Friday, 20 May 2011 05:11

No! Microsoft Didn't Overpay for Skype - They Need to Bulk Up To Compete With Google: Where Does This Leave Apple, RIM???

Several BoomBustBloggers inquired as to my opinion of what apparently was an overpriced acquisition of Skype by Microsoft. At first blush, it appears as if the management of Microsoft has lost their mind. A second look (as well as access to our proprietary research) reveals a more interesting perspective. To make a long story short, Microsoft is trying to replicate Google's cloud services.

If you reference pages 29 to 36 in our the Google valuation report from 8 months back (63 pg Google Forensic Valuation - tutorial, [Google Final Report 10/08/2010 to download] to plug in your own assumptions see Google Valuation Model (pro and institutional), you will find the answer to why Microsoft is willing to pay $8.5B to buy Skype. Skype, like Google Voice which is tightly integrated into Android,  will be folded into the mobile operating system to give full mobile VOIP capabilities that will most likely tie in with Microsoft’s server products ex. Exchange server for storing voicemail along email, voice recognition, transcription services, etc.) , just as Google purchased Grand Central (page 55 on, in the report) to turn it into Google Voice to move vast amount of profitable mobile telephony services out of the reach of telcos and totally to Google’s cloud – leaving only data services to the telcos. This is happening now, reference Sprint’s wholesale adoption of Google Voice by offering users to switch transform their Sprint numbers into GV numbers without breaking their contract. As excerpted from the afore-linked source:

Google was already a competitor

Communications services, especially voice services, are rightly seen as the last bastion of clear telecoms operator advantage over alternative means of offering such services, with the telephone number itself being the key enabler.

In many other areas, such as applications and content, telecoms providers are already losing out in terms of service usage and brand loyalty to aggressive, software-driven players such as Google and Apple. Verizon may previously have partnered with Skype for similar-looking services, but Skype is not Google; as an Internet voice specialist, Skype’s ability to impact the telecoms value system is nowhere near as profound as Google’s.

As such, Sprint’s inviting of Google into the telecoms inner sanctum, through this formal partnership to offer Google Voice, might therefore look something like throwing the baby out with the bath water.

But may prove a better friend than foe

So, what does this really mean?

It means exactly what I said it would in my forensic valuation of Google last year. You see, many market participants – and especially the sell side analyst community SIMPLY DO NOT UNDERSTAND WHAT KIND OF COMPANY GOOGLE IS. Google is a PURE PLAY INTERNET COMPANY. It is  pure play that caters both to the consumer and the enterprise. Most analysts and investors believe Google to be a search engine and an ad serving company. That perception is wrong and will result in a FAIL! Google is literally, THE CLOUD! The excerpt above is an example of Google selling its cloud services, wholesale, to Sprint – giving Sprint a market advantage over Verizon (who has partnered in a very whimsical fashion that limits synergies) with Skype and particularly over AT&T as it threatens with the T-Mobile merger to become the behemoth that the anti-trust department once broke it up for being. Remember the Ma Bell being disincorporated into the baby bells? Well this baby is trying to grow into a monopoly again….

So, what’s in it for Sprint to sell off its money making (those telcos truly overcharge for that stuff!) voicemail services? Economies of scale, the same advantages everyone else gets when they outsource and offshore! Sprint is simply literally offshoring to the cloud. They get to keep (at least so they think) their interface with the customer through control of the phone number, yet offload the complex software development and data center complexities to a third party while Google gets to monetize its massive investment in cloud infrastructure and services. Google also gets to cross sell is myriad of cloud services to said clients. Think the Google Music Beta (storage and streaming from the cloud), Android,  Gmail, Google Talk, Google Docs, etc. Google has already invested heavily in Sprint and the results are already showing. Who has had the best Android phones over the past year? Don’t be surprised to see more coming out of this duo. More importantly, expect to see the entire telco industry either snap up smaller VOIP providers in an attempt to counter the Microsoft/Skype/Windows Phone 7 combo and Sprint/Google Voice – not to mention drive the prices of these smaller guys though the stratosphere, 1999 dot.com bubble style ala LinkedIn yesterday (where are those damn puts???!!!) as they get into bidding wars with Apple,  RIM and HP or rush to outsource their own voicemail offerings to Google and/or Microsoft. This is a case where some of the big boys may find it wise to side with the behemoth monopolist, for Google is starting to become dangerous in the power and influence it wields.

Reference our ruminations on Skype last year in our Google Forensic report

As excerpted from the Google forensic report for subscribers (63 pg Google Forensic Valuation, [Google Final Report 10/08/2010 to download] to plug in your own assumptions see Google Valuation Model (pro and institutional).


So, Did Microsoft overpay for Skype?

