Why did Microsoft spend $8.5bn on Skype? (Detailed Report)

Microsoft Skype
In a bold move, Microsoft acquires Nokia and catapults itself to the top of the smartphone world. The full integration of Windows Phone 7 software into Nokia hardware will result in a better user experience for customers, a zero-fragmentation platform for developers, easier deployment of a smaller number of SKUs for retailers, and more reliable update management for carriers.
It's worked before. Microsoft's hardware/software integrated devices, Xbox and Kinect, are enjoying strong revenue growth and great margins: $1.9bn revenue last quarter, 50% more than last year, with 10% operating profit.
In a prepared statement, Microsoft CEO Steve Ballmer says:
I welcome Stephen Elop back into my executive staff. His brief leave of absence has allowed us to more fully explore the possibilities of combining the best smartphone hardware, Nokia's, with the best OS, Windows Phone 7. Google's anticompetitive Android free and open licensing practices unfairly tilted the playing field against our better product; they made it impossible for us to sell Windows Phone 7 software. Instead, we're now ready to do battle with Apple from a superior position: a stronger product carrying the Windows Everywhere flag, wider carrier distribution around the world, and more retail partners in US, Europe, and BRIC nations. With our acquisition of Nokia, we're now a $100bn company, back where we belong: at the top of the high-tech industry.
When I woke up, I heard a different story: Microsoft bought Skype for $8.5bn.
We all know Skype: free voice and video calls from computer to computer, plus paid services if you need to dial a phone. As Skype prepared for its long-awaited IPO, we got financial data from their S-1filing with the SEC. S-1s are always instructive: This is usually the first time a private company opens the kimono – and the SEC watches closely as you prepare to sell shares to widows and orphans.
The Profit & Loss statement in Skype's S-1 looks like this:
With revenue of $860m in 2010, Skype's operating profit is a modest $20m, with a net loss of $69m due to interest expenses stemming from $686m in long-term debt. Except for in 2008, when they saw a $42m profit, Skype has racked up huge losses, including $1.4bn in 2007 and $370m in 2009.
(Technically, these figures straddle two different corporate structures because of Skype's complicated history. Started in 2003 as an independent European company, Skype was acquired by eBay in 2005 for a price pegged between $2.6bn and $3.1bn. After the acquisition, eBay discovered its ownership of Skype was "encumbered": A crucial piece of Skype's technology was owned by another company, Joltid, which was essentially in the hands of Niklas Zennström, one of Skype's founders. eBay settled with Joltid for about 14% of Skype. This caused wags to say the crafty Skype founders sold the company twice – and it certainly didn't make the ex-management consultants running eBay look so sharp. In 2009, eBay sold 70% of Skype to private equity and venture investors in a transaction that valued the company at $2.75bn.)
Why did Microsoft pay $8.5bn – 10 times the company's revenue – for a business that has changed hands so many times, never made money, and comes with substantial debt? (Admittedly, the $686m debt number is manageable – for Microsoft).
One eloquent answer comes from Brad Horowitz, a partner at the Andreessen Horowitz venture firm started by Netscape's founder. Horowitz invokes the network effect: A large number of users attracts more users and so on, in a kind of gravitation well:
500,000 new registered users per day – 170 million connected users – 30 million users communicating on the Skype platform concurrently – 209 billion voice and video minutes in 2010
And he concludes:
Today, I tip my hat to an old rival, Microsoft. By acquiring Skype, Microsoft becomes a much stronger player in mobile and the clear market leader in internet voice and video communications. More importantly, Microsoft gets a team, ably led by the exceptional Tony Bates, that can compete with anyone.
Well, this is a nice encomium to the guys who transformed the venture firm's $50m investment in Skype a few months ago into a $150m payday. My own venture investor hat is tipped to MM. Andreessen and Horowitz.
But not so much to Steve Ballmer.
Looking at Microsoft's recent quarterly numbers, we see the continuation of a now old and getting older tradition: losses in the Online Services Division. Only a few weeks ago, TechCrunch wondered: When Will Microsoft's Internet Bloodbath End? Business Insider provided a vivid illustration for the problem:
In just the past 12 months, Microsoft has lost $2.5bn in its online business. They spend $2 to make $1 in revenue. Buying and "integrating" Skype will make the picture even redder.
So, again, why spend $8.5bn on Skype?
The official explanation is that Skype will be targeted at professional users. For these, Microsoft already has a product called Lync, although not many have heard of it. And they have Messenger for consumers. (Actually, it's Windows Live Messenger for Windows and Microsoft Messenger for the Mac.) I don't think it's unfair to ask how, how well, and when Microsoft's Grand Unified Messaging platform will effectively exist, and how it will be monetised.
Given Microsoft's track record, there isn't much evidence of its ability to perform such integration, nor of its ability to move a big platform forward at a competitive pace, certainly not faster than what Google seems able to do with Google Voice, Talk and Google Video for Business.
The theory must be that every Windows PC will come with "Skype inside". But that isn't much progress: There are already 170 million connected Skype users, and 500,000 new registrations everyday. And imagine how carriers will react when they see a Skype client bundled with every Windows Phone 7 device, further pushing them towards their preordained destination: dumb pipes.
Today, Skype is joyfully used in both consumer and business environments. It's not perfect, but the price is right and Skype is now a verb. The next thing we know, Microsoft will take a good if imperfect service and "improve" it by integrating it with Office or SharePoint (a good product on its own). And, at some point, Microsoft will try to make us pay for it. In more ways than one.
But, again, the history isn't there. Microsoft's ability to successfully charge for a formerly free product is lacking.
Reactions to the Skype deal have been negative, if not downright derisive. Many see the Skype acquisition as more evidence that Microsoft can't innovate, or even effectively copy and out-implement any more. One local exec asked, rhetorically, how much it'd take to re-implement Skype. $100m? $1bn? It's not a question of money. Microsoft spends tons in R&D: 15% of sales, about $9bn per year. (Apple spends 2% of revenue, less than $2bn.) Think of iTunes: it's been out there for close to 10 years and there's no iTunes clone coming out of Redmond. Microsoft has to buy what it no longer has the people or the culture to create – or copy.
David Pogue, the NY Times' tech guru, thinks this acquisition will go where so many went before: to failure by mediocrity and to poisoning by matrix management.
Ben Brooks, a Microsoft shareholder – and not the disgruntled kind – comments on the Skype deal and concludes: The Ballmer Days Are Over. Perhaps, but who can tackle the job of turning Microsoft around?
In last year's 30 May Monday Note, I wrote Ballmer had opened the "Second Envelope". He was running out of explanations: first blame your predecessor, then fire a few subordinates. Next, you're out of excuses and out the door.
Since then, a few more subordinates have decided to "spend more time with their families": CTO Ray Ozzie, who wrote a long, long farewell memo (don't do that, it doesn't make you look good); tablet executive Bill Mitchell; Bob Muglia, president of the server and tools division. We'll exclude Stephen Elop, the president of the business division who went on to rescue Nokia, as he might have left of his own volition – or of his seeing Ballmer looking for the next excuse.
Last year, I noted Microsoft's stock had been stagnant for almost 10 years. Things haven't improved since then:
In the past 12 months, Microsoft's stock has fallen by 11% while the Nasdaq climbed 25%, Google 7%, and Apple 44%.
Having run out of ideas and envelopes, is Ballmer spending $8.5bn of Microsoft's $50bn cash, its biggest acquisition so far, as a desperate tentative to keep the company, or himself, in the game?


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