For many, Google's (NASDAQ:GOOG) (NASDAQ:GOOGL) YouTube has been the go-to site for all that is melodic. Major music labels have turned to the platform to distribute music videos and collect ad revenue while viewers enjoy free listening. It's been a major boon for both YouTube and the music labels -- 27 of the top 30 most viewed videos on the platform are music videos -- but that happy dynamic might be on the verge of disruption. Facebook (NASDAQ:FB) has reportedly been in talks with major labels to feature their videos on its platform, and they could be a better suitor than YouTube. 

How will YouTube handle the competitive heat?

A full transcript follows the video.

 

Sean O'Reilly: Facebook is all about that bass, on this tech edition of Industry Focus.

Greetings, Fools! I am Sean O'Reilly, joined today by the one and only Dylan Lewis, and yes, if you're wondering, he did dare me to do that intro.

Dylan Lewis: Oh, yeah! How could you not? The topic just lent itself so well.

O'Reilly: Fits perfectly. Today we're going to be talking about Facebook and their evil plans to encroach on YouTube's territory. First, we want to talk a bit about what we said last week.

Lewis: Yeah. We got teed up pretty well for this episode because ...

O'Reilly: This was fate. This was like ...

Lewis: It's perfect. Sometimes the news rolls the dice and comes up snake eyes.

O'Reilly: Aligned. Yeah.

Lewis: Last week we talked a bit about how Facebook had talks with major labels interested in getting into music, The Verge reported. They met with Sony, Universal, and Warner, and something we speculated about was that it doesn't make sense for them to be a streaming music play because people aren't used to paying money on Facebook's platform, and it's really tough to make the economics of that work out without premium because the royalty rates from music are going to crush you.

O'Reilly: Right.

Lewis: We were trying to speculate and figure out exactly what they were doing here. Lo and behold, a week later we get some extra insight.

O'Reilly: The clouds parted, and here we go.

Lewis: Thanks to some information from the New York Times and Billboard we're finding out that Facebook is going after YouTube's signature; the music video turf.

O'Reilly: Oh, man.

Lewis: That's why they were in these negotiations. We talked about how they had some preliminary discussions, and looking at it now we're getting some details. Facebook's proposed adding a small number of music videos, which would be chosen by the labels to people's news feeds.

They've told the labels they'd be adding them in the coming months if all things work out. It's not something we'd see anytime soon, but it's something to keep an eye on coming down the road. I think the most interesting thing is the ad split is going to be pretty favorable. They haven't determined exactly what it's going to be yet, but it looks like it will be better than what YouTube is currently offering those labels.

O'Reilly: For starters, I'm a huge YouTube consumer. That's how I get my music. I am not picky, and that's why Vevo got created. They realized every teenager in America was watching music videos on YouTube. I can see why Facebook would want to get in on this, because they want the eyeballs. I'm wondering why the ad split is going to be better. Is it because Facebook has 1.2 billion users and they have that trump card? What's the deal?

Lewis: I think it comes down to the fact that they can afford to. If you can cite ads to specific videos and impressions -- you look at Facebook's platform versus YouTube's platform, and this is something I was going to get into later, but YouTube can only serve up an ad in that video screen.

If you're rolling around on their interface, that's where you're going to get the ad impression. If you're scrolling through a Facebook feed, you have the pre-roll ad that can come up, but you also have banner ads on the side.

O'Reilly: You've got all kinds of good stuff going on. Are these music videos going to be on my news feed?

Lewis: It's not totally clear right now.

O'Reilly: Meghan Trainor's Facebook page?

Lewis: I wouldn't be surprised to see an authorized channel the way we're seeing with YouTube, but if a label wants to promote something and add it in there, that's totally an option. It's going to be interesting to see what they do with this.

O'Reilly: What's the big difference going to be? I happen to like YouTube's way I function on there. I can skip an ad; my life's pretty OK.

Lewis: As with ad blocking, like we discussed, it's pretty easy to watch and consume music on YouTube and have a really great user experience. I think the benefit is more on the music label's side than it is on the end consumer's side.

Consumers might not see all that much of a difference, it's just a different platform that they're consuming it on. I think what piques the label's interest is that it seems Facebook is more willing to police the unauthorized content that is available.

O'Reilly: Oh, boy.

Lewis: You're on YouTube and you can see a video that is not the official music video, but a lyric video that someone puts together in PowerPoint and syncs up to the music. I think you're probably not going to see that.

O'Reilly: I could not see Facebook letting that fly.