In retrospect, it is an interesting move by MSFT since Skype has 677 existing members. Many feel Microsoft is overpaying for Skype, but anybody who has access to our proprietary research can see that the price MSFT is paying is about right using Google as a benchmark. This is why company management is always better at strategic acquisitions than financial pundits from the outside looking in. That doesn’t necessarily mean that they are good, simply better than financial investors at strategy.

This also leaves Apple and RIM out in the cold for this level of user access and VOIP telephony/cloud-based data storage pretty much ends with Google Voice and Skype. Apple will have to build organically, ex. bulk up Facetime (which will need a LOT of work which they don’t have the time nor probably the resources either – Google has already incorporated video conferencing in its latest iteration of Android and it works over any network vs Apple’s rendition needing a WiFi network) or attempt to buy a smaller outfit and bulk that up as well. Either path will be both expensive and time consuming without a guaranteed nor necessarily clear path to being able to compete with the new Windows 7/Skype or Android/Google Voice integrations.

This is reminiscent of the many warnings that I have given my readers and subscribers in regards to prematurely dismissing Microsoft as a frontrunner in these mobile computing wars. See the original articles from last summer: Don’t Count Microsoft Out of the Ultra-Mobile Computing Wars Just Yet July 14th, 2010:

I recommend that my readers NOT underestimate Microsoft’s ability to come from behind on this one.  Out of the three competitors that I feel have the most potential – Apple, Google/Android, and Microsoft – Microsoft is the only company to have:

    1. A fully established and pedigreed cloud ecosystem for the enterprise (Google’s Docs and Gmail apps are relatively new in comparison, and Apple has only burgeoning consumer offerings that have been recently launched).
    2. The most advanced audio/video client side interface with both streaming and subscription services, to be offered through the Zune interface of Windows Mobile 7. For those who haven’t used it, the new Zune software/hardware combo puts iTunes to shame. Google doesn’t have a comparable offering of note.
    3. The de facto standard Office productivity platform, which also happens to be very, very difficult to replicate and/or reverse engineer. It also happens to be, by far the most feature rich. One should expect enhanced compatibility between Windows Phone 7 devices and Office apps.
    4. A rich version of Office productivity apps that can run from the cloud (Office 2010, currently available for download).
    5. A steady stream of revenue derived from practically every smartphone sold. Just like MSFT makes money on every PC sold, it also gets a license fee for every smartphone that needs to interactive with Exchange server, which is practically every phone that needs to interact with a Fortune 500 mail server. This is a legacy benefit from being the de facto standard in the enterprise. Whose product do you thing works best with Exchange? Secret APIs?
    6. The only major mobile OS vendor who also owns one of the top top gaming platforms – the X-Box system. Expect rich, 3D/HD, cloud-based X-box gaming to come to a Windows Mobile 7 phone/table  near you. Imagine X-Box Live (a killer app in its own right) with comparable graphics on a Windows Phone with a 4 or 5 inch super AMOLED screen.

For these reasons and more, Microsoft will be a force to reckon with. I’m not saying they will win the ultra-mobile computing wars, but it will be most unwise to count them out due to their bumbling and stumbling – all to be expected from a big company that has been on top for so long, getting fat and losing touch with its true customers due to an unfettered monopoly revenue and profit stream from its cash cow products. Of course the question still remains, where does this leave Apple and RIM? After all, Google has placed its equity investments in data infrastructure already:

Related reading:

  1. A Realistic Look At The Success Of Google’s Investment History

  2. Google’s Q1 2011 Review: Part 2 Of My Comments On The Gross Misvaluation of Google

  3. The Google forensic report (63 pg Google Forensic Valuation, to plug in your own assumptions see Google Valuation Model (pro and institutional)

Last modified on Friday, 20 May 2011 08:43

4 comments

  • Comment Link shaun noll, CFA Thursday, 02 June 2011 21:49 posted by shaun noll, CFA

    great post Reggie, MSFT at 7x earnings ex cash still looks like a buy to me, certainly not the type of investment you expect to double but I wouldn't be surprised to see a 15%+ IRR over the next 5 years for MSFT equity owners, which can be juiced a bit by selling calls and puts around your position.

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  • Comment Link Binh Sunday, 22 May 2011 00:55 posted by Binh

    "In retrospect, it is an interesting move by MSFT since Skype has 677 existing members." -- What does this mean??

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  • Comment Link Igal Perelman Saturday, 21 May 2011 19:56 posted by Igal Perelman

    Thanks for the post, many great insights. Two more points:

    1. Microsoft was bidding against Skype's coming IPO.
    2. Skype is a P2P network, not a cloud one. There are still many other synergies though.

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  • Comment Link Reggie Middleton Friday, 20 May 2011 11:00 posted by Reggie Middleton

    More on the logic, or lack thereof, of an MSFT Skype aqcuisition: http://www.wired.com/epicenter/2011/05/microsoft-buys-skype-2/

    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.

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