Why Microsoft Is Buying Skype for $8.5 Billion

Just days after reports that Google and Facebook were interested in partnering with, and possibly buying VoIP company Skype, Microsoft announced that it was buying the company for $8.56 billion in cash.

Last year, Skype had revenue of $860 million on which it posted an operating profit of $264 million. However, overall it made a small loss of $7 million, and had long-term debt of $686 million. This is the second time Skype has been bought out; after being started in 2003, it was purchased by eBay in 2005 for $3.1 billion. EBay then sold the majority of its stake in 2009 to a private investment group for $1.2 billion less than it paid.

The purchase was Microsoft’s biggest ever, surpassing even the $6 billion acquisition of advertising firm aQuantive in 2007. That alone makes it surprising; the company’s track record with large purchases is decidedly mixed. Danger, the exciting mobile technology company that produced the Hiptop, better known as the T-Mobile Sidekick line, was purchased for an estimated $500 million in 2008; the result of that purchase was the disastrous KIN phone and a complete failure to integrate the bought-in talent. The aQuantive purchase too had mixed outcomes, with Redmond unable to find a role for the Razorfish division before eventually selling it off in 2009; Microsoft continues to be unable to make a profit from online advertising.
Microsoft has in the last couple of years shied away from similar large acquisitions, sticking to buying smaller, easier-to-manage organizations, leading some to argue that this was a direct result of the digestive difficulties faced with the large purchases. A $7 billion Skype acquisition would show that perhaps Redmond believes it has resolved such problems.

Microsoft’s own software already has considerable overlap with Skype. Windows Live Messenger offers free instant messaging, and voice- and video-chat. It currently boasts around 330 million active users each month, typically with around 40 million online at any one moment. Microsoft has an equivalent corporate-oriented system, Lync 2010 (formerly Office Communication Server) that allows companies to create private networks that combine the communications capabilities of Live Messenger with corporate manageability. The underlying technology of both platforms is common, allowing interoperability between Live Messenger and Lync. The company also plans to integrate Kinect into Lync to create more natural virtual presences.

Skype, in contrast, has around a third the number of active users: 124 million each month. It also has fewer simultaneous online connections: typically 20-30 million. Its instant messaging and voice and video call features are broadly similar to those found in Windows Live Messenger, though arguably more refined.

Though the Skype user base is very much smaller than that of Windows Live Messenger, it does have one key difference: About 8 million Skype users pay for the service. Skype integrates telephone connectivity and is able to make both outbound and inbound phone calls, and while its online services are all free to use, these phone services cost money. Skype also has points of presence across the globe, making it easy to buy phone numbers in foreign markets to cheaply establish an international telepresence.

Skype certainly has some things of value. The telephony infrastructure would make a valuable addition to the Messenger/Lync platform. It could also tie in well with Exchange 2010, which offers voicemail integration. Adding telephony to Lync, Exchange, and Live Messenger is certainly a logical way to extend those products.

Perhaps more adventurous, integrating Skype-like functionality into Windows Phone would be something of a game-changer. Integrated multinational VoIP support would potentially be enormously disruptive to the cellphone market. However, as good as this might be to end-users, it would probably serve only to kill Windows Phone stone dead for carriers.

As much as telephony integration into Microsoft’s communications products and VoIP integration into its telephony product makes sense, it’s hard to make sense of the deal. The purchase price is a phenomenal amount of money to spend on a company that has long struggled for profitability, and it’s hard to believe that it’s truly the most cost-effective way of getting access to telephony and VoIP technology. Microsoft could build equivalent telephony infrastructure for much less, just as Google is doing for Google Voice.

Similarly, although Skype is in many ways a better instant messaging and voice- or video-calling client than Live Messenger, it’s hard to believe that it’s $7 billion better. The Skype client itself is written almost as if it were a piece of malware, using complex obfuscation and anti-reverse engineering techniques, and it would be disquieting for Microsoft to release something that behaved in such a shady way; at the very least, the client would surely have to be rewritten to avoid the obfuscation and outright hostility to managed networks that Skype currently has.

Even the access to paying customers is hard to justify. The terms of the deal mean that for each Skype customer, Microsoft is paying about $1,000. And on average, those customers are worth a profit of about $30, presuming most of Skype’s income comes from subscriptions and call charges. That’s a huge disparity.

Windows Live Messenger users have shown no propensity towards paying money, unlike Skype’s 8 million paying users, and it may be a challenge to convert them from nonpaying to paying. However, since at the moment they have essentially nothing to pay for, it’s difficult to use that as evidence that they wouldn’t pay if there were services worth paying for. Especially as there’s likely to be quite a bit of overlap between the customer bases: People aren’t giving Skype the money instead of Microsoft because they prefer paying Skype, they’re doing it because Microsoft simply doesn’t sell Skype-like telephony facilities. And Lync customers are already on the payment treadmill, so it should be far easier to extract further payments from them for additional services.

Ultimately, it’s hard to see how the Skype purchase is worthwhile from a technology or user-access perspective. The technology isn’t good enough and the users aren’t lucrative enough or plentiful enough to justify it. But that doesn’t mean it won’t happen — and the prospect of keeping the company out of reach of Google and Facebook may just make the purchase irresistible.