Will Skype Transform Microsoft?

By Stephen D. Simpson, CFA | May 13, 2011 AAA

Any time a large company has both a lot of cash and a lack of growth, analysts love to play what I call the Chinese Menu Game. Pick a company from Column A, pick another one from Column B, and voila ... the analyst has a plan as to how the company can effectively exploit its cash hoard and reignite growth, as well as a call for that analyst's institutional salesforce to make on an otherwise slow news day.

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Though there was no particular shortage of rumors surrounding possible bidders for Skype, including Google (Nasdaq:GOOG) and Facebook, and no shortage of rumors about possible targets for Microsoft (Nasdaq:MSFT), those two lines of thought never really intersected. At least, not before Microsoft announced on May 10 that it was acquiring Skype in a deal worth a total of $8.5 billion. (For more, see A Primer On Investing In The Tech Industry.)

Skype Gets Another New Home
Despite being fairly good at attracting users and becoming a significant presence in overseas voice calls, Skype has had a hard time finding a permanent home. The company was bought by eBay (Nasdaq:EBAY) roughly two years after its founding, but never really lived up to eBay's hopes of it as a new growth platform beyond auction services. As a result, three years of ownership and a $1 billion-plus impairment later, eBay sold 70% of Skype to a private investor group.

Now Microsoft has come in to the picture and made Skype its largest-ever acquisition. The company will operate the business as a division within Microsoft. At $8.5 billion, Microsoft it paying a hefty price - 10 times revenue and well above the implied valuation of about $2.5 billion about 18 months ago. (These deals can make or break investors' returns. For more, see Analyzing An Acquisition Announcement.)

What Microsoft Gets Today
It is a little difficult to get fresh information on all of Skype's numbers, but Microsoft's own press release indicated that there are 170 million connected users of Skype in comparison to Windows Live Messenger and its 330 million or so users as of 2009. While Skype is a smaller player in terms of messaging users, Skype's platform is arguably better in many respects and Microsoft can certainly leverage that across its existing users.

What's more, Skype is the largest player in the international voice call market and unlike Microsoft's Windows Live Messenger, Skype has attracted paying customers. Calls within Skype are free, but calls to external landlines and cell phones come with a fee.

What Skype Might Mean For Microsoft
If Microsoft can do nothing to make Skype more than it is today, this will be a colossal waste of shareholders' money. However, there are some interesting potential applications of the technology.

It seems natural to tie Skype and Microsoft's Xbox together; combine that with the Kinect device and there are a lot of interesting personal services that could be delivered to the home (maybe remote medical check-ups or distance learning from around the globe?).

Likewise, why couldn't Microsoft offer this to businesses as a rival teleconferencing and collaboration tool for users of systems from Polycom (Nasdaq:PLCM), Cisco (Nasdaq:CSCO) or Logitech (Nasdaq:LOGI)? After all, there's already a partnership in place between Skype and Avaya for communication and collaboration products for businesses.

And what about thinking really big? Skype already has mobile versions and there's no reason to think that Microsoft couldn't use it to develop some sort of integrated VoIP smartphone. That could be an intriguing option for mobile users, a threat to the likes of Apple (Nasdaq:AAPL) and Research In Motion (Nasdaq:RIMM) and a nightmare for carriers like Verizon (NYSE:VZ) and AT&T (NYSE:T). (For more, see How To Pick The Best Telecom Stocks.)

The Bottom Line
Unfortunately, there are a lot of "maybe" and "could be" with this deal. Microsoft is clearly making a big bet that Skype can open new markets to the company and reignite growth. History suggests that Microsoft doesn't do so well with big acquisitions, and the notorious Microsoft bureaucracy could snuff out many of the promising cross-platform opportunities for this deal. If ever there were a case for cautious, and perhaps even skeptical, optimism, this might be it.

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