Is Twitch.tv Worth $1 Billion to YouTube?

While countless companies are spending millions on creating original TV-like content to attract users to their services, YouTube has found a way to grow its base of users who create and market their own videos for free.

YouTube, which is wholly owned by Google (GOOG 2.25%) (GOOGL 2.37%) has reached a deal to buy Twitch, a streaming video company that allows video game players to share game-play videos, for $1 billion Variety reported.

The deal will be all cash, according to the report. 

Twitch launched in 2011 and now reaches 45 million visitors a month, according to a company press release. The service has more than one million "broadcasters," or people creating game-play videos, which can then be viewed by other Twitch users. The platform allows users to broadcast, watch, and talk about video games. Most of the content is user-generated and free to Twitch, which like YouTube, makes money selling ads.

What is Twitch?

In the dawn of the video game era, the nation was overrun with Pac-Man Fever, and people wanted to get better at the arcade game. One way was to buy a book that showed players the moves and patterns to beat each level. Instead of playing by reflex, people could memorize a series of joystick moves complete with timing cues that would earn them a cherished spot on the high-scorers list.

Twitch is the modern equivalent. Using the service -- which is available on both Sony's (NYSE: SNE) PlayStation 4 and Microsoft's (NASDAQ: MSFT) Xbox One consoles -- game players can share video of themselves playing the game. Why would anyone want to do that? Today's games are far more complicated than Pac-Man, requiring strategy and inventiveness that goes well beyond memorizing a series of moves.

People share game-play videos to show off their moves and people watch them to be entertained and to learn how they might tackle a similar game situation. It's along the lines of a person who can barely stand on a skateboard watching ESPN's X Games -- it's partly because what the competitors are doing looks nearly impossible and partly it serves as an educational video. 

Why does YouTube want it?

YouTube already serves more than six billion hours of video per month to one billion users worldwide, according to Variety. The site serves as a platform for game-play videos, but it doesn't have the credibility within the video game community that Twitch does. YouTube is a broad, general video play whereas Twitch targets a specific community and serves it very well.

In addition to game-play videos, Twitch has a number of shows produced specifically for the service. They range from news programs to interview shows to coverage of gaming tournaments, and basically anything else that dedicated gamers would be interested in.

Twitch has some deals with established content creators, which it may pay for, but the vast majority of the company's content is created for it for free by its users. Those users or partners can make money if their videos prove popular (just as individuals can earn cash on YouTube), but for most of its videos Twitch has no content creation cost. Twitch has highly invested "partners" creating content that keeps its average user on the site for a stunning 106 minutes a day. That more than triples the roughly 30 minutes or so a day people spend on Facebook (15 hours and 30 minutes a month, according to StatisticBrain.com).  

Having a ton of engaging content without making expensive upfront bets on producing videos remains a holy grail for the content industry. Netflix (NASDAQ: NFLX) will spend around $2 billion each year licensing and creating content while YouTube sits back and lets its users do if for them for free. Broadcast and cable networks will spend billions developing shows for next year and most of those shows will never provide any return on investment.

Spending $1 billion on Twitch gives YouTube an additional platform it can clearly monetize. The company is buying content and eyeballs it can make money off of at a predictable rate. However long it takes to earn the purchase price back, YouTube has no risk that it's sinking cash into shows people won't watch. Partners only make money if Twitch makes even more money.

Owning content is still important

YouTube built its business on cute cat videos, people getting hit in the groin by various things, and other generally short user-created content. One of the limits of crowd-sourced or user-created content is that most people lack the ability and the equipment to create longer-form pieces. Game-play videos change that because most of the video is simply recording during a game-play session. Twitch offers tools to add commentary and annotations (like the way announcers draw on the screen during football games). All together, it allows for the easy creation of longer-form videos that people actually want to watch.

With Twitch, YouTube is grabbing a sizable player that is growing quickly. In March Twitch accounted for 1.35% of all downstream bandwidth on North American fixed-access broadband networks -- nearly triple from the previous fall, according to bandwidth-equipment company Sandvine.