Why $100bn YouTube is Google's Hidden Gem

Morningstar equity analysts expect YouTube revenue to grow to more than $29 billion by 2021, driven by increase in digital video ad demand and subscriber growth

Ali Mogharabi 6 October, 2017 | 8:24AM
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Morningstar equity analysts have taken an in-depth look at Google's YouTube, as we believe this business with a strong competitive advantage has been underappreciated by the market and may be a more important contributor to Google parent company Alphabet (GOOGL) and Google's strength than commonly believed.

While Alphabet does not provide much detail regarding YouTube or other businesses under Google, we looked at the total addressable digital ad market, along with potential streaming video subscribers, and estimate that the business could be worth up to $102 billion or 15% of Alphabet's overall market cap and 62 times more than the $1.65 billion Google paid for YouTube in 2006. 

We believe YouTube is an important contributor to Alphabet’s network effect – where a service gains in value as more people use it - as content providers are attracted to YouTube's massive user base, while additional content continues to bring more users onboard searching for and consuming more videos on the platform. The business also contributes to Alphabet's large and valuable collection of user data and the behaviour of billions of YouTube video watchers.

We think this data is an immensely valuable intangible asset that is not only another prime source of Google's competitive advantage today, but also one that should grow even stronger as future ad dollars are spent on YouTube. Investors also should not underestimate the benefit of diversification, as YouTube revenue lessens Google's dependence on search ad revenue. 

We anticipate YouTube continuing to expand its content library, which will perpetuate its network effect and treasure trove of view data that will continue to attract both viewers and advertisers. We estimate that YouTube will generate over $29 billion in revenue by 2021, up from our 2016 estimate of $12 billion. By 2021, we expect YouTube's subscription offerings YouTube Red – which offers an ad-free experience - and YouTube TV to generate combined revenue of $5 billion.

While our latest valuation on YouTube has also increased our valuation of Alphabet, the holding company remains a three-star stock, which means it is fairly valued by the market. However, we encourage potential investors to allocate capital to that name on any pullback. 

As we look across Alphabet's various businesses with strong competitive advantages, we think YouTube is a hidden gem and is worthy of additional analysis. YouTube was founded in February 2005 and quickly emerged as a leading site for video posters and viewers.

Alphabet's Google spotted the potential exponential growth of YouTube's users and content library early on and acquired the firm in November 2006 for $1.65 billion, a high price tag for a service that was earning minimal revenue at the time, but a deal that was a shrewd move in retrospect, in light of the tremendous network effect the firm has built over the past decade. YouTube currently stands as the leading online content distributor.

Based on various reports, the firm is boasting more than 400 hours of video uploads a day and five billion daily video views. YouTube's latest monthly average user count stands at 1.5 billion, according to its CEO, Susan Wojcicki. We estimate that the firm generated $12 billion in gross advertising revenue in 2016. We project total YouTube revenue to grow to over $29 billion by 2021, driven by increase in digital video ad demand and subscriber growth.

Google's Powerful Algorithms

We view YouTube as a firm with valuable intangible assets associated with user data, as well as a company that benefits from powerful network effects between viewers and content providers, both user-generated and professional. If YouTube were an independent company, we would probably propose it to be a wide-moat firm in isolation. We continue to believe that YouTube's parent, Google, holds significant intangible assets related to overall technological expertise in search algorithms and machine learning, as well as access to accumulation of data that is deemed to be valuable to advertisers.

In our view, the same can be said of YouTube. Its video search capability, along with its growing content, has kept bringing back viewers. YouTube's massive user base allows the firm to collect rich data about content type and topic viewing, video length viewing, time-of-day viewing, and additional user behaviour information. With such data and a large user base, YouTube is likely able to offer an attractive return on investment for advertisers and build a growing network of ad clients, like what we have witnessed Google's search function accomplish over the years.  

In our view, YouTube's variety of content, ranging from user generated, which over time has created YouTube stars, to premium, or studio-produced and live events, reinforces the firm's network effect. As YouTube's content library attracts more users who create additional content, upping the value of the platform for current and new users, the network effect flywheel will continue to spin. In our view, YouTube has become the hub of nearly all types of content. To generate revenue from content, digital content owners may begin seeing YouTube and its 1.5 billion global audience reach as the most effective content distributor. 

In terms of YouTube's audience, with such variety of content, users aged 16 to 34 from all around the world are attracted to YouTube, which makes the platform attractive for advertisers. We expect online video consumption to continue to increase within this age group, which is valued highly by advertisers. Overall online video watching in the US has been increasing as users in the 18-to-24 age group are watching at least three hours of video online, up from two hours only two years ago. 

In the US, an estimated 80% of the 18-to-24 age range uses YouTube, according to a study by media company GfK MRI. Based on a study conducted by Defy Media, we estimate that about 84% of youths within the 13-to-24 age range view content on YouTube, compared with 91.5% using other social network platforms such as Facebook, Instagram, Snapchat, and Twitter.

We note that the social network figure is likely to be lower if broken down into each specific platform only. In fact, in the same study, when youths within that age range were asked which video source they "can't live without", 67% answered YouTube and only 48% said social media.

YouTube advertising revenue

Facebook's Threat is Real

While YouTube remains the market leader, other social networking companies, such as Facebook and Twitter, are also trying to grab a piece of the attractive and growing video ad pie. While we think Facebook (FB), with its strong network effect and base of more than 2 billion users, can make headway competing with YouTube, we have strong doubts about the ability of Twitter (TWTR) to slice out a substantial piece of the pie. 

Our valuation of YouTube is $102 billion, based on sum of the parts, which includes six times YouTube's 2018 ad revenue plus two-and-a-half times YouTube Red and YouTube TV revenue. In our bull-case scenario, we value YouTube at $130 billion, around 28% higher than the base case. Components of the sum-of-the-parts method include seven times 2018 ad revenue plus three times the subscription revenue.

We have assumed higher click rates for ads as more TV ad dollars than estimated in our base case are likely to shift to digital. In this case, we have also assumed YouTube will successfully attract more subscribers to its Red offering mainly because of YouTube Red Original programmes. Along with a higher YouTube TV subscriber count, we expect total YouTube revenue to grow at a 24% compound annual growth rate to around $35 billion by 2021.

We think YouTube would be worth $80 billion in a bear-case scenario as we are assuming that more viewers would tolerate more ads in exchange for free content on YouTube. In this scenario, YouTube TV is likely to have more difficulty attracting subscribers, given the presence of many other players in the space. Based on our bearish assumptions, we have estimated total YouTube revenue of $23 billion in 2021, which represents only a 14% five-year compound annual growth rate. Our bear-case valuation, which is 22% lower than our base case, represents five times 2018 ad revenue plus only one times YouTube's subscription revenue. 

With our updated estimates of YouTube revenue, we now forecast total Alphabet revenue of $126 billion in 2018, up $1.2 billion from our prior estimate. We have forecast a 16% five-year compound annual growth rate for Alphabet's revenue with such growth coming on the back of not only continuing growth in digital advertising, but also the firm's growing market share in the cloud market.

Although we believe that Alphabet is fairly valued today, YouTube is an entity that investors should continue to keep an eye on, as it is an important contributor to Google's growth and economic competitive advantage.
































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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Alphabet Inc Class A185.07 USD-0.27Rating
Alphabet Inc Class C186.78 USD-0.28Rating
Meta Platforms Inc Class A498.87 USD-2.70Rating

About Author

Ali Mogharabi  is an equity analyst for Morningstar

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