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YouTube's Bold Move Toward Profitability

YouTube helped make Scottish singer Susan Boyle an overnight sensation, but the video-sharing site isn't getting much in return. Clips of the singer's spectacular debut on U.K. TV show Britain's Got Talent have been watched an estimated 100 million times. But like most videos on YouTube, the Boyle snippets don't carry ads and therefore do little directly to make money for the site.

To reverse the trend, Google (GOOG) is setting up partnerships with big media companies that would help it generate more advertising dollars from the millions of videos hosted on YouTube. This month, YouTube added sections for movies and TV shows and announced deals to bring content from Sony Pictures (SNE), CBS (CBS), MGM (MGM), Lions Gate Entertainment (LGF), Starz (LMDIA), and others to the site. Almost three years after purchasing YouTube, Google is taking the boldest—and some say smartest—steps yet to wring profit from its $1.65 billion buy.

By growing its library of professionally produced content, Google aims to make YouTube a more attractive destination for advertisers. "As a repository of user-generated content, YouTube was not going to make it," says Youssef Squali, analyst with Jefferies & Co. "They're putting together the building blocks" for profitability, Squali says.

A Losing Proposition?

By many estimates, Google loses hundreds of millions of dollars on YouTube each year. Credit Suisse (CS) analysts believe Google makes about $240 million in annual revenue from the site but spends $711 million, partly for bandwidth from Internet service providers such as Cogent (CCOI) and partly to license content from providers such as Universal Music. Other analysts and people close to YouTube say the figure is too high, though Google doesn't disclose financial figures for the division. A YouTube spokesman says analysts often overestimate figures for such expenses as bandwidth and storage.

Marketers have largely balked at the unpredictable and sometimes racy quality of video clips on the site. "Advertisers were reluctant to show ads next to content they didn't really know," says Jean-Phillippe Maheu, chief digital officer for the North American arm of advertising agency Ogilvy & Mather Worldwide. Google also avoided placing ads next to content that may have been posted without the creator's permission. "We only run ads on partner videos, and not all partners choose to run ads on videos," says YouTube spokesman Aaron Zamost. Whatever the reason, ads show up on a small portion of its videos—from 3% to 9%, according to estimates by researcher eMarketer.

As if making money for its owner weren't reason enough, YouTube has more cause to step up its advertising game. It's facing increasingly stiff competition from Hulu, the joint venture of News Corp. (NWS) and NBC Universal (GE), which has helped demonstrate that there's a market for ads run in conjunction with professionally produced content. In March, just a year after its launch, Hulu became the second most popular site for online video after YouTube. Hulu shows "in-stream ads," or short video ads before, during, and after its programs. That, says Ogilvy's Maheu, is "a format that TV advertisers are used to."

Currently, YouTube advertises mainly in four ways—through video and banner ads on the home page, sponsored videos placed alongside search results, so-called "overlays" and other ads that occur on the video player while a clip plays; and contests and promotions. Google plans to keep those ad formats, but with the new content will expand to include in-stream ads, which often fetch higher rates. And while online advertising more generally is under pressure this year, demand for online video ads is on the rise. EMarketer recently revised its 2009 projection for the market to $1.05 billion, from $850 million previously. "Advertisers want (online video) because it's the main way they are able to do brand advertising online," says eMarketer senior analyst David Hallerman.

Getting Recent TV Content

As alluring as professionally produced content may be, YouTube may need to round out its roster of recent programming. Hulu benefits from ties to major content owners that let it post popular new shows from Fox, NBC, and other networks shortly after they've aired on TV. By comparison, YouTube's recent crop of content includes only one TV show that was created in recent years, CBS's Harper's Island. Many TV networks reserve top-flight programming for their own Web sites, says Arash Amel, an analyst at London-based media researcher Screen Digest. "YouTube is one step removed from that," Amel says.

Of course, Google has the cash to pony up for programming. "Once you prove the concept, you'll go out and write a bigger check and get some of the newer content," says Jefferies' Squali. In exchange for a content license, YouTube typically pays partners a small royalty each time a video is watched in addition to a percentage of any revenues it generates from ads.

If money isn't enough to lure content creators to YouTube, the site's size might. In March, it attracted 89.5 million unique viewers, compared with Hulu's 8.9 million. Bobby Tulsiani, an analyst at Forrester Research (FORR), says YouTube will need to grab the millions of viewers who come for viral hits like Boyle and send them to areas of the site with more advertising. "Imagine if they can do millions of views on something like Star Trek," Tulsiani says. "Then if I'm NBC, I'm listening."

Chris Dale, a spokesman for Google, says the company will have an easier time convincing content owners to bring new shows to YouTube once the revenue model behind the older content has been proven. "Hollywood recognizes that we have an audience of unprecedented size and we have this huge global footprint," Dale says. "They want to get in front of that audience but they want to see how it goes first."

Once Google has won viewers who surf the Web, it will try to keep them as they move on to other screens. Within two years, "prime time is going to be programmed by the consumer," says YouTube product manager Shiva Rajaraman. He believes YouTube will deliver movies, music, and shows to the living room, where families will huddle around Internet-connected TV sets. And if advertisers feel at home on YouTube, they might settle comfortably into those other rooms as well.

With Robert D. Hof in Silicon Valley.

Douglas MacMillan is a staff writer for BusinessWeek in New York.

MacMillan is a reporter for Bloomberg News and Bloomberg Businessweek in San Francisco.

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