Has Microsoft hit the right number for Skype?

The computing giant's $8.5bn purchase of the internet telephony pioneer has perplexed many analysts

Steve Ballmer, Microsoft's chief executive, called it "entirely consistent with our irrepressible, forward-looking nature". Some analysts called it reminiscent of the dot.com bubble a dozen years ago. Microsoft's investors appeared largely to take the view that the proof of the pudding will be in the eating.

The pudding, in this case, is Skype, the internet-telephony pioneer, which Microsoft has swallowed whole in a takeover deal worth $8.5bn (£5.2bn). It is the largest acquisition in the software giant's 36-year history, and will be by far its biggest gamble.

For multiple reasons, the pressure is on Mr Ballmer to justify the high price he has agreed to pay. Microsoft is not the first large company to think it could make decent money out of Skype. It was acquired by eBay in 2005, only to be offloaded in 2009 after the company failed to pull off the promised integration of Skype phone and video calls into its famous online marketplace.

Similar promises of integrated Skype and Microsoft services were made yesterday, to the sceptical faces of the analyst community.

More importantly, while Microsoft continues to harvest cash from its reliable old bankers – the Windows operating system for PCs and its Office software for businesses – it has thrown billions of dollars at a new generation of businesses on the internet – through its MSN media and email business and its Bing search engine – to decidedly mixed results.

It faces losing out in the battle to dominate the smartphone, since Apple and Google's Android dominate the operating-system market, with Windows struggling to make inroads. In this context, the Skype deal looks like a desperate roll of the dice, even if it barely makes a dent in Microsoft's cash pile of $50bn.

The company has been toiling away on its own communications platform, something it calls Microsoft Lync, which synchs up users' instant messaging, video conferencing and phone calls, but in a giant swerve it has snapped up a business with worldwide name recognition. As Mr Ballmer put it yesterday: you don't often get the chance to buy a company whose brand name has become a verb.

And Skyping is increasingly popular. A total of 145 million people signed in to chat in the last three months of 2010, the last for which figures were published, compared with 105 million in the same period the year before. In 2010 as a whole, Skype recorded 207 billion minutes of voice and video conversations.

Yet this surging popularity has not been accompanied by surging profitability. On revenues of $860m last year, Skype managed to lose $7m. Most people don't pay at all for the service, which connects Skype users for free over the internet as an alternative to having to pay national or international telephone charges. At the end of last year, 8.8 million people were paying Skype for additional options, though, including connecting to ordinary landlines or mobile phones. That was 1.5 million more than the previous year.

Microsoft isn't just banking on that number growing of its own accord. It hopes to push Skype as a service for businesses, perhaps by integrating it with its Office products, including the Outlook email service. Mr Ballmer set out plans, too, to produce new services that bring Skype video conferencing to Xbox Live, the gaming and entertainment services built around Microsoft's gaming console.

"Together we will create the future of real-time communications so people can easily stay connected to family, friends, clients and colleagues anywhere in the world," Mr Ballmer said yesterday.

Microsoft made its offer just over a month ago, after working more and more closely with Skype on technological collaborations and partnerships. It appears to have blown potential rival bidders out of the water.

Rumours circulating in Silicon Valley suggested that Facebook and Google had been mulling offers in the $3bn to $4bn range, just above the level bankers had told Skype to expect, should it pursue a stock-market flotation instead. The private-equity-led consortium which owns Skype has been looking for a way to cash in on its investment almost since buying the company from eBay in 2009.

Those owners – the venture-capital group Silver Lake Partners, the founder of Netscape, Marc Andreessen, and the London-based Index Ventures – bought in at a valuation of $2.75bn and have made an estimated three times their money. Also, eBay kept a 30 per cent stake, which means it has now snatched an approximate 30 per cent return on its 2005 acquisition, where once the deal had looked like a wash.

At $8.5bn, the price tag has left Microsoft's followers scratching their heads. Kim Caughey Forrest, an analyst at Fort Pitt Capital, said: "[Executives] really have to do some explaining as to how this company merited that price and how they'll return the value to shareholders. It smacks of that 1999, 2000 time period when valuations were granted on eyeballs not revenue and earnings."

Skype will be run as a standalone division inside Microsoft by its current chief executive, the British technology industry veteran Tony Bates. Mr Bates was hired by Skype from the software giant Cisco last year. "Microsoft and Skype share the vision of bringing software innovation and products to our customers," he said yesterday.

Investors appeared to be taking a cool, rather than stone-cold, view of the deal. Microsoft shares were down by 1.5 per cent yesterday in a rising stock market.

"It doesn't make sense at all as a financial investment," said Andrew Bartels, an analyst at Forrester. "There's no way Microsoft is going to generate enough revenue and profit from Skype to compensate. I'm sure shareholders are saying that Microsoft should have given a dividend to shareholders rather than spend it on this."

How Skype took off

2003 Founded by entrepreneurs Niklas Zennstrom of Sweden and Janus Friis, a Dane. The name is a contraction of "Sky peer-to-peer".

2005 Acquired by eBay for $2.6bn, in the hope that buyers and sellers would use Skype to talk to each other.

2006 Passes 100 million user accounts.

2008 Skype is the largest single carrier of international phone calls, a study shows.

2009 Company sold to a private equity group after eBay admits it "does not have synergies with our e-commerce business".

2010 Files with regulators to list on Nasdaq stock exchange, but delays flotation in the hopes of attracting a takeover bid.

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