The Tycoon Report

Google Steals the Show

I hope you remember my article on August 2nd when I discussed a start-up company that was shaking up the online video market place – as a matter of fact, this company actually defined the market!

The company I talked about was YouTube.com – as of Monday, that name might sound much more familiar than it did two months ago.

The reason for this is that as of Monday night, Google (Nasdaq:GOOG) acquired YouTube for $1.65 billion in stock! 

That’s three times the size of the News Corp. (NYSE: NWS) – MySpace transaction, and it propels Google into the forefront of the online media space.

I’ll discuss valuation in a moment, but I just want to say that this is a sad day for the likes of AOL and Yahoo! (Nasdaq: YHOO) – two companies with extremely strong backgrounds in media & entertainment – who let this company slip through their fingers.

Just to quote myself from my August 2nd article:

“It’ll be a sad day in the Valley if AOL lets Yahoo! or Google steal this company away too.” 

And a sad day it is indeed – but not for Google…or for the Co-founders of YouTube, Chad Hurley and Steve Chen, the 29 and 28-year-old founders, respectively.

According to some estimates these guys are now worth $200 - $300 million each.

Not a bad return for a company that only officially launched 19 months ago!

Let’s Talk Valuation First

Ok, so Google acquired the company for $1.65 billion in stock – on the conference call held on Monday evening the company stated that this was done in order for the transaction to be tax-free for YouTube shareholders.

Now, could another company – say, Microsoft (Nasdaq: MSFT) – have acquired YouTube in an all-stock transaction?  Not likely!

Microsoft’s stock price has been range-bound for quite some time and looks like it’ll be sticking to that range for a while longer.  If I’m a YouTube shareholder, I’d rather go for the stock that many predict will break $600 per share in the near future.

The structure of the deal aside, what about that hefty price tag? 

I mean, are the risks of this transaction worth the potential reward?  But more on that later, let’s just take a few minutes to check YouTube’s financial situation.

I won’t discuss YouTube’s cost structure in too much depth – for one thing it’s hard to predict, especially now that Google owns it, and because the price of storage and bandwidth is dropping every quarter.

This company will have very different profit margins a year from now.  But let’s just look at the revenue the company should be generating right now.

To be clear, YouTube is a 100% free service.  Its business model is the same as a typical television network – it’s all based on advertising.  

Because YouTube has stuck to the policy of not including “pre-roll” ads in its videos – pre-rolls are 10 – 15 second ads that appear before a video is played, similar to a commercial on television – they rely on sponsorship deals and regular banner ads.

YouTube supposedly serves 100 million videos each day.  And it has a single banner ad above each video.  

In the online advertising world, advertisers pay publishers on a CPM basis – this means that they pay a certain price for every 1000 advertisements shown.

So, to keep it simple, we’ll say Google serves 100,000,000 ads each day.  When we divide that number by 1000, we get 100,000 CPM’s each and every day.

Because much of YouTube’s audience is a younger demographic, and not extremely focused, we’ll guess that YouTube gets an average “CPM rate” – the price an advertiser is willing to pay for every 1000 ads displayed – of $1.

That would put YouTube’s daily revenue at $100,000 – that’s annual revenue of approximately $36 million.  That’s not including any sponsorship deals, however, so let’s tack on another $10 million annually.

With annual revenue of $46 million, YouTube just got acquired for 35 times annual sales – that’s a bit rich in my book, but the growth and the user base may justify it.  We also have to think about this in competitive positioning terms. 

Google will have to contend with the likes of AOL-TimeWarner (NYSE: TWX), Microsoft and let’s not forget News Corp. (NYSE: NWS) and its MySpace.com property if it tried to “go it alone” in the online video market.

So the YouTube acquisition allowed the company to take the “top spot” in one fell swoop.

And What about MySpace?  

This raises another interesting question – Google just cut a $900 million ad deal with MySpace and then it goes and acquires one of MySpace’s largest competitors.

The MySpace.com people weren’t pleased and Eric Schmidt will be having a meeting with Rupert Murdoch later this week to discuss the deal. 

The other interesting thing is that MySpace supplies the majority of YouTube’s traffic – if the mammoth social network begins blocking all YouTube content, who do you think will get hurt – MySpace (that already has its own video service) or YouTube?

I think it’s obvious, and that isn’t the only risk YouTube, and now Google, is facing.

Napster 2.0? 

The other thing we need to keep in mind is that much of YouTube’s high-trafficked content is copyrighted material (e.g. TV & movie clips, music videos, etc.).

I mean, isn’t this what Napster was eventually shut down for? 

To YouTube’s credit the company has been cutting a ton of content deals with major production houses such as Sony-BMG and CBS (owned by Viacom).

But it has yet to cut a deal with Mr. Murdoch – owner of Fox and coincidentally, MySpace.com.

It seems that no matter which way we turn, YouTube is running smack into the “News Corp. Wall.” 

The company faces a ton of liability for generating money off of content that is not its own and is currently battling one law-suit related to copyright infringement.

Maybe Google thinks that because of the clout it carries in the tech markets and the recent deal it cut with both AOL and MySpace it will be able to work something out to the benefit of all.

That may be the case, but it will certainly take a little time to smooth out all the wrinkles and will further impact YouTube’s profitability if it has to share revenue with content owners.

But don’t write this off as a bad acquisition just yet. 

YouTube is still the hottest media property on the web today.  It’s cutting sponsorship deals left and right lately and by integrating Google AdWords, the revenue of the site could grow dramatically.

In my opinion, the biggest hurdle that Google/YouTube will face in the coming months is from MySpace. 

If Murdoch gets angry and decides to sue the companies or just shut off the traffic spigot – YouTube and Google will be in for the battle of their lives.

I’ll be keeping a close eye on how the talks between the companies progress later this week.

Until next week ...