Lewis: Yeah. I'm sure that's a major negotiation point with Facebook. That's a nice trump card to be able to pull out, because you're saying all the impressions for the song that users are going to be getting are going to be your official impression, and you're going to be collecting ad revenue on that.

O'Reilly: Wow. I almost wonder -- when you said Facebook can afford it, I was wondering because, let's face it, you and I both know Google (NASDAQ:GOOG) (NASDAQ:GOOGL) has a monopoly on Internet search, more or less. They could afford to do a little bit more with YouTube.

Lewis: This is Facebook building out their platform a little bit. One of the most interesting things for me, starting to look at how this might impact YouTube, is that -- I was looking at the top 30 most viewed videos on YouTube.

O'Reilly: Oh, boy. "Gangnam Style" is No. 1, right?

Lewis: "Gangnam Style" is No. 1. It's got 2.4 billion.

O'Reilly: Oh my God.

Lewis: Yeah. That's insane. How many would you say -- out of 30 -- are music videos?

O'Reilly: I don't know. I really like watching cat videos on YouTube.

Lewis: I think a lot of people do.

O'Reilly: I'm going to say 20 or 25.

Lewis: 27.

O'Reilly: Oh, wow!

Lewis: Including all of the top 15.

O'Reilly: I should have gone for the jugular on this one. Is one of the three something other than the sneezing panda?

Lewis: It's Charlie Bit My Finger, The Wheels on the Bus -- some kid's show ...

O'Reilly: That's arguably...

Lewis: Debatably, a music video.

O'Reilly: You wouldn't have seen it on MTV or anything.

Lewis: Yeah, and I think the third one is this Russian television show. I don't know.

O'Reilly: "In Soviet Russia we watch YouTube."

Lewis: This is big business for YouTube. I think that's something we talk more about in the second half of the show.

O'Reilly: Yeah. Before we move on -- because we've got some very good analysis on what YouTube's doing to get their megastars, including musicians who do their thing -- I want to make sure our listeners are aware of a very special offer for all of our Industry Focus listeners. If you found this discussion informative, and you're looking for more Foolish stock ideas, Stock Advisor may be the service for you.

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Moving on here. If you're Sergey Brin, are you hating Mark Zuckerberg right now?

Lewis: I don't want to get into their interpersonal relationships, but the business standpoint of things -- it's always tough. I think YouTube has always been a black box for people. They haven't really known what the impact is.

O'Reilly: We don't know.

Lewis: Yeah. They don't break it out in financials. The best bet we can go off of is some insider leaks and works from analysts. There's a Credit Suisse analyst that estimated YouTube comprising about 15% of Google's total revenue. That amount would rise to around 20% by 2020. That's one estimate we can work off of.

O'Reilly: But we also know that YouTube "breaks even."

Lewis: That 15% winds up working out to about $10 billion of Google's $68 billion trailing-12-month revenue. Another estimate I've got comes from a Wall Street Journal report dated back in February 2015; it puts that number close to $4 billion, or 6% of overall revenue.

O'Reilly: That's quite a disparity. That actually speaks to the black-box analogy. I popped over to Google's 10k before we went on air, and they don't say.

Lewis: It reminds me of [Amazon.com's] Web service. You have no idea what the hell is going on.

O'Reilly: Then they went public with it, and the stock went up $80 million.

Lewis: With these things you're always wondering, "Is there a reason they're not telling us?" As you mentioned, the most interesting part of this is, while it's a sizable portion of revenue; that cash isn't coming down to the bottom line.

Citing that same Wall Street Journal article; apparently YouTube is roughly breakeven, from insiders with knowledge of the operations. Apparently big costs for paying for content and the equipment to deliver the speedy videos are what's weighing down this revenue-driving arm.

O'Reilly: This is a big problem we're seeing with a lot of these social-media type of platforms; like Twitter. They're spending $200 million a year on servers to handle a massive amount -- how many servers do you think it takes to handle all the data on YouTube?

Lewis: It's insane.

O'Reilly: Can you imagine?

Lewis: It's absolutely insane.

O'Reilly: The human brain can't even comprehend. They're spending all this money, and they're bringing on ads, but it's breaking even. I don't know what the end game is there.

Lewis: I thought the content aspect of things was particularly interesting with this news from Facebook because, as I understand it, the standard ad relationship has YouTube taking a 45% cut of ad revenue. That's pretty generous, considering they're just in the delivery business. That's pretty great. I've heard some rumors -- and maybe you could speak to this a bit -- the service pays in the single-digit millions for some content providers as a retainer to stay loyal.

