Tuck faculty explore the nuances behind the biggest deal in Microsoft’s 36-year history.
by Kirk Kardashian May 19, 2011
At first blush, the numbers behind Microsoft’s deal to purchase Skype for $8.5 billion don’t look good. The price tag is three times higher than what eBay netted when it sold Skype 18 months ago. It’s almost 10 times Skype’s revenue and 400 times its operating income in 2010. Plus, Skype posted a $7-million loss last year. Not surprisingly, most of the business world was skeptical about Microsoft’s chances of recouping its investment.
Tuck faculty member Anant Sundaram was skeptical too. But when he looked more closely at Skype’s financial statements, Sundaram—who teaches corporate valuation and is co-developing a corporate valuation iPad app called “iValue”—realized that most of the pundits were overlooking a key metric: free cash flow. Yes, Skype lost money in 2010, but only if you focus on its net income, a number that was rendered unreliable by various accounting maneuvers after it was bought and sold by eBay.
Sundaram wanted better data, so he added back depreciation and amortization—the non-cash charges on the financial statements—to operating income (after adjustments for taxes, reinvestment, and other things), and found that Skype had somewhere around $120 to $180 million in free cash flow at the end of last year. “Although it would seem like this is a loss-making company,” he says, “if you focused on free cash flow, they actually have a reasonably decent, healthy cash flow.”
Put another way, Skype’s free cash flow was about one sixth of its revenue, which is not bad. “That came as a bit of a revelation to me,” Sundaram says.
Still, there’s plenty to be skeptical about. If we assume a mid-point free cash flow of $150 million, the purchase price is 57 times greater than the free cash flow. That’s almost double the typical ratio in corporate acquisitions, which means Microsoft will need to aggressively grow Skype’s business, and leverage Skype to grow Microsoft’s business, in the years to come. Just how aggressive will these companies have to be? “The short answer,” Sundaram says, “is that they have to increase Skype’s cash flows for every year, from now to forever, by about 12 or 13 percent.”
Is that a high growth rate? “Ludicrously high,” Sundaram adds.
But not outside the realm of possibility. If the cash flow growth rate starts out very high, say 50 to 55 percent, and then fades steadily to something like nominal gross domestic product growth for the long run, Microsoft’s move may be vindicated. “I still think it’s an over-valuation,” Sundaram explains, “but not an outrageous over-valuation.”
After all, look at Facebook: it has 700 million members who don’t pay anything to use its services. But the latest indications from private investors such as Goldman Sachs put Facebook’s value at $50 billion. Skype has 663 million users, of which 9 million are paying customers. If Skype could monetize even a fraction of its users and increase its paying customers, perhaps it could be a real competitor among Google and Facebook. “If we are saying, ‘Why not?’ to a $50 billion valuation of Facebook,” Sundaram says, “$8.5 billion for Skype isn’t so crazy.” He also points out that Facebook grew its cash flow at more than 100 percent per year in the past couple of years, and that Google, starting in 2002 (when it was similarly-sized to today’s Skype), grew its cash flow at an average of over 60 percent per year through 2010. So there is some precedent for Microsoft’s aspirations.
If you stick with the official story from Microsoft, it plans to use Skype to bolster its existing software, not to change the business model to get advertisements in front of the eyeballs of its users. Could that strategy pay off? Maybe, says M. Eric Johnson, the Benjamin Ames Kimball Professor of the Science of Administration and director of Tuck’s Center for Digital Strategies.
Johnson points out that the Skype deal comes on the heels of a strategic partnership between Microsoft and Nokia—the leading mobile phone manufacturer in the world—to feature Windows software on its phones. Since most new smart phones have forward facing cameras, mobile video conferencing through Skype is becoming a popular way for people to communicate domestically and internationally.
“If there’s any place they’re going to find really big synergy,” Johnson says about the combination of Microsoft and Skype, “it’s the mobile phone market. Because then it’s not just selling Skype or figuring out how to monetize Skype, it’s using Skype to monetize Windows Mobile and develop a platform that’s really competitive with the iPhone.”
The only problem with this plan is that it cuts out the cell service providers like AT&T and Verizon, since using Skype with a cell phone circumvents international calling plans. But using Skype requires the transmission of vast amounts of data, so the likely play is for cell companies to get rid of flat data rates, if they haven’t already, or increase data fees. “They might not get a long-distance charge out of you,” Johnson says, “but they can charge you for being a data hog.” The extent to which data costs provide a disincentive for using Skype on cell phones is unknown, “but it’s going to be really fascinating to watch it play out,” Johnson believes.
