Questioning the Value of Microsoft's Skype Acquisition

Includes: EBAY, MSFT
by: MGI Research

Investors have been watching Microsoft (NASDAQ:MSFT) for some time wondering what the company will do with its growing cash hoard that has reached some $50 billion. As company observers know, Microsoft has been relatively conservative with regard to its acquisition strategy, and that, with the exception of the failed bid to acquire Yahoo, has until now focused on comparatively small companies. The pending acquisition of Skype is certainly large (particularly in price @ $8.5 billion), the immediate reaction of the investment community has been largely critical.

In developing our thoughts on the acquisition, our initial bias was toward being contrarian. However, as we look at the various pros and cons behind the deal, we find ourselves siding with the generally critical view. In fairness to Microsoft, the company has done an excellent job improving its MGI-X score, reflecting improving efficiency relative to its growth and investment in R&D. For a variety of reasons, management has struggled to effectively communicate these changes.

Our key observations are as follows:

1) As a strategic deal, there is no apparent or compelling vision as to how Skype visibly moves the needle in terms of revenue growth or profitability for Microsoft. In watching the interviews of Microsoft CEO Steve Ballmer, we were thoroughly underwhelmed by the rationale cited for the deal. If Microsoft wanted to integrate Skype into various product lines such as Microsoft Office, or Microsoft Phone, it certainly did not need to buy the company to achieve that goal. On the surface, it appears to be a defensive move to hold on to the SOHO/SMB markets vs Google (NASDAQ:GOOG) (Google Apps + voice vs MSFT Office365 + Skype). On the positive side for MSFT, wireless networks to date have largely been built from the outside in. To Microsoft’s credit, the next ten years may deliver a reversal. This means wi-fi and other micro-cell technology, combined with VOIP, could become a really big deal. Based on Ballmer’s presentation of the deal, this outcome would be accidental, rather than premeditated, but a shareholder plus nonetheless.

2) As an economic transaction, aside from the fact that Microsoft will be able to acquire Skype on a tax efficient basis using offshore cash, the high valuation of the company in terms of price/sales, price to EBITDA, in our view more than offset the positive of the tax efficiency.

3) Why didn’t Microsoft buy eBay (NASDAQ:EBAY), Research in Motion (RIMM), or even SAP? Any one of these transactions represents a more interesting opportunity than Skype. In particular, Microsoft could have bought eBay and gotten as a bonus a 30% ownership stake in Skype.

4) Buying Skype lessens the likelihood of any other large deals in the short term (six-to-nine months) – not due to any financial limitation, but rather given Microsoft’s conservative and uninspired acquisition strategy, or lack thereof.

5) The deal appears to be almost more of a defensive move to protect existing revenue streams, rather than a means to increase revenues.

Has Microsoft Missed its Window?

Please excuse the pun, but Microsoft transitioned from a rapidly growing company to a mature business (albeit with double digit revenue growth in many of its businesses) and may have missed the point-in-time opportunity to really leverage its scale and financial power by failing to move aggressively on non-linear acquisitions (or even a series of incremental strategic buys). In fairness, Microsoft’s conservatism may be a hold over from the years in which they were battling anti-trust claims.

The company has failed to realize that good or great ideas can come from outside, and perhaps remains too focused on protecting Windows – a franchise that is likely to remain very durable regardless of strategic missteps or investor apathy.