Even though over 1 billion people view YouTube videos every month, the Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) subsidiary was still struggling to turn a profit as of the end of last year, according to The Wall Street Journal [subscription required]. The company generated $4 billion in revenue last year but still couldn't cover its costs, which include servers, engineers, and content licenses.
YouTube CEO Susan Wojcicki has hinted at a potential subscription service for YouTube that would remove ads, and it looks as if the company has gotten much closer to actually launching that service. Re/Code reports that the new subscription option will tentatively launch at the end of October, and it combine the currently in-beta YouTube Music Key with an ad-free YouTube experience. What's more, citing "video industry sources," Re/Code says the price will be $10 per month -- the same price Google currently charges for Music Key.
Can it make a profit?
As a music streaming service, YouTube's reported subscription service would be subject to having the music rights' owners take their fees. For competitors such as Spotify and Apple Music, that happens to be about 70% of revenue. So straight off the bat, YouTube would be down to just $3 per subscriber.
And if you think YouTube could structure its subscription so that only a portion of the price goes toward music streaming, think again. The major record labels have staunchly resisted allowing streaming services to price their offerings below $10 per month. Tim Cook & Co. battled the record labels ahead of the launch of Apple Music to offer the service for less, and it failed to budge them. The best it could do is offer a family plan, which allows up to five separate accounts for $15 per month.
YouTube generates about 80% of its ad revenue from pre-roll video ads. Last year, that would have been approximately $3.2 billion. The Wall Street Journal says YouTube was able to break even with its $4 billion run rate last year, but YouTube has increased its content costs this year with plans to produce its own original programming.
Still, $3.2 billion translates into just a bit more than a quarter per month per user. So if everyone signed up for YouTube's new subscription service, YouTube's profits would skyrocket.
But not everyone's going to sign up
The people most likely to sign up for a YouTube music/video subscription service would be those who use YouTube regularly -- not the casual viewer who clicks on a video from another website. More engaged users naturally generate more ad revenue for YouTube.
If we apply the 80/20 principle to YouTube's revenue, 200 million of YouTube's viewers generate about $2.6 billion in video ad revenue. That implies that those users most likely to sign up for an ad-free YouTube subscription generate just over $1 per month in video ad revenue. That makes the $3 per month YouTube would have left over after the music-rights holders take their cut profitable.
What's more, YouTube could generate subscriptions from users who aren't quite die-hard YouTube fans but simply love music. Ad-free YouTube is a major differentiating factor in the growing number of music streaming services. Some subscribers will surely see that as a nice bonus, not a main selling point. That factor increases the profitability of the service as well, since the opportunity cost for those subscribers is lower.
Future opportunity cost
Another thing to consider, however, is how quickly YouTube can grow its average video ad revenue per user. In 2013, eMarketer estimated that YouTube generated $1.96 billion in net ad revenues, just half of what The Wall Street Journal pegged YouTube's revenue at in 2014. This implied phenomenal growth indicates that YouTube is capable of strong growth for quite a few more years.
While it may be able to keep some ad exposure with subscribers through display ads and promoted videos, YouTube is missing out on that potential growth in video ad spending on its site. With other music streaming services available for just $10 per month, YouTube could have a hard time increasing subscription prices at some point in the future, should the opportunity cost rise too high.
For now, however, YouTube's subscription service looks like it will finally allow the video site to turn a profit for its parent company. Ten years is a long time to wait for profitability, but the company now called Alphabet has been able to use data from YouTube to improve its other products, so it hasn't been a waste at all. As YouTube continues growing ad revenue and drives subscriptions, it could generate a nice return for Alphabet on its $1.65 billion investment.
Adam Levy owns shares of AAPL. The Motley Fool owns shares of and recommends GOOG, GOOGL, and AAPL. 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.