initial thoughts on Microsoft/Skype

the purchase

Yesterday, May 10th, MSFT announced it had agreed to buy Skype from its private equity owners for $8.5 billion in cash.

a little history

If you recall, e-Bay bought Skype from its founders–who opened up for business in 2003–for a total of $3.1 billion ($2.6 billion up front, an additional $500 million in incentive payments) in 2005.  The idea was that free phone calls between seller and bidder would somehow boost e-Bay’s online auction business.  That didn’t work.  In 2009, after Meg Whitman was ushered out of the company and new management began to clean up, e-Bay tried to sell Skype.  Only then did it learn that Ms. Whitman had neglected to secure the basic intellectual property behind the internet phone service (whoops!).   But e-Bay eventually managed to sell roughly 70% to Silver Lake for a price that valued the whole company at $2.8 billion (Silver Lake did manage to acquire the IP from Skype’s founders).

After freeing itself from the “bureaucratic mess” of e-Bay, as the New York Times reported, quoting a Skype blogger, the company dusted itself off, filed for an IPO about eight months later and simultaneously began exploring the possibility of a private sale.

Enter MSFT, which intends to link Skype to its e-mail, X-Box and office collaboration offerings on the idea that this will make them all more attractive.

This will be the largest purchase for MSFT ever, though not its highest-ever offer.  Remember, MSFT made an unsuccessful $44+ billion bid for YHOO in 2008.  In that instance, the YHOO board (strangely, given the firm’s operational difficulties) rejected the $31 a share offer, which was at about a 60% premium to the pre-bid price.  The S&P 500 is about flat since that time.  YHOO has  new CEO and is now trading at just under $19.

why Skype?

Skype is probably not the purchase you or I would make if we had a loose $8.5 billion lying around.  I don’t think it’s one that GOOG would make  …or AAPL   …or WMT.  In addition, as far as I can see, MSFT had no interest in Skype when it was in the process of being sold for less than $3 billion a year and a half ago–which for me is the most troubling part of the deal.

But the acquisition may not be as bad as it looks on the surface.  It also gives you insight, I think, into what MSFT sees as its best viable investment options.  To elaborate:

foreign earnings

1.  Like many US-based international companies, MSFT has a ton of profits it has earned overseas that are lying around in low-yielding offshore bank accounts.  There are two reasons for this:

economically, repatriating these earnings to the US would subject them to federal income tax at a rate of 35% minus any foreign tax paid.  Since the funds are presumably in low- or no-tax jurisdictions, a company returning the funds to the US would have to fork over a third of the money to Uncle Sam. Why do it without a clear domestic need for the money?  Suppose you repatriated a large amount, paid tax and then figured out you wanted to use it for an acquisition abroad?  Better to keep your options open.

financially, unrepatriated funds can’t be used to pay dividends to US shareholders.  So in some sense, this money is not worth 100 cents on the dollar to US shareholders.  A generation ago Wall Street would have worried about this and applied a discount PE multiple to low-tax foreign earnings.  No more.  Today’s investors seem to me to be indifferent to the tax rate a company pays.  They capitalize all after-tax earnings at the same rate.  So in today’s world, repatriating funds, which lowers reported eps, lowers the stock price as well.   …another reason not to do it.

If we assume MSFT will pay for Skype with money marooned in a zero tax rate jurisdiction, then paying $8.5 billion for Skype in Luxumburg is like paying $5.5 billion in the US.

a quick-and-dirty payback analysis

2.  In an interview with Forbes, Silver Lake says that if MSFT manages Skype well, it could eventually be worth $25 billion-$30 billion.  (Huh?  If this is the case, why in the world are they selling 100% of what they own?)

Let’s assume, just for the sake of argument, that Skype, which is around breakeven in its seventh year of operation and has only 8 million paid users, somehow grows profits in a linear fashion to $500 million five years from now and $1 billion in ten years, before earnings flatten out but continue at the $1 billion a year level.  Let’s also assume that MSFT doesn’t spend a penny integrating Skype into its software offerings.  How long does it take MSFT to recover its $8.5 billion?

The answer is 13.5 years.

That’s a looong time, especially in the fast-changing world of the internet.  In fact, if we were calculating a present value and not just a simple payback, or if we were assuming the MSFT has to spend money to integrate Skype (which it will have to, I think), recovery would be even loooooonger.

What makes Skype an attractive investment for MSFT, then?  The simple answer is that this is the highest-return investment the company can find that’s within its core competence.  Yes, it could buy something in an unrelated field, like a department store or a circus or a mining company, as Big Oil did when it was flush with cash in the mid-Seventies.  But ideas like those are always disasters.  In other words, the Skype deal underlines how mature a company MSFT is.

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