Microsoft: $8.4 Billion Down the Drain

By Alex Daley, Casey Research

The big news in tech right now is Microsoft’s agreement to acquire Internet-based voice and video chat provider Skype from its current parent, eBay, for about $8.4 billion in cash.

And, as usual, the pundits in the technology sphere are quick to jump on the Microsoft-bashing bandwagon, calling the deal everything from stupid to moronic to genius (apparently much more rarely the latter). Ars Technica asks if the deal is "for real." And the most popular meme of the day seems to have been coined by famous tech entrepreneur Dave Winer in a twitter post:

How can they not screw it up, indeed? In ways, it is hard to imagine this deal going right.

Before I step too deeply into the fray, I must expose a major potential bias upfront. It’s been less than two years since I left the hallowed halls of One Microsoft Way to pursue other interests. In my time there I had occasion to work on many, many different businesses, including some significant time with the online services group, where this acquisition may land (though there is an equally large chance it becomes part of the Windows division, which has controlled the current competitor, Windows Live Messenger, since late 2009 – more on that in a moment).

Whether or not the acquisition can be successful is largely predicated on what Microsoft can do wrong to screw it up, versus what they can do right. After all, in recent quarters Skype has regained some of the momentum it seemed to have lost with the acquisition by eBay in 2005.

For eBay, what had for many years looked like a poorly spent $3.1 billion – the company had failed to integrate Skype into its core business the way it did with PayPal, and essentially let it wither in a corner untouched and unsupported many argued – suddenly seems like a solid investment that doubled their money in six years.

For their money, Microsoft is getting a brand name of pretty significant weight in the online world. Though certainly not a Google- or Facebook-level brand, the Skype name is somewhat eponymous with the act of video calling on the web. If Microsoft plays its cards right, it may be able to build upon that brand and make it even more well known.

However, given the company’s history of consolidated branding, and flip-flopping like a pancake between brands (MSN Search -> Live Search/Live.com -> Bing), the chances of the company making the right decisions here seem somewhat iffy.

What Microsoft didn’t get in the transaction is just as telling as what they did.

For starters, they did not gain much in the technology department. Microsoft has years of experience running both instant messaging and voice and video chat programs.

• The company has Windows Live Messenger (formerly Windows Messenger, formerly MSN Messenger). Both programs offer voice and video chat, and calling to traditional telephone numbers.
• With 330 million monthly users globally, Messenger dwarfs Skype’s 124 million users. Though estimates peg the number of users on Messenger using voice or video at less than 10%, while 95%+ of Skype’s users use at least voice – calls are the reason to download Skype for the overwhelming majority of users. Plus, 8 million of Skype’s users pay for services at some level, most commonly buying "Skype Out" minutes to call land lines and cell phones, versus reportedly much smaller numbers of paying customers for Microsoft’s comparable service.
• Microsoft also operates Xbox Live, the complementary online service to its wildly popular Xbox gaming console, which includes voice chat amongst mutual gamers and friends in its features list. With 11 million users, Xbox Live is much smaller than the other two, but the proportion of active voice chat users is relatively high – and thus the network.
• In 2003, Microsoft acquired Placeware, a popular online conferencing service for business which included group Internet-based voice calls, and video screen sharing, which the company rebranded Microsoft Office Live Meeting. They’ve since lost much of the market share the company once had to Webex (now owned by Cisco) and GoToMeeting (now owned by Citrix), but remain in third place with the technology and infrastructure still firmly intact to grow larger.

There is one critically important technology though that separates Skype from its competitors – the Skype platform is much more peer-to-peer oriented and requires fewer centralized servers than a typical Voice over Internet Protocol (VoIP) network. However, this technology is well understood and could be relatively easily replicated by a company with Microsoft’s research expertise if it ever came down to needing it.

Microsoft also doesn’t gain much in the revenue department from the deal. Skype’s $890 million per year in gross revenues are respectable and growing at a 25%+ clip prior to the announcement of the deal. But, compared to the deal size, and to Microsoft’s $60 billion in annual gross revenues, the numbers aren’t that meaningful. Skype lost $7 million net in the previous year on those revenues, but under Microsoft and with its $660 million in debt erased, the unit would probably have made on the order of $240 million in profits, based on its 2010 pro forma results.

Unfortunately for Microsoft, even doubling the $240 million in profit from the Skype unit would still not be enough to put its online services business back into the black, as that unit is currently losing about $2.5 billion per year for the company.

So many years after the eBay acquisition this may not matter as much as it once did, but Skype’s founders, Niklas Zennstrom and Janus Friis (who also founded the once wildly popular file sharing service Morpheus using the same peer-to-peer technology), are no longer with the group. In 2009, with the financial crisis in full swing, the two were rumored to have been trying to buy the company back from eBay with the help of private equity investors, at a steep discount to the original buyout price. Obviously eBay made out better by waiting for valuations in tech to rise again, pocketing this large infusion of cash from Microsoft on the backs of rumored bids from both Google and Facebook. But the brand and initial meteoric growth of the product were due in large part to the smarts of the company’s founders. An acquisition with them at the helm may have been a better deal for Microsoft, which has largely seen its best online talent headed out the door for Google and Facebook the last few years.

The nitty gritty of this deal’s value will come down to execution, ultimately – as it always does.

Skype is a healthy brand for the moment, with a growing user base and decent revenues and margins. With a little push from Microsoft, which has some of the most popular websites in the world and millions of impressions of unsold ad inventory among other assets at its disposal, Skype’s growth could accelerate dramatically.

However, if Microsoft starts meddling too much with the product – introducing large numbers of ads as they have in the Messenger interface in the past, or forcing users to move over to the much-maligned Windows Live ID authentication system – they could easily see more users defect to fast-growing competitors like Apple’s Face Time service.

Microsoft’s CEO Steve Ballmer has long preached the gospel of "integrated innovation," or building tight coupling between different software systems to help one sell another, as the secret to Microsoft’s success. Unfortunately for the company this strategy has yet to translate online. In the case of Skype, for Microsoft and its shareholders a good return on this significant investment (the largest ever for the company), success is likely predicated on the company resisting its urge to consolidate.

Though, in the eyes of Microsoft executives, virtually any outcome might seem better than letting the company fall into the hands of Google, which still has no strong foothold in social or communication software – one of the few online areas where Microsoft still maintains a market share advantage.

Unfortunately for shareholders, anything less than a stellar success might just look like billions more flushed down the drain in Microsoft’s thus far failed bids at online dominance. Even if the company can quadruple the size of Skype’s business, they will still be losing money online if nothing else changes and they will have only added a few percentage points to top line growth – neither of which is likely to move to stock price in any major way.

[Alex Daley is one of the best experts around at guiding investors to the massive profits that can be found in today’s tech stocks. If you’d like to get in on his 90%+ gains, click here for a risk-free subscription to Casey Extraordinary Technology.]