --which is now shutting itself off froma large number of people.

Last year, eMarketer estimated that about 60 million people stream video on its platform every month. Hulu says it has only 12 million paid subscribers between its operations in the U.S. and Japan. So only about one out of every five Hulu viewers is a paid subscriber.

Hulu will lose out on revenue from its free viewers, but that's not the biggest concern here. The free service provided a platform to sell its premium subscription to viewers. Just as Spotify uses its free-listening tier to grow paid subscribers, Hulu has been able to do the same. Now, Hulu's free content is only distributed to other websites, and its branding is largely stripped away.

The move will make Hulu marketing and sales more difficult as the company's brand identity is still relatively weak. A survey from iModerate last Summer found that most respondents were eager to try Hulu, but were mainly interested in watching one specific show.

Hulu has expanded its original content offerings, and acquired the rights to the EPIX catalog since that survey to round out its service. But Netflix is still hard to beat when it comes to the amount of value it brings to the table.

Even Time Warner's (NYSE: TWX) HBO is barely holding its own against Netflix. The company's over-the-top service, HBO Now, brought in about 1 million subscribers in the year after it launched. During the same period, Netflix added more than 5.5 million U.S. subscribers.

Opening the door for competition

There are three ways Hulu's proposed change could go. Everything could work out perfectly, and Hulu could convert a good percentage of viewers into paid subscribers. The vast majority of subscribers would still likely pass on Hulu's paid service.

The question is, what becomes of those free viewers? Do they succumb to the pressure to subscribe to a paid streaming service? In that case, Netflix is likely to benefit to some degree, as it remains the market leader, and has the strongest brand identity of any of its competitors, including Hulu.

With the prevalence of paid streaming options, the majority of free Hulu streaming users are likely to seek out free streaming alternatives. That opens the door for YouTube to grab more watch time, or the growing number of free streaming services. Alternatively that time could also go to non-video-focused digital platforms, like social media.

The benefits of premium only

On the other hand, the move by Hulu makes its service (now paid only) appear more like a competitor to other premium services like Netflix. If Hulu uses the opportunity to establish a stronger brand identity now that it has an improving content catalog to back it up, it could pay off in the long run.

Hulu plans to launch a digital pay-TV service next year that streams live networks. Time Warner came on board as an investor earlier this month, and it agreed to include its networks in the upcoming service. As Hulu positions itself as a paid-only service, the perception of Hulu will change in consumers' minds: If you want Hulu, you have to pay for it.

Hulu is still running at a loss, as Time Warner's latest earnings outlook made clear. Making the decision now to shutter its free tier should have a minimal impact on its earnings.

The downside, however, is that it will decrease Hulu's marketing efficiency because it likely converted many customers from its free tier, and it opens the door for competitors to take that time spent with Hulu. On the upside, it positions Hulu as a premium service, not an also-ran Netflix competitor.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Adam Levy has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Netflix, and Time Warner. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.