Microsoft’s other big plan is to sprinkle Skype’s technology around its Xbox, Windows, and Outlook software. Of these, Johnson thinks Outlook is the place where Microsoft truly stands to benefit from its ownership of Skype. “The power in the Microsoft Office suite has definitely been declining,” he says, “but Outlook still stands as their fortress of strength, because most businesses still use it.” If Skype is integrated effectively into Outlook, it could become the do-it-all application for business communication, allowing users to chat, text, phone, email, calendar, and videoconference seamlessly. Today, videoconferencing is big a missing piece in Outlook—most businesses use Cisco’s WebEx for that. “If Microsoft can really make this work,” Johnson says, “there’s a lot of value there.”
As Microsoft figures out how to inject Skype into its business software, Johnson asserts it’s going to have to rehabilitate Skype’s image as a consumer-oriented tool that presents a security threat to companies’ networks. This is a valid concern, since Skype is a peer-to-peer service that basically bores a hole in network firewalls, allowing massive amounts of data to pour through. As a result, many businesses prohibit their employees from using Skype. But the problem is easily solved: Just switch Skype from a rogue application to something that’s standard-issue, and businesses will adapt. “If it gets sold with Outlook and bundled into business software,” Johnson says, “then I’m sure this issue will go away.”
Even for a company as big as Microsoft, which has nearly $50 billion in cash, an acquisition of this magnitude is not without its risks. The day after Microsoft announced the deal, it shed $1.3 billion in value, a sign that investors weren’t sanguine about the news. They have good reason to be skeptical, since Microsoft’s track record on acquisitions isn’t stellar. For instance, in 2007 it paid $6 billion for the online advertising group aQuantive, but that has barely dented Google’s mountain of market share. The same goes for its search engine partnership with Yahoo.
Sundaram, who advises senior managers privately and in Tuck Executive Education programs, believes that Microsoft’s bold purchase might indicate just how desperate it is to grow its market value. “One of the things that CEOs struggle with,” he says, “is wondering where the next $10 to $20 billion business is coming from. Because there aren’t many of those around.” It’s extremely time-consuming and rare for companies to achieve this kind of growth from the inside, Sundaram says, so they look to buy firms whose operations and technologies can be force multipliers.
Can Skype do that for Microsoft? Only time will tell.
The Hype About Skype
Tuck faculty explore the nuances behind the biggest deal in Microsoft’s 36-year history.
by Kirk Kardashian
May 19, 2011
At first blush, the numbers behind Microsoft’s deal to purchase Skype for $8.5 billion don’t look good. The price tag is three times higher than what eBay netted when it sold Skype 18 months ago. It’s almost 10 times Skype’s revenue and 400 times its operating income in 2010. Plus, Skype posted a $7-million loss last year. Not surprisingly, most of the business world was skeptical about Microsoft’s chances of recouping its investment.
Tuck faculty member Anant Sundaram was skeptical too. But when he looked more closely at Skype’s financial statements, Sundaram—who teaches corporate valuation and is co-developing a corporate valuation iPad app called “iValue”—realized that most of the pundits were overlooking a key metric: free cash flow. Yes, Skype lost money in 2010, but only if you focus on its net income, a number that was rendered unreliable by various accounting maneuvers after it was bought and sold by eBay.
Sundaram wanted better data, so he added back depreciation and amortization—the non-cash charges on the financial statements—to operating income (after adjustments for taxes, reinvestment, and other things), and found that Skype had somewhere around $120 to $180 million in free cash flow at the end of last year. “Although it would seem like this is a loss-making company,” he says, “if you focused on free cash flow, they actually have a reasonably decent, healthy cash flow.”
Put another way, Skype’s free cash flow was about one sixth of its revenue, which is not bad. “That came as a bit of a revelation to me,” Sundaram says.
Still, there’s plenty to be skeptical about. If we assume a mid-point free cash flow of $150 million, the purchase price is 57 times greater than the free cash flow. That’s almost double the typical ratio in corporate acquisitions, which means Microsoft will need to aggressively grow Skype’s business, and leverage Skype to grow Microsoft’s business, in the years to come. Just how aggressive will these companies have to be? “The short answer,” Sundaram says, “is that they have to increase Skype’s cash flows for every year, from now to forever, by about 12 or 13 percent.”
Is that a high growth rate? “Ludicrously high,” Sundaram adds.
But not outside the realm of possibility. If the cash flow growth rate starts out very high, say 50 to 55 percent, and then fades steadily to something like nominal gross domestic product growth for the long run, Microsoft’s move may be vindicated. “I still think it’s an over-valuation,” Sundaram explains, “but not an outrageous over-valuation.”
