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Irrepressible we are, irrepressible we will be!
The Skype buy was affordable. But, did it make sense for Microsoft to buy a firm that still hasn’t figured out a way to make profits?
Issue Date - 19/01/2012
What adjective would you use to describe the act of paying 30 times the EBITDA (earnings before interest, taxes, depreciation, and amortisation) and 400 times the operating income for the acquisition of a company that hasn’t figured out a way to make profits in the last five years? Irrepressible (difficult or impossible to control or restrain) fits the bill pretty well. Why? Because during the press conference (on May 10, 2011) announcing the $8.5 billion acquisition of Skype (an online phone and video calling service) Steve Ballmer, CEO, Microsoft made everyone believe that there couldn’t be a better reason for the deal than an irrepressible urge when he said: “We are irrepressible in moving forward, and pursuing new things. This Skype acquisition is entirely consistent with our ambitious, forward-looking, irrepressible nature.”

On the face of it, the acquisition looks nothing more than an attempt to project Microsoft as a company in tune with the times. But before we seal our verdict on the viability of this transaction, let us delve into the fundamentals first. Keeping aside the obscene amount that the tech giant has coughed up, what makes this deal a center of speculations & apprehensions is Ballmer’s record with respect to strategy. Apart from losing formidable competitive advantages to Apple in the form of tablets and music players, the CEO’s deal making conscience has not been very encouraging so far. In fact, while recently speaking at the annual Ira Sohn Investment Research Conference in New York, David Einhorn, President, Greenlight Capital (the company which holds 9 million shares of Microsoft) called for Steve Ballmer to step down. Raison d’être: In 2001 & 2002, Ballmer experimented in the area of M&As for the first time in his capacity as CEO by shelling out over $2 billion to take over two ERP software vendors – Great Plains Software and Navision. Microsoft estimated that the businesses would be generating more than $10 billion in combined annual revenues by the end of 2010. Come today and $1 billion per annum is what the two units are actually churning out (as of 2010). That’s exactly $9 billion short of initial predictions.

Again in 2007, the Redmond based company shelled out $6 billion (a premium of 85%) for acquiring aQuantive (an online advertising outfit). The $2.6 billion operating loss incurred by Microsoft’s online services division for the year ending March 2011 signifies that the acquisition hasn’t really paid off as of now. Even the $500 million purchase of Danger Inc. in 2008 resulted in Microsoft withdrawing the disastrous Kin line of phones from the market.

However, compared to prior target companies, Skype (apart from being cool and a verb for online voice and video calling) looks a lot more lucrative. As of 2010, the popular service has 663 million registered users out of which 170 million are connected. Impressively, Skype users made 207 billion minutes of voice and video calls in 2010. So far so good! But unfortunately the rosy picture just ends here – only 8.8 million of these users actually pay. That roughly boils down to 1.32% of the entire user base. Further, Skype incurred a loss of $7 million on revenues of $860 million in 2010. In short, the company still hasn’t figured out a way to make profits. What’s more? If one were to calculate Skype’s revenue per user, it would round up to just $1.3.

If these facts weren’t enough, then Microsoft should have at least learned a lesson or two from eBay’s Skype misadventure before taking the plunge. In 2005, the online auction portal paid $2.6 billion to acquire Skype. The idea was to integrate voice and video calling features into the auction process. But, after three years of failed attempts to derive synergies, eBay wrote off $1.4 billion from the value of Skype. It’s not that Skype is not growing, it’s growing; but only in terms of numbers that really don’t matter. Last year, its monthly users stood at 145 million implying an increase of 38%. Paid users were also up by 19%. However, if Microsoft wants a 10% annual ROI, paid users will have to grow by 4,000% y-o-y, which seems unlikely anytime soon.

Further, with the acquisition, Microsoft plans to embed Skype’s services across its offering. Potential combinations include linking the service to Outlook e-mail, Xbox game console, Windows mobile phone and corporate suite Lync. But, except for the Xbox and Outlook combinations, Skype’s services don’t fit anywhere else. Moreover, Skype significantly overlaps with Microsoft’s video chatting and web-conferencing tools. This could turn out to be a major hindrance in integrating Skype services with Windows Phone 7, a mobile operating system which is being developed by Microsoft in collaboration with Finnish telecom giant Nokia.

No doubt, Microsoft is sitting on $40 billion in cash, and that does make the Skype acquisition affordable. But this does not mean that it should be spending irrationally. The fate of all major M&A rests on execution and Microsoft is not an exception. Agrees Michael Hodel, the US based CFA at Morningstar as he tells B&E, “Microsoft will need flawless strategic and tactical execution over the coming months and years to keep its shareholders from losing money on this transaction.” However, the challenge in this case is to leverage the 663 million users without destroying what attracted so many people in the first place (the service is free). Well, we still wonder how Ballmer and team will pull this one off!

Amir Moin           

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