In October, Alphabet's (NASDAQ:GOOG) (NASDAQ:GOOGL) Google launched YouTube Red, a $9.99 per month subscription service which strips ads from all YouTube videos, grants access to original content from some of YouTube's biggest stars, and unlocks premium features to its YouTube Music streaming app. Users can also save videos and play videos in the background.
Google introduced a free one month trial starting on Oct. 28 for U.S. users, but it's unclear when YouTube Red will arrive in other markets. At the time, many people were skeptical that the service would work due to YouTube's reputation as a free service. However, its iOS app was recently ranked as one of the top ten grossing apps on the iPhone in the U.S., indicating that a large portion of trial members have been converted to paid members.
Solving YouTube's profitability problems
It's unclear how much revenue YouTube generated with these conversions, but it could help YouTube finally achieve profitability. Google acquired YouTube for $1.65 billion in 2006, but it didn't start generating meaningful revenue until 2010 by introducing skippable ads. Advertisers were more willing to buy these ads, since they only had to pay if an ad was fully watched.
In 2011, Google invested $100 million into its YouTube Original Channel Initiative to support the launch of Google TV. That ambitious effort convinced A-list stars like Madonna and Tom Hanks to host their own YouTube channels, but it quickly became too costly to maintain. Over the past two years, YouTube let advertisers use Nielsen technology to gauge viewership of their ads, reserve ad spots on videos from top YouTube stars, and add "buy buttons" to videos.
Last year, YouTube's revenue rose 33% annually to $4 billion, according to The Wall Street Journal's estimates, accounting for about 6% of its top line. However, expenses incurred from paying for content and investing in streaming technology gobbled up those revenues and caused YouTube to simply break even on the bottom line. This convinced YouTube to broaden its audience and diversify its top line away from ads. That's why it spun off new platforms like YouTube Kids, YouTube Gaming, and YouTube Music, and launched YouTube Red to collect subscription fees.
Following in Netflix's footsteps
Google's move into subscriptions is clearly influenced by Netflix (NASDAQ:NFLX). Netflix popularized subscription-based ad-free streaming TV shows and films, which gradually replaced the a la carte model popularized by iTunes. To reduce the hefty licensing fees it pays to content providers, Netflix started producing its own premium shows and movies. Google, realizing that people are now willing to pay for ad-free videos and original content, is trying to tap into that same market with YouTube Red.
But instead of producing pricey shows like House of Cards, YouTube wants its own in-house talent to create original content. However, the terms are harsh -- any partnered creator who declines the new YouTube Red contract will have their videos on both the ad-supported and ad-free tiers hidden from view. These top YouTube partners previously earned a 55% cut of ad revenues. Google has stated that these creators will receive the "majority" of its subscription revenues, but hasn't disclosed any exact figures.
Google is also using YouTube Red to counter Facebook's (NASDAQ:FB) alarming growth in video. Research firm comScore estimates that Facebook surpassed YouTube in total U.S. desktop video views last year. Ampere Analysis estimates that Facebook could deliver two-thirds as many video views as YouTube across all platforms by the end of this year.
Facebook is capitalizing on that growth by imitating YouTube's strategies. Over the past year, Facebook let its users embed their videos on third-party sites, started sharing ad revenues with content creators, added a new feature called Suggested Videos, let celebrity users stream live video to followers, and introduced 360-degree videos similar to YouTube's 360 videos. In October, it started testing a dedicated video channel as a separate tab on its home page.
The more time Facebook's 1.55 billion monthly active users spend within this video ecosystem, the less time they spend in Google's ecosystem. As a result, Google gathers less user data to create targeted ads, which hurts its core advertising business.
Don't call it a pillar of growth yet
YouTube Red's appearance as a top grossing iOS app is surprising, but let's not call it a "pillar of growth" yet. Some of those paid users might have forgotten to cancel their trial subscriptions, while others might still be sitting on the fence.
But if YouTube Red is successful, it could help YouTube diversify its revenue away from ads while expanding its ecosystem to include video, music, and gaming videos. That growth could help YouTube counter Facebook's growth and help it challenge streaming leaders like Netflix and Hulu.
Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Facebook, 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.