After all, look at Facebook: it has 700 million members who don’t pay anything to use its services. But the latest indications from private investors such as Goldman Sachs put Facebook’s value at $50 billion. Skype has 663 million users, of which 9 million are paying customers. If Skype could monetize even a fraction of its users and increase its paying customers, perhaps it could be a real competitor among Google and Facebook. “If we are saying, ‘Why not?’ to a $50 billion valuation of Facebook,” Sundaram says, “$8.5 billion for Skype isn’t so crazy.” He also points out that Facebook grew its cash flow at more than 100 percent per year in the past couple of years, and that Google, starting in 2002 (when it was similarly-sized to today’s Skype), grew its cash flow at an average of over 60 percent per year through 2010. So there is some precedent for Microsoft’s aspirations.
If you stick with the official story from Microsoft, it plans to use Skype to bolster its existing software, not to change the business model to get advertisements in front of the eyeballs of its users. Could that strategy pay off? Maybe, says M. Eric Johnson, the Benjamin Ames Kimball Professor of the Science of Administration and director of Tuck’s Center for Digital Strategies.
Johnson points out that the Skype deal comes on the heels of a strategic partnership between Microsoft and Nokia—the leading mobile phone manufacturer in the world—to feature Windows software on its phones. Since most new smart phones have forward facing cameras, mobile video conferencing through Skype is becoming a popular way for people to communicate domestically and internationally.
“If there’s any place they’re going to find really big synergy,” Johnson says about the combination of Microsoft and Skype, “it’s the mobile phone market. Because then it’s not just selling Skype or figuring out how to monetize Skype, it’s using Skype to monetize Windows Mobile and develop a platform that’s really competitive with the iPhone.”
The only problem with this plan is that it cuts out the cell service providers like AT&T and Verizon, since using Skype with a cell phone circumvents international calling plans. But using Skype requires the transmission of vast amounts of data, so the likely play is for cell companies to get rid of flat data rates, if they haven’t already, or increase data fees. “They might not get a long-distance charge out of you,” Johnson says, “but they can charge you for being a data hog.” The extent to which data costs provide a disincentive for using Skype on cell phones is unknown, “but it’s going to be really fascinating to watch it play out,” Johnson believes.
Microsoft’s other big plan is to sprinkle Skype’s technology around its Xbox, Windows, and Outlook software. Of these, Johnson thinks Outlook is the place where Microsoft truly stands to benefit from its ownership of Skype. “The power in the Microsoft Office suite has definitely been declining,” he says, “but Outlook still stands as their fortress of strength, because most businesses still use it.” If Skype is integrated effectively into Outlook, it could become the do-it-all application for business communication, allowing users to chat, text, phone, email, calendar, and videoconference seamlessly. Today, videoconferencing is big a missing piece in Outlook—most businesses use Cisco’s WebEx for that. “If Microsoft can really make this work,” Johnson says, “there’s a lot of value there.”
As Microsoft figures out how to inject Skype into its business software, Johnson asserts it’s going to have to rehabilitate Skype’s image as a consumer-oriented tool that presents a security threat to companies’ networks. This is a valid concern, since Skype is a peer-to-peer service that basically bores a hole in network firewalls, allowing massive amounts of data to pour through. As a result, many businesses prohibit their employees from using Skype. But the problem is easily solved: Just switch Skype from a rogue application to something that’s standard-issue, and businesses will adapt. “If it gets sold with Outlook and bundled into business software,” Johnson says, “then I’m sure this issue will go away.”
Even for a company as big as Microsoft, which has nearly $50 billion in cash, an acquisition of this magnitude is not without its risks. The day after Microsoft announced the deal, it shed $1.3 billion in value, a sign that investors weren’t sanguine about the news. They have good reason to be skeptical, since Microsoft’s track record on acquisitions isn’t stellar. For instance, in 2007 it paid $6 billion for the online advertising group aQuantive, but that has barely dented Google’s mountain of market share. The same goes for its search engine partnership with Yahoo.
Sundaram, who advises senior managers privately and in Tuck Executive Education programs, believes that Microsoft’s bold purchase might indicate just how desperate it is to grow its market value. “One of the things that CEOs struggle with,” he says, “is wondering where the next $10 to $20 billion business is coming from. Because there aren’t many of those around.” It’s extremely time-consuming and rare for companies to achieve this kind of growth from the inside, Sundaram says, so they look to buy firms whose operations and technologies can be force multipliers.
Can Skype do that for Microsoft? Only time will tell.
May 2011