Google + YouTube = Natural Monopoly

In the lesser of the two highly anticipated events of the weekend, Google announced that it will acquire the video sharing community YouTube for $1.6 billion in stock.

No rocket science needed to analyze the deal.  Google likely hopes to leverage its advertising client base and technological platform to reach YouTube's 30+ million users who view 100 million videos and post an additional 65,000 new clips every day.  Advertisers will now gain access to video media (beyond Google Video clips) in addition to paid-per-click text links on Google's home search page, knowing that the company's proven technology will ensure a good deal of accuracy in placing ads on relevant video clips and thus provide them a respectable return on investment.

Some speculated that one of YouTube's largest investors, Sequoia Capital's Mike Moritz (an original Google investor), would forgo a deal, believing that YouTube could become the next Google.  However, today's agreement demonstrates that the firm required Google's ad placement technology and advertiser client base to generate meaningful revenue growth.  Although YouTube has begun to build a copyright recognition platform to screen videos, the firm could not easily replicate Google's ad bidding system.  So, in joining forces to realize the potential of both companies, one could say that the next Google is likely Google.  This isn't an original perspective, but I believe it will be fruitful for investors.

To complete the deal, Google pays nothing in cash, allowing the transaction to remain tax free for YouTube investors and employees and preserving their $10 billion cash reserve.  The deal only dilutes the existing shareholder base by about 1.2% (at $430/sh, with 310M diluted shares outstanding, Google will issue 3.72M new shares worth $1.6B).  In comparison, Yahoo would have diluted its existing shareholder base by about 4.3%, and has yet to complete its ad placement technology that provides the user base reach (Google performs twice the number of searches as Yahoo each day), breadth of advertiser clients, and the quality of ad placements that Google does.

About a year ago, I noted the decline of the newspaper industry because of the migration of advertising dollars online and the emergence of free classified services such as Craigslist that have crippled newspaper revenue growth.  While regional and small town newspapers had formerly been touted as "natural monopolies" because of their gatekeeper role in allowing advertisers to reach the local population, Google has quickly become that type of monopoly.  As the company develops a reputation for providing the best, most relevant and useful search results for nearly any subject, it attracts more and more users. Once Google established itself as the dominant place for information, advertisers knew that they had to place their ads on there to reach the most individuals.  With Google's ad placement technology, local and global reach, and the ability to target users searching for specific information, advertisers could achieve a much higher return on their ad dollar investment -- unlike local newspapers who may have had some demographics from the publisher but nothing to match the specificity and reach of Google's searches. 

As Warren Buffett recently remarked, newspapers are in competition with the cemetery for readers.  Although he owns the most profitable newspaper in the US, The Buffalo News, he would never make the same purchase in today's climate.  He also mentioned what I consider the "2 by 24 problem" -- having 2 eyeballs and only 24 hours a day creates problems for media outlets competing for user/viewer attention in an age of expanding access points (Internet vs. TV).  As more people spend their free and work time online, they migrate away from traditional media sources -- TV and newspapers -- and use the internet for news and entertainment, precipitating the eventual popularity of video.  The large TV networks and newspapers must find a way to maintain their audience through online offerings.

The proliferation of wired (DSL, cable modem) and wireless broadband has facilitated the popularity of online video, enabling firms to provide much more data-intensive services that could greatly expand the media types provided in those search results.  YouTube demonstrates the potential of video search services in a high-speed data, increasingly Internet-focused world.  And, like Google in its early existence, YouTube developed a reputation for one of the most comprehensive, interesting libraries of videos that could be readily uploaded, shared and discussed in a community-like environment.  That attracted many other users and has become the default location to search for specific video content on the web.

Does this sound familiar?  Is this another "natural monopoly?"  Time will tell, but YouTube's initial popularity remains promising.  The firm will of course need to filter and remove copyrighted content, work with copyright holders to license their material, and determine the best method to utilize Google's advertising placement capability into a site that has yet to fully integrate advertising into its (YouTube's) service.  Also, sites with large user bases and nascent video services, such as MySpace, could compete for users.  But I think that Google and YouTube founders/investors realized that if you could combine one existing natural monopoly with a rapidly developing one, maintain "independence" as a service, and capitalize on the tendency for viewers to prefer one site, the combined firm's future growth could be pretty significant. 

I may be too optimistic, but I also think that those expressing pessimism regarding the future of the combined firm and its acquisition price may be underestimating the combined Google-YouTube's ability to competitively challenge MySpace for users.  Although MySpace's competitive position seems unbreakable right now, Google's advertising client list and technology seems to be much more difficult to replace.  The Wall Street Journal's Kevin Delaney will report tomorrow (reg. required) that News Corp. (Fox) Chairman Rupert Murdoch may have complained to Google execs regarding the acquisition following MySpace's agreement to use Google search technology.  Of course he's worried.  He doesn't want to compete against a firm whose technology he needs to help him fully monetize MySpace's user traffic, technology that he does not control, cannot develop quickly, and cannot get from Google competitors.

I also think that a lot of "why didn't I think or invest in this first" sentiment currently exists that may be influencing the long term view of the pairing (generated from reports that the founders may each pocket $200M).  Ideas and engineering talent are the lifeblood of Silicon Valley, and currently, innovation that can capture an audience of 30 million in 12 months remains in short supply.

As a side note, somewhere, Steve Jobs is smiling -- most consumers may watch much of this using their iTV or widescreen video iPod.  Google CEO Eric Schmidt recently joined the board of Apple, the current "arms dealer" to the music industry and the likely future one for video.

Thanks again for your time, and I welcome any feedback. 

Disclosure: Author is long AAPL