Summary
Google paid a very high price YouTube, but had to do so in order to maintain its competitiveness. Translating YouTube's massive user base and usage levels into profits is going to be a huge challenge.
Analysis
Google absolutely overpaid for YouTube, yet also had little choice. While some very flawed estimates put the two-year old company at a $90 million annual run rate, there is still no financial justification for paying 18X trailing revenues. However, Google probably couldn't have sealed the deal for a penny less.
Online video consumption continues to grow at a shocking pace, but no one (outside of the adult industry) has executed a strategy to turn these eyeballs into dollar signs. Impatient Internet users continue to shun video ads, and there is not a critical mass of online advertisers ready to deploy them yet, either. Sales of video content are gaining traction, but remain very small and mostly focused on re-purposing of tv shows and other mainstream productions. In time, Google/YouTube will likely develop a finely tuned revenue model for these facets of the business, but I suspect that we are several years away from seeing it.
So, why did THIS deal have to be done? Contextual advertising inventory. While still the clear market leader, Google is seeing ever-increasing waves of competition in its core contextual advertising business. MSN is gaining steam, Yahoo is debuting a major upgrade and Ask.com (IAC) did a major re-launch just days ago. Competition is significantly heating up, and threatens to infringe on Google's limitless appetite for inventory.
Keep in mind that with performance-based advertising, you must show ads roughly 19 times for free before finally generating a revenue-producing action on the 20th view. As Web usage continues to concentrate in a handful of properties, winning the advertising rights for those properties becomes vital for continued growth. In the near term (1 - 3 years), the YouTube deal is done under the same rationale as Google's Myspace partnership, MSN's alignment with Facebook and the countless second and third tier deals that don't make big headlines.
Google may indeed crack the secret to building a hugely profitable video business in the next several years, but for now, it's the un-sexy world of text ads that made this deal a Must Do.
