Deal only makes sense in fast-forward

Even Google, it seems, is prepared to admit that the $1.65bn it has just agreed to pay for YouTube is in danger of being seen as a new high point in Silicon Valley’s latest bout of dotcom fever.

“You can imagine it would be difficult to justify this on a stand-alone basis,” David Drummond, head of corporate development, said on Monday. It is only when you come to look at the future use that Google can make of YouTube’s audience, he suggested, that the deal starts to make sense.

On at least one measure, the high entry fee that Google is paying to take the leadership position in online video may not be as outlandish as it first appears.

YouTube has about 35m unique visitors in the US. Add in its foreign audience, and the company probably streams short videos to some 50m people each month, according to Charlene Li, an analyst at Forrester Research.

That is equivalent to about $32 for each visitor – a seemingly high price to pay given the scarcity of advertising on the YouTube site. However, a comparison with News Corp’s purchase last year of social networking site MySpace, another online deal that stretched traditional financial metrics, suggests that it falls broadly within the same range.

Intermix Media, owner of MySpace, claimed 27m unique visitors when it agreed to the News Corp deal, putting the price paid per user at $22. Since then, valuations for successful online community sites have jumped – thanks in no small part to MySpace’s continued success inside News Corp. Provided it can generate advertising around YouTube’s online audience, a price of $32 per user could easily be justified “within a year or two”, says Josh Bernoff, another Forrester analyst.

That is still a big “if”. Success will depend on how well Google can apply three of its key assets to the YouTube audience and website.

Potentially the most important is the Google advertising network. Speaking late last month, Chad Hurley, YouTube’s chief executive, brushed off the suggestion of an advertising deal with Google that would simply “plug” adverts collected by the Google system into YouTube’s website. Instead, he suggested that the video site needed to build its own advertising network to deliver the sort of branded advertising experience that Yahoo has created.

On Monday, however, most observers agreed that the search engine giant stood a far better chance of building a successful business around YouTube’s early success than the upstart video site did on its own.

“I have no doubts about Google’s ability to monetise this [audience],” said Roger McNamee, a veteran Silicon Valley financier. “They can monetise anything that brings millions of people together.”

The second asset that Google hopes to apply to YouTube is its search technology. If the company’s mission is to organise all the world’s information, then the masses of user-generated videos starting to find their way online represent an important source of raw material for the search engine company, according to Sergey Brin, Google’s co-founder.

“Search is a very difficult problem,” said Mr MacNamee, particularly when it comes to identifying videos by image recognition, a technology that could eventually play a big role in helping users sift through YouTube’s vast library.

Third, Google has already built a global network that should be able to deliver YouTube’s video streams far more effectively, and at lower cost, than it has been able to do itself. Google has already identified 20-30 ways that it can bring these three capabilities to bear on YouTube to reap the synergies to make sense of the high price tag, said Mr Schmidt. “We don’t lack for ideas.”

Google’s calculations, however, are based on some big assumptions – most importantly, that YouTube can keep and continue to expand its online audience, and that it can continue to act as a magnet for an ever-growing array of online video.

Both of those assumptions could be in danger if established media companies decide they do not want their copyrighted material to appear on YouTube.

If Google takes a stricter line on copyright enforcement – as many observers now expect – that could strip YouTube of much of its content.