Microsoft's (MSFT) $8.5 billion acquisition of Skype makes strategic sense, but the price is steep. The deal appears expensive on every valuation metric: $8.5 billion represents over 30 times Skype's adjusted 2010 EBITDA and more than 3 times the reported $2.75 billion valuation when former owner eBay (EBAY) sold 56% of Skype to investors in late 2009. Microsoft will need flawless strategic and tactical execution over the coming months and years to keep its shareholders from losing money on this transaction.
Microsoft hopes to leverage Skype's peer-to-peer communication technology prowess to enhance the value proposition of its business and consumer collaboration products and services. Some compelling services that could emerge include video conferencing via Kinect, video chat on Windows Phone devices, PCs, or tablets (similar to Apple's (AAPL) FaceTime service) and usage of Microsoft's Lync and Skype to communicate with users external to enterprise customers' organisations.
Skype also has a large base of about 170 million connected users, but average monthly paying users numbered only 8.8 million as of December 2010. The relatively few paying users makes it unlikely that Microsoft sees substantial value in Skype's existing customer base, although the firm could use its advertising services to monetise Skype's nonpaying users.
We don't believe the acquisition will significantly alter Microsoft's credit quality and, as such, we don't plan to change our AAA rating. The high price tag on the deal is more of a concern to equity investors. Microsoft has generated more than $19 billion in free cash flow during the first three quarters of fiscal 2011. Even after returning $14 billion to shareholders via dividends and buybacks, net cash has increased to $38 billion from $31 billion at the end of fiscal 2010, with gross cash sitting at $50 billion. Further, the company is paying for Skype with overseas cash, which avoids a repatriation tax hit.
The reduction in cash on the books has little impact on our credit rating model. Prior to the deal, we had expected Microsoft to generate enough cash to meet its obligations roughly 17 times over during the next five years. Removing the $8.5 billion it will pay for Skype, without any incremental cash flow the firm will provide, takes that ratio down only modestly to about 16 times.
We don't plan to change our Business Risk assessment of Microsoft as a result of the Skype acquisition. That said, we would get concerned if Microsoft's management made a habit of overpaying for acquisitions on a regular basis.
