Where the Rubber Meets the Skype

In the early days of my company, one of our first big customers described our system as "where the rubber meets the sky:" wildly visionary yet entirely practical. It was a great complement.

In 2003, the founders of Skype had a vision that was both wild and practical: "free" phone service. They realized that PC's had become powerful enough to run packet-switching protocols for handling voice calls. Different packet-switching protocols had been used inside the telephone system for decades, but required expensive, special equipment owned and operated by the phone company. Skype's founders realized that the user had already paid for both the PC and the Internet connection, so computer-to-computer voice calls needed no new spending by the user, hence the perception of being "free."

It gets better. The Skype founders realized that with the PC and the Internet doing almost all of the work of handling the call, their business would require only a tiny amount of capital compared to building out a new telephone system. Further, users would recommend the system to other users, so it would cost almost nothing to attract new customers. A handful of employees and a small fleet of computer servers could handle millions of users.

It seemed like the Estonian founders discovered a new gold mine. In 2005, eBay snapped up the burgeoning enterprise for a reported $2.6 billion. Their timing could not have been worse. Wall Street's love affair with Internet stocks was already over; the champagne toasts turned to a long, nasty hangover.

Despite management turmoil, write-downs, and divestitures, Skype kept growing, reaching 663 million signed-up users by 2009 and handling 13% of all international calls by 2010. Skype kept adding services, including calls to and from ordinary wire-line and wireless phones, for a fee. Most of Skype's revenues ($525M in 2008; $575M in 2009) are for those calls, and most of its expenses are settlements to ordinary phone companies for those same calls ($225M in 2008; $290M in 2009).

These figures illuminate Skype as a money-making engine. With almost 50% gross margin, few employees (less than 1,000), and relatively low capital investment, Skype should be a solid money-maker.

But a limited one. While Skype is valuable to its users, they already paid their PC manufacturer and Internet provider for all of the resources that deliver that value. Skype recovers none of this in their business model. Zip. Zero. Nada.

The sizzle is that Skype is the world's largest voice carrier, largest international operator, largest video conferencer, etc. The steak, or more exactly the hamburger, is that Skype is a reseller of conventional telephone minutes. A solid and profitable reseller, but a modest one by telecommunications industry standards. The thing is that other companies get the revenue for most of Skype's sizzling services.

If you think of Skype as a phone company with 663 million customers, it should be enormously valuable. The entire US telecommunications industry, with less than half as many customers, has an aggregate market capitalization of $383 billion. If that were the case, Microsoft's $8.5 billion buy-out offer would be a steal.

But Skype is not a phone company. It's cash business is to resell conventional phone minutes. That cash business might, in a stretch, be worth one-third of Microsoft's offer. So what it is?

Perhaps the customer base? But a Skype account does Microsoft no good by itself. They will have to figure out how to invest even more money to follow up on that contact to sell them something else.

The going rate on Facebook is about $1 per click-through. A click-through means that the user already has interest in the offer and wants to learn more, a big step ahead of where Microsoft will be with Skype users when the deal closes.

Steve Ballmer is paying almost $13 per user. Make that $10 if you take out the value of Skype's minute-reselling business. So it's hard to see how Microsoft could possibly sell enough product to enough people to justify this heady price. Microsoft would have to sell an additional Xbox machine or Office license to each and every one of Skype's 663,000,000 users for the deal to make sense.

Ballmer does have an easier go than Meg Whitman. She spent almost $35 per user on Skype in 2005, and eBay never figured out how to leverage it. I don't see it.