OCTOBER 2, 2006

Technology

By Steve Rosenbush

Why Online Video Sites Are Hot Targets

As TV viewing habits change, media companies—and advertisers—are looking elsewhere: They've set their sights on a new breed of startups

As the Internet snaps to life with homemade movies, TV shows, and other forms of video, companies that offer online video are seeing the value of their businesses surge. How much their value is rising, however, is becoming a topic of increasingly hot debate, among moguls in Hollywood, entrepreneurs in Silicon Valley, and investors in New York.

Mark Cuban, the tech entrepreneur and owner the Dallas Mavericks, said on Sept. 29 that anyone who buys YouTube, one of the most popular video sites, is a "moron." His comments came the same week that analyst Jordan Rohan of RBC Capital Markets argued that MySpace, the social networking site that generates a huge volume of video traffic, could be worth $15 billion in three years. At its heart, this debate is over what role these Internet video companies will play in the media world—bit players, important supporting actors, or the new media stars.

VALUABLE VIEWERS. While the value of each company clearly depends on its particular performance, the factors that are proving important for Net video players are quite different from those of traditional media companies. In traditional TV, more viewers mean more money. The correlation is direct, although advertisers pay a bit more for younger viewers.

That's not necessarily so online. A smaller audience may be more valuable than a big one, if the small one does the sorts of things that advertisers like—such as clicking on ads, buying products, or visiting related content. The bottom line is that Net video companies can be judged on a wider range of factors than traditional media companies, which makes some of them worth more and some worth less.

In September, a group of investors, including Maveron, a venture capital firm founded by Starbucks Chairman Howard Schultz, put $12 million into VideoEgg, a small but promising video site (see BusinessWeek.com, 9/27/06, "VideoEgg Gets a Jolt of VC"). One thing that encouraged the VCs was the rate at which viewers clicked on advertising from VideoEgg's sponsors. The "click-through" rate, as it's known, was well in excess of 1%, compared with an industry average of a fraction of 1%. In other words, VideoEgg's audience could be worth as much as a site with twice the number of viewers, because it delivers so many more of its viewers to advertisers.

MONEY POURING IN. Investments are pouring into the sector to get a piece of this emerging media world. Besides the VideoEgg deal, Sony (SNE ) paid $65 million for Grouper, a startup known for its online video audience and its technology. Time Warner (TWX ) and Michael Eisner have invested in online TV site Veoh. The founders of Web phone service Skype, which was acquired by eBay (EBAY) last year, are launching a new online video site, currently operating under the code name of The Venice Project (see BusinessWeek.com, 7/24/06, "Kazaa, Skype, and now 'The Venice Project'").

News Corp. (NWS ) undoubtedly got the bargain of the bunch with its purchase of MySpace for $580 million. While Rohan's $15 billion valuation may be overstating it, there's little question that MySpace is now worth several times what News Corp. paid for it. News Corp. is now shifting more assets into the Internet (see BusinessWeek.com, 9/18/06, "Murdoch to Bid Satellite Goodbye").

CHANGING HABITS. Behind the flurry of deals are fundamental changes in the way consumers use technology and media. Investment bankers say traditional media companies and older Web portals such as Yahoo! (YHOO ) are alarmed by the habits of younger consumers. Members of the so-called Millennial generation, who were born starting around 1980, don't watch TV the way their parents did.

"We believe the value of (television) station assets will decline as Millennials become the most powerful user of media and (the) coveted target for advertisers," research firm Frank N. Magid Associates said in a report. "Millennials are multitaskers with cluttered lives, shared attention and a wide array of appliances in their lives—TV remains one of them, it's just not used in the same manner." The report said Millennials spend 2.48 hours a day online, the same amount of time they spend watching TV, and about 2.2 hours a day listening to music.

Media conglomerates are racing to get in front of changing demographic habits. "And Web portals such as Yahoo, which viewed themselves as the main gateway to the Internet, are alarmed, too. Millennials don't view the portals in the same way that older users do," said investment banker Jay MacDonald, of the media banking firm DeSilva & Phillips. Younger Internet users are more likely to turn to MySpace, Facebook, or YouTube.

