Google's YouTube Acquisition May Just Work

| About: Alphabet Inc. (GOOG)

Google Inc. (NASDAQ:GOOG) agreed to acquire YouTube today for $1.65 billion. In a recent issue, Business Week estimated that the privately-held video service loses from $900,000 to $1.5 million a month. We might be a bit rusty on our financial calculations, but we could have sworn that a losing cash stream was worth zero. What is Google thinking?

Let's preface this by some rough number work. Assuming that Google's internal required rate of return is 22.4 percent annually, or its trailing 12 month return on investment, and further assuming that the Internet giant pays $1.6 billion upfront and that YouTube will lose $1 million per month for a year, what would the monthly income need to be thereafter for the project to break even after five years? By our calculations, it would be about $67 million a month.

Mind, that's not profitability; that's breakeven, and we are ignoring legal liability that could turn out to be substantial. Our $67 million answer is not hard analysis. It seems unlikely that profits will suddenly kick in after a year of losses and show no gradual growth. Furthermore, we are only making an educated guess of what Google's internal required rate of return might be, and its return on investment has trended downward over the past few years. But for the sake of argument, the take home should be that the profits needed to justify the cost paid need to happen sooner rather than later, and need to be massive.

The question becomes what Google could change at YouTube to make a turnaround so substantial that it swings from weighty losses to profits a magnitude higher. First, there's the legal liability. Media companies right now are in a conundrum. Assuming that the major studios are still feeling their way to a new business paradigm in online content distribution — the friction, of course, being that the studios are loathe to allow people to move content between devices, exactly what consumers want most — YouTube's legal woes seem likely to dissipate and reform into a new revenue stream for the content providers. Indeed, today's announced deals seem to be doing just that.

There's also the idea that Google could see some huge synergistic benefit that would boost revenues, reduce costs or both. It is difficult to see what that could be right now with the exception that if Google bought YouTube it wouldn't need to continue funding Google Video.

Speculatively, if Google were to make massive infrastructure investment, to effectively become an Internet backbone, it would both transform YouTube's per-movie variable cost to a fixed-cost investment and solve in one fell swoop its "net neutrality" problems in Congress, assuming that the telcos agree to extend typical traffic exchange agreements to Google. This has long been rumored as one of its plans. Of course, that would also vault Google into the telecommunications business, which it might not find a comfortable fit.

In any case, before dismissing YouTube as a waste of money, we'd point to MySpace and its acquirer News Corp. (NASDAQ:NWS) Cost: $580 million. One founder now estimates the worth at $20 billion. It took about a year. That's a positively Google-esque rate of return.

At the time of publication, Paul DeMartino did not directly own puts or calls or shares of any company mentioned in this article. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

Note: This is independent investment and analysis from the investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by

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