Microsoft-Skype: inspirational or hype?

May 20, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

It is fair to say that over the past twenty years in my career as a banker, I have seen some transactions in the telecoms industry which have resulted in significant value erosion.

Time Warner’s merger with AOL, WorldCom’s series of acquisitions in the late 1990s and the old Cable & Wireless’ effective swap of the hugely profitable Hong Kong Telecom for hugely loss-making U.S. data centres are three notable examples.

So when I first heard of Microsoft’s plans to acquire Skype for $8.5 billion my immediate reaction was “oh no, not again”. However, after digesting the news of the deal I think there is at least a chance that this can turn out to be an inspired move by Microsoft.

Let’s look at the transaction from two perspectives — from that of Microsoft’s shareholders and from the many millions of Skype users.

In the short term, this looks to be an expensive deal for Microsoft and its shareholders. $8.5 billion equates to a transaction based on ten times Skype revenues and over thirty-four times earnings before tax, interest and depreciation (EBITDA).

This compares with the valuation of Bharti, India’s premier telecoms company, on some three times revenues or ten times EBITDA.

Furthermore, eBay acquired Skype for just $2.6 billion five years ago and just two years ago an investor group paid eBay $1.9 billion for a 65 percent stake. So why did Microsoft pay so much?

The short answer is that Microsoft sees huge potential from converting Skype’s 600 million registered users into demand for a whole suite of Microsoft products and services. This is where the story gets interesting for both Microsoft’s shareholders (future profits and value creation) and Skype users.

The rationale for the deal is “to increase the accessibility of real-time video and voice communications, bringing benefits to both consumers and enterprise users and generating significant new business and revenue opportunities”.

In practice, this means that Microsoft will be cross-selling the vast array of Microsoft family products to Skype users.

Skype’s revenue per user ratio today is hardly stunning. $850 million revenues and 600 million users is not an impressive ratio compared with mobile phone operators or DTH companies. But Microsoft is taking a bet on how it can convert Skype’s users. Here’s how.

Think of the vast number of Microsoft products in your home whilst you are using Skype. You are using a version of Microsoft Windows on your PC. There is a chance that you are using Microsoft Office for your daily email and study/business tasks.

For relaxation you may be playing on your Microsoft Xbox and Kinect. Your Smartphone may be running a version of Windows Phone and very soon if you are a Nokia smartphone user your phone will be too.

Microsoft will not only be reminding all of its Skype users to buy or upgrade these services on a very regular basis, it will also be connecting Skype users through these very products, encouraging the effective creation of a “Microsoft Skype world”.

This visionary type of acquisition is not new. AOL envisaged a world where its millions of users would be buying Time Warner content. But the problem a decade ago was that users didn’t want to wait 24 hours to download a movie over their 56 kbps AOL connection.

The world is a different place in 2011 and even rural India will be enjoying fast download speeds soon once broadband wireless access (BWA) services are fully available.

Microsoft will succeed or fail with this transaction on the basis of how successful it is on converting Skype’s thrifty users into future Microsoft revenues. They have a hard task here because Skype users are a smart bunch — they don’t like paying too much for their requirements.

Furthermore, there are alternatives out there, with a certain company called Apple creating its own community and also the increasingly powerful Google Android.

If Microsoft gets the implementation of this acquisition right, then $8.5 billion might turn out to be a fair value. If it can’t then it will join the list of companies that have overpaid for acquisitions. Let’s hope Microsoft gets the execution right.

One comment

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A very big step indeed.

Posted by kategeorge | Report as abusive

[…] Skype’s revenue per user ratio today is hardly stunning … But the problem a decade ago was that users didn’t want to wait 24 hours to download a movie over their 56 kbps AOL connection. The world is a different place in 2011 and even rural India … read full article… […]

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