O'Reilly: Right.

Lewis: Is that ...?

O'Reilly: They could -- there are alternatives popping up. [...] There's very little alternative, and they're like, "Maybe we could leave and make a higher cut. I don't know." Re/code had actually come out with some great articles. One was "YouTube Pays Some of Its Biggest Stars to Make More Stuff for YouTube."

I'm paraphrasing here, but "YouTube has paid more than $1 million to one group" -- they wouldn't say the group -- "that creates widely viewed videos as promise to remain active on its platform." YouTube literally wrote a $1 million check to a group of ...

Lewis: Artists?

O'Reilly: Maybe it was the Swedish House Mafia guys. We need more animal videos. That's crazy to me. I hear these stories about YouTube's most profitable stars. That woman in Asia that does makeup videos.

Lewis: Oh, yeah.

O'Reilly: She makes $8 million a year. I'm like, "Man, I need to become a YouTube star."

Lewis: I think for YouTube you're going to see more of this, because it's important for them to keep people that have a lot of loyalty on the platform.

O'Reilly: Right. Another great article I found on Re/code was "YouTube Takes Out Checkbook Again, Pays Its Stars to Make Videos." 'YouTube is planning to invest millions in some of its biggest stars and deals intended to create high quality content for the site. The deals are also designed to encourage those stars to keep working on YouTube instead of migrating to other platforms" -- like Facebook.

"The plan comes a couple years after YouTube spent more than $100 million on a push to get video makers to create channels for programming for the site in an effort to make it more like TV." I look across the aisle and I see what Netflix and Amazon are doing. I just started watching Amazon Prime's Mozart in the Jungle. Have you checked that out?

Lewis: No.

O'Reilly: I highly recommend that.

Lewis: Really?

O'Reilly: Highly. Stars I've never seen before. There's one who's a British actor that I knew, but I have to assume in the future we could each have Internet TVs with five apps -- YouTube, Amazon, Netflix, and something else. I'm wondering at what point YouTube will start making TV shows.

Lewis: Yeah. It's definitely a possibility. To bring it back to that cost dynamic a little bit; I think this "paying for content" is where it gets problematic for YouTube if it's at a breakeven.

O'Reilly: You're talking about more money, basically.

Lewis: Yeah. You're talking about more money to keep people on this platform, and the 30 highest-viewed videos, 27 of them are music videos. I'm guessing those aren't exclusive.

O'Reilly: Yeah.

Lewis: You're not paying a flat retainer. I'm sure it's more of an ad split with those music labels. The high traffic, and most cost efficient stuff for you to show is going to wind up on another platform. A platform that can offer more favorable ad rates to the people that are providing the content. That's a difficult dynamic to battle.

O'Reilly: The real winners here are us, of course.

Lewis: Yes. The viewers are always the winners. To temper expectations a bit; this isn't "Sell, sell, sell!" for Google. It's not a huge concern for YouTube, because this is something that Facebook is slowly rolling out. This could be along the lines of its instant-articles type pilot, where we're seeing some main providers bring in a couple a week here and there.

O'Reilly: So it could be Katy Perry's next music video breaks first on Facebook, or something.

Lewis: Possible. Very possible. I think the takeaway here is, this is a very good thing for Facebook, but you want to see how Google reacts, and you want to see if they're able to retain their high-value content providers.

O'Reilly: Awesome. Before we go I want to tell you -- I didn't tell you this before -- Facebook offered me the opportunity to send somebody money when I was on Messenger the other day.

Lewis: I got prompted for that the other day, too.

O'Reilly: I was like, "Oh my God, Mark Zuckerberg."

Lewis: If you want to reimburse me for those tacos.

O'Reilly: Yeah. Very good. Well, thank you for your thoughts, Dylan. I'll see you next week.

Lewis: Always a pleasure, Sean.

O'Reilly: If you are a loyal listener and you have questions or comments we would love to hear from you. Just email us at focus@fool.com. Again, that's focus@fool.com. As always, people on this program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against those stocks. So don't buy or sell anything based solely on what you hear on this program. For Dylan Lewis, I'm Sean O'Reilly. Thanks for listening, and Fool on!

Dylan Lewis has no position in any stocks mentioned. Sean O'Reilly owns shares of Facebook. The Motley Fool owns and recommends Amazon.com, Facebook, Google (A shares), Google (C shares), and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.