ANOTHER THORNY ISSUE. At the same time they're intrigued by the possibility of online video, investors and potential acquirers are skittish about its uncertainty. No one knows how much advertising can be generated from online video or which sites will benefit the most. The rapid rise of sites like YouTube raises fears that such sites could fall out of favor just as quickly. As a result, most VCs and media companies are sticking to small deals that get them into the game, without taking on the risk of major moves.

A $20 million or $30 million investment is one thing; a deal for YouTube, which could top $1 billion, is entirely different. "Buyers aren't just basing these deals on current revenue or profits, but on a host of things a company might do for them in the future. That makes them difficult to value, which is why buyers are often more willing to take a bet on a smaller company," MacDonald said.

Sorting out the intellectual property rights issues of video on the Web is another thorny issue. That's what Cuban had in mind when he made his comments about why it didn't make sense to buy YouTube. The site has become so popular with its mix of amateur and professional video that people view 100 million videos there a day. There have been rumors that YouTube has been looking to sell itself for $1 billion or more, although the site's rising popularity has pushed up its operating costs to an estimated $900,000 to $1.5 million a month (see BusinessWeek.com, 9/18/06, "YouTube: Waiting for the Payoff").

EARLY PAYOFF. Cuban argues that YouTube is at risk of being sued by content owners who say YouTube violates their intellectual property rights. He thinks that it could be sued just as media giant Bertelsmann was sued in early 2003, after it acquired file-sharing pioneer Napster. "I don't think an acquisition would be smart until all the copyright issues are decided. It would be reminiscent of BMG buying Napster," Cuban said in an e-mail to BusinessWeek.com. "Personally, I think YouTube, like Napster, can help drive sales of products. But my personal opinion isn't copyright law. The (unsuccessful) arguments in favor of why Napster should be allowed to continue in 1999 were similar to the ones being made for YouTube (which raises doubt's about YouTube's future)," Cuban said.

Yet MySpace offers an interesting contrast in how online video is already beginning to pay off. MySpace is used for online distribution of TV and film from News Corp.'s Fox Entertainment. The site, built around a network of home pages laden with messages and photos, already generates a huge volume of video, according to comScore Networks. A comScore report on Sept. 27 said MySpace generated 1.5 billion video streams during the month of July, beating out No. 2 Yahoo and No. 3 YouTube. The survey only ranks free video streams. If the market is measured by the number of video users, as opposed to the number of videos watched, MySpace ranks third behind Yahoo and YouTube.

As film and TV make their way online, advertisers want to take advantage of the rising popularity. The process has started. "MySpace is currently sold out of video ad inventory," Rohan said. Advertisers are very excited about online video, which is why the value of sites that tap into the market is so high, according to Ryan Jacob, manager of the Jacob Internet Fund. Jacob, who owns shares of News Corp., said video is "very alluring" to advertisers because it's "easier to monetize" than other forms of advertising.

"A SHOW-ME PERIOD." Although skeptics may scoff at the idea, advertising may be integrated into amateur video, too. Maveron partner Jonathan Fram, who led the firm's investment in VideoEgg, says he thinks the startup could become a very big company. It has found a niche helping individuals and companies that can't afford or don't want to manage their own video infrastructure put video on their sites.

There are plenty of compelling investment ideas, media executives say. "I think there is some really great innovation going on out there. I continue to be amazed by some of the creativity of these companies," says Ross Levinsohn, president of Fox Interactive Media, which includes MySpace. "But the jury is out when it comes to the question of how any Web 2.0 property is going to make money. We're all in a show-me period."

The last bull market in the Internet sector ended in disaster for many companies. But for all the failures, a few winners such as Yahoo and Google (GOOG ) emerged. Despite the risks of investment, few big media or Internet companies are willing to sit back as the next group of leaders emerges.