Google/Youtube to Share Video Revenue

[Slimy]

Over the past several weeks, and continuing into the present time, Google has been actively attacking the problem of copyright violations for videos posted to its search properties by entering into complex revenue sharing agreements with major content providers, such as studios. This news was revealed during Google's third quarter 2006 conference call late Thursday afternoon.

But many of the formulas and the variables for those deals, these same executives admitted, are too complex to be explained to analysts, and some are actually still being determined, especially as the Web continues to evolve.

The implication here is that Google's agreements with content providers may be comprised, at least in part, of "agreements to agree" on a revenue sharing system, once it is determined where that revenue will eventually come from. Yet it's these agreements which will forestall content providers from challenging Google's rights to provide videos, especially as it takes control of leading streaming video provider YouTube.

"We were able to do some very interesting deals using a combination of financial pre-payments, revenue shares, other ways in which the money flows," said Google CEO Eric Schmidt, in response to a question from a Bear Stearns analyst. "We saw that, in our partnerships, the best partnerships come when both partners have a share in the revenue success of the deal, and that's typically the deal structure that we've been doing. I'd rather not go into the specifics of those deals."

Schmidt went on to remind the analyst that Google's deal with YouTube had yet to be closed, and that it remains a separate company, implying that any deals Google has already made with content providers may not yet apply to YouTube.

Google's SVP for global sales and business development, Omid Kordestani, elaborated further: "We're very excited to see not only that Google has had great momentum in talking with content partners - in fact, a majority of the executive team have been busy meeting with as many companies as possible, and would like to touch many of them in the coming weeks, and are actively talking about ways in which we can bring...all the Google capabilities that can improve the way these products can be offered to users, and generate a lot of revenue for the content owners. We're also very pleased that we saw that same philosophy at YouTube, that they were very actively striking these relationships, and they are complex."

But how will Google find a way to monetize the YouTube service - in effect, to produce an efficient business model for a service that's operating at full throttle, but which doesn't yet have one. As Kordestani responded, a clear answer hasn't yet presented itself. The secret is apparently the fact that so many people use YouTube now, that there has to be money behind that usage model somehow.

"It is a new space. We're all trying to understand each other," stated Kordestani. "We think ultimately the answer lies with the fact that there's a lot of usage here, a lot of interest from our users, and that we believe there's a great monetization engine at Google can provide here to make this all work for all the parties."

It was another stellar quarter for Google, with revenues of $2.69 billion - a 70% increase over the third quarter of 2005, and a 10% increase over the prior quarter. Breaking that figure down, 60% of those revenues came from "Google.com," which encompasses the division of the company that shares the least amount of revenue with its partners.

Still, the 39% of revenues that came from "Network Revenues," which include from AdSense - the portion which Google shares with partners to a much larger degree - grew by 54% over Q3 2005.

That portion is the greatest contributor to what Google calls Traffic Acquisition Costs (TAC), which as the company grows, Schmidt said, will be its way of normalizing its "cost of sales" in a more conventional accounting method. In the last quarter, Google's TAC was $825 million, $780 million of which came from AdSense. Google's own net income for the past quarter alone was $733 million.

If Google were in the hardware business like Intel and AMD -- which get bad comments whenever their gross margins fall to 50% and below -- Google's margins could be considered even lower.

In a surprising statement during Thursday afternoon's third quarter conference, Google's president for technology, Sergey Brin, referred to the development of Google Video and YouTube going forward as separate properties. At least in Brin's view, they'll exist together, but they won't be combined.

Brin's comments were prepared in advance, and not made extemporaneously or in response to a question from analysts, ostensibly to explain how the company is researching new search methodologies for video.

"When I perform a search," Brin said, "I often find that the best answer is not necessarily a Web page. I know that sounds like heresy from Google, but in fact, if you're learning a sport, if you want to build a house, if you want to study a science, often videos are the best medium to learn about those things...and this has obviously been a significant initiative for us. I'm speaking about both Google Video, which we've developed over the past few quarters or so, as well as, obviously, YouTube, which we announced our intent to acquire. Both of those together are going to really help to get more video to more users, providing them with better information to large classes of their kinds of search queries."

Google executives declined to share further light into the impetus behind its acquisition of YouTube, though they clearly indicated that it would not set a pattern for any future acquisitions. In fact, Eric Schmidt and others emphasized that the company will resume its typical growth pattern of partnering with other firms rather than buying them outright, adding that the partnership model has proven most effective in driving growth in both market share and revenue.

"We believe at Google that we're more effective when we partner," Schmidt stated in his opening remarks. "Partnerships are a huge benefit, not just for Google, but also for whomever the partner is. We see impressive growth in the area of partnering with existing and new companies from content technology and advertising perspectives, [and] we've laid the groundwork for many more coming. This industry is clearly poised for growth, and this is still the early stages of something that is likely to be a very major transformational industry."

Responding to a question from a Citigroup analyst, Google CFO George Reyes made it quite clear that the YouTube deal -- which involved a stock trade -- would not be the model for Google's future growth. "I think you should think of this as a one-off, one-time that we did [this], and going forward, we're going to use cash."

Can Google afford to do this? If you look at this quarter's numbers, you bet. "I'm sitting here looking at the free cash flow for this quarter alone," Reyes told another analyst, "and it's $512 million. So the cap-ex [capital expenditures] investments that we need to make, we can easily afford, and drive them to build more value for the company."

If the company expects to continue to maintain such a tremendous cash flow, can it afford to continue to stake its entire future on a bet that advertising alone can sustain the momentum?

"It's important that we develop other good sources of revenue going forward," stated CEO Eric Schmidt. "We think that advertising, and in particular search advertising, will be the majority of our advertising revenue for many, many years. We have a number of very interesting successes: The enterprise business continues to churn along. It would be an enormous success on its own merits."

By "enterprise business," Schmidt is referring to products and services Google is positioning toward server administrators, such as Google Apps for Your Domain. "You can see that product, as it becomes more successful, could become...a very significant source of revenue," said Schmidt, before adding that his company's online payment service, Google Checkout, which got off to a rocky start last June, could also provide some supplemental income.

But as Google continues to roll out more and more products, it could become more difficult for it to realize "monetization" with each new item, as Sergey Brin admitted. "If we continue to develop so many new, individual products that are all [in] assorted silos," he said, "you'll have to essentially search for our products before you could even use them. You'll have to search before you can do a search, in many cases.

"Instead...we're trying to create horizontal functionality across a range of products, across media types, and so forth," Brin continued, Google Apps for Your Domain being one example. It's the integration of existing services with new functionality, he explained, that makes that offering work well separately. "There are increasingly many ways that we're integrating together all of our search offerings, so you don't have to pick where you're going to search first."

The message Schmidt wanted to close with today was that Google will go back to focusing on partnerships, despite the "one-off" acquisition of YouTube. "The partnerships are much more than just revenue partnerships," he said. "They really are a way of doing business for us going forward."

In response to questions about legal concerns about video copyright, Schmidt offered this alternative to legal confrontation: "This value of video is to partner, not to focus on the legal aspects, but to focus on the business partnership aspects, because we certainly want to respect everybody's copyrights. They need us; we need them. The combination should produce some very interesting new partnerships, which we are hopefully going to work on, especially after the integration of YouTube is complete."

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