Tuesday, May 10, 2011

Microsoft Buys Skype

From this Microsoft (MSFT) press release:

Microsoft to Acquire Skype

$ 8.5 billion appears to be an awful lot to pay for a business that has barely earned a penny in its eight years of existence.

Of course, eBay (EBAY) was thought to have paid too much when they paid $ 2.6 billion for Skype in 2005. They bought it with the idea that eBay buyers and sellers would use it to communicate. It didn't work out.

Appearing to admit defeat, eBay then sold a 70% stake to a consortium led by Silver Lake Partners for $ 1.9 billion in 2009. So at that time Skype was valued at $2.75 billion. (70% of a $ 2.75 billion valuation = $ 1.9 billion in cash to eBay*).

eBay retained the remaining approximately 30% equity investment in Skype.

Well that remaining 30% stake that eBay still owns is now worth ~$ 2.6 billion based upon the $ 8.5 billion Microsoft is paying. So while the experiment with Skype didn't work out eBay has financially more than reversed the error.

eBay initially paid $ 2.6 billion (plus $ 500 million in earnouts) back in 2005.

Between the two transactions (the initial Silver Lake led deal and now Microsoft) eBay gets:

~$ 1.9 billion (from Silver Lake back in 2009)

plus

~$ 2.6 billion (Microsoft)

= $ 4.5 billion.

So eBay ultimately did a whole lot better than others probably imagined a few years ago. It still was not a great use of capital by them when you look at opportunity costs but at least no longer a disaster.

Meanwhile, Silver Lake Partners and the other investors sure did alright.

Time will tell whether this makes any sense for Microsoft.

Wall Street Journal article: Microsoft to Acquire Skype

TechCrunch article: Done Deal! Big Deal. Smart Deal? Microsoft Buys Skype For $8.5 Billion In Cash

"...only time will tell if it will become indeed a significant threat, or a giant dud." - Techcrunch

So what's that $ 8.5 billion going to buy Microsoft? As an investor that's not easy to gauge.

Count me as skeptical.

I don't doubt Microsoft could make this into something uniquely valuable by integrating Skype with other Microsoft assets over time. It's a potential boost to their offerings in enterprise collaboration and the competitiveness of Windows Mobile among other things.

Here's one take on how it may make sense for Microsoft.

Why Microsoft is buying Skype for $ 8.5 billion

To some extent, I get the story behind this deal and my guess is it may even work out strategically (a.k.a. excuse to use too much shareholder money to buy an asset) yet likely still not enhance shareholder returns. Owners can't spend stories and strategic wins. In other words, management domain may end up enhanced here while owners pockets...not so much.

So, even if the rational is fine, it's not clear what it means in the long run economically. It's one of the reasons I don't like investing in tech companies unless the valuation is extremely low. For now, the question that cannot be answered is: Do they know what they are doing or just finding clever ways to burn up too much of the owners cash?

Most likely a bit of both.

Either way, if this makes so much sense for Microsoft why not buy Skype when eBay was under pressure to unload it at a much lower price less than two years back?

So the move may, in fact, turn out to make sense but they certainly paid more than they had to if they had just a bit more foresight.

I'm guessing that being behind the curve on so many fronts they felt that for competitive reasons this was a move that had to be done.

At the current valuation, I'd still expect a solid return from Microsoft's stock over five years despite the 1) odd tendency to misallocate capital and 2) real threats from Apple/Google/other competitors. As a company, Microsoft's overall story may or may not be a beauty but for an investor the long-term arithmetic still works at current valuations.

The bottom line is that, at the margin, the high price paid for this specific deal likely destroys some shareholder value even if it eventually works out okay otherwise in the long run. Fortunately, Microsoft's size makes the damage done to shareholders relatively small.

So far that is. It will soon become wise for investors to move on if a few more of these expensive "strategic" acquisitions is in the works.

You pay less for a company with management that routinely overpays on acquisitions.

Speaking of cash, the owners of Microsoft had plenty of it at nearly $ 50 billion on the balance sheet ($ 50 billion of cash - $12 billion of debt = $ 38 billion net cash).

I say had, of course, because now there is $ 8.5 billion less of it (to be fair they are still rather cash rich but a few more moves like this and it's real money even to Microsoft). If Skype is producing anything near $ 1 billion in free cash flow several years down the road or boosts Windows Mobile in a material way then the risks taken with this deal will end up making some sense. If not, Microsoft had (and has) the chance to buy a perfectly inexpensive stock at or near an ~8x multiple with that cash. Far more certainty in that.

The companies in which we have our largest investments have all engaged in significant stock repurchases at times when wide discrepancies existed between price and value...The obvious point involves basic arithmetic: major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value. When companies purchase their own stock, they often find it easy to get $2 of present value for $1. Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value for each $1 expended. - Warren Buffett in the 1984 Berkshire Hathaway Shareholder Letter

The fact is we may or may not ever know if this made financial sense for shareholders as Skype's future financial performance could easily be buried within a company Microsoft's size.

One of the concerns with all the cash that tech companies hold on their balance sheets is that it will be wasted.

This move by Microsoft should probably reaffirm that concern.

With nearly $ 6.8 billion of cash on the balance sheet at the end of the most recent quarter, eBay wasn't exactly cash poor before this transaction:

$ 6.8 billion cash, cash equivalents, and short-term investments
- $ 1.8 billion debt
= $ 5.0 billion net cash**

Once the deal is done with Microsoft they'll have $ 2.6 billion more.

Maybe the cash eBay receives from this transaction will be invested in something with a more clear cut return for shareholders.

Adam

Long positions in both MSFT and EBAY

* Plus a note from the buyer in the principal amount of $125 million
** eBay also had $ 2.7 billion in long-term investments at the end of 1Q
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