Is Hulu Undervalued?

Earlier this year, Disney (NYSE: DIS  ) and Twenty-First Century Fox (NASDAQ: FOXA  ) backed out of a sale of their joint-venture streaming video service Hulu, of which Comcast (NASDAQ: CMCSA  ) also owns a one-third share. The company reportedly garnered bids around $1 billion.

It's likely that amount undervalues Hulu, as the company reported that it expects revenue to top $1 billion in 2013 -- up 44% from 2012. There were numerous factors pushing the price down, but a price to sales ratio of 1 doesn't seem right, especially compared to its closest analog Netflix (NASDAQ: NFLX  ) , which sells for over 5 times its expected 2013 revenue.

What kept the price down?
There's a large discrepancy between Hulu's and Netflix's price partially because Netflix has several valuable content deals locked up for the future. Hulu was offered with just two years of content rights guaranteed from Fox and Disney. There's a fair amount of risk in video streaming services especially considering the rising price of content.

In fact, Netflix has focused on locking up big deals well into the future with the big names including Disney, DreamWorks Animation, and Warner Brothers. While these deals come with hefty price tags, they provide a hedge against the rising cost of content for video streaming companies.

It shouldn't be a surprise then that the owners decided not to sell Hulu. The company is more valuable in the hands of the content producers than nearly anyone else, because it inherently holds less risk. It's not like Disney will refuse to license its content to itself.

Potential for growth
Of course, revenue isn't the only thing that ought to determine the value of a company. Investors also need to factor in potential future sales and profits.

Netflix is expected to grow its sales 20.9% this year and 18.8% next year off a base of $3.61 billion last year. Comparatively, Hulu expects revenue growth of 44% this year off a base of $695 million. If we assume the company can continue to add subscribers at the same pace as the last year and a half (2 million per year) and that subscription revenue accounts for 40% of total revenue (which appears higher than historical averages), Hulu should expect another 40% increase in revenue in 2014.

Hulu's sales ought to continue growing at a faster rate than Netflix considering its smaller base, although Netflix is making lots of headway internationally. There's no reason Hulu can't follow the same route.

More importantly, Hulu ought to become profitable more easily than Netflix can maintain its current profitability. Hulu's parent companies hold the fate of Netflix in their hands. Should the companies one day find more value in keeping the streaming rights to their content away from Netflix, they could do so. They could also hold out for more money as Netflix's revenue grows. Perhaps, if Hulu Plus sees slowing revenue growth, the owners may begin streaming additional content on the platform, which may compel subscribers to switch.

This is likely a reason Netflix has gone the way of contracting original programming -- as a hedge against the competition pulling the rug out from under it. In working directly with production companies, Netflix is better able to control its access to the content rights, but is not necessarily an exclusive licensee past the first window -- as is the case with House of Cards, now available on DVD.

Is the market undervaluing Hulu?
I certainly believe Hulu is worth more than $1 billion, especially in the hands of Disney, Twenty-First Century Fox, and Comcast. Even $5 billion -- nearly the same price-to-sales ratio as Netflix -- might be undervaluing the property.

Of course, in the hands of these three media giants each valued between $79 billion and $135 billion, $5 billion split three ways is not a significant portion of their market cap. But Hulu has the potential to grow into a much larger and more profitable revenue stream than it is currently, and investors may not be valuing that properly.

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