The Turbulent Times

Ebay’s purchase of Skype for $2.6Bn in cash and shares, with an extra $1.5Bn revenue earn-out based on achieving goals up to 2008, looks very expensive – some would say insane. The question everyone is asking is – what can Ebay have seen that makes it worth that much money? This blog (my first!) takes a stab at answering that question.

With total transactions exceeding $10Bn per quarter in the second quarter of 2005 on which Ebay made net revenues of over $1bn, the Ebay economy is the size of a medium-sized first-world nation. Ebay is one of the few internet companies that has comfortably exceeded its growth estimates over five years, as in 2000 the Ebay management team forecast annual net revenues of £3Bn by 2005, a growth rate in excess of 50% per annum. Maintaining that growth rate is going to become much harder.

Ebay has a transaction-based business model, taking around 5% of the proceeds of each auction. All of Ebay’s transactions are electronic – they have no role in the physical transfer of items won. All of Ebay’s acquisitions to date have been about extending the range and scope of transactions they offer or reducing barriers to participation. Skype, at first glance, appears to be the first major deviation from this strategy. However, the primary reason for the purchase is to access yet more new transactions, as Ebay’s investor presentation to announce the Skype purchase made clear.

Skype is disruptive

Skype’s free software completely eliminates the need for a central telephony infrastructure. According to Gartner analyst Ron Cowles, "[Skype] is a disruptive technology because it's not geographic in nature. It does have the ability to change both the consumer and corporate markets, especially as the company adds more features." Skype is currently growing much faster than Ebay was at the same point in its short life.

Skype has several advantages:
• A large and rapidly-growing user community
• A built-in contact system, directory search and text messaging
• It inherits little of the inflexible structure and complexity of the telephone infrastructure, allowing it to add new features very quickly.
• It’s voice quality, although variable, can be better than toll quality
• It has no need for interconnect agreements with other telco’s, except to deliver Skype-In and Skype-Out.
• The Skype API

To be truly disruptive Skype must overcome its disadvantages. These include:
• having to use a computer and headset to make a call
• lack of mobility
• lack of additional services
• variable call quality

All the signs are that this is happening, as Skype-capable handsets and other developments related to convenience and mobility are now available. Bluetooth and 802.11 home networks allow Skype calls to be made from anywhere in the home, and dual-use phones will hide the details of switching between Skype and normal telephony. Mobile handset manufacturers like Motorola are embedding Skype clients in handsets. Skype has signed a deal with its first 3G mobile operator, Germany’s E-Plus, which will offer its customers free use of Skype's service as part of its flat-rate data subscription package for 3G data card users. More and more businesses are claiming to be enthusiastic Skype users, even if not for customer calls.

Skype’s open API now allows the software to be embedded in other applications. Already website integration services like Jyve and Qzoxy have arrived, and more are following.

Some of Skype’s needs are outside its direct control – call quality for instance. Fortunately for Skype, improvements in internet services are following their own upward trajectories based on other drivers. BT’s 21CN integrated IP network is an example of this, and will eventually enable Skype to offer better than toll-quality voice at all times. The only potential issue here is the number of Skype supernodes required to support the growing call volumes, which could be an opportunity for the telco’s to earn revenues from Ebay – once they get over the shock of losing their call traffic revenues.

Skype’s current customer base, growth rate and positive network externalities means that any direct competitor starting now, even an open-source development, has almost no chance of building their own viable community. It is not in Skype’s interests to open its own network to interconnection with other, similar services – that would destroy its positive network externality.

What is the valuation based on?

The price Ebay paid for Skype will have been calculated based on a number of elements, which will include a multiple of the revenues, ($60M in 2005), an element for ‘visible’ revenue growth ($200M in 2006, 150,000 new users per day), an element for the value of its community (44M subscribers), an amount for cross-marketing synergies (only 1% overlap, according to Ebay) and Skype’s brand. The bulk of the money paid, however, is for growth opportunities not yet revealed - those due to Skype that Ebay will continue with, and those due to new services exploiting Ebay and Skype synergies.

In terms of cost of customer acquisition, Ebay has acquired Skype’s 44 million active customers (Q2 2005) for $60 per customer. Vonage’s cost of customer acquisition is around $200, whereas Skype’s before (and after) the acquisition is essentially zero.

Skype could theoretically pose a threat to Ebay’s model, in that once bidders are identified vendors could withdraw the item from the auction and complete the transaction via a free phone call to the bidders. However this is unlikely as the auction format ensures that continuing with the auction achieves the highest price for the vendor.

What Ebay didn’t buy Skype for

Ebay didn’t buy Skype for its current or future voice revenues. They just don’t make a dent in Ebay’s growth requirements.
Ebay didn’t buy Skype for its software. It could re-create that itself. However, it will have thought hard about the value of Skype’s API.
For exactly the same reason, Ebay didn’t buy Skype to provide a free telephony system for buyers and sellers. However, it’s a nice add-on capability.
Ebay isn’t going to build call centres. That is a low-growth market, easily defended because of Skype’s open API.
Cross-marketing synergies are more likely to benefit Skype than Ebay – it is difficult to imagine a reason that a Skype user may suddenly decide to take part in an auction just because Ebay owns Skype. It may encourage people to take a look, however.

Ebay will not:
• Charge for user-to-user Skype calls. Charging would slash the community to a fraction of its current size.
• Move further into the telecommunications market. Ebay does not build or buy businesses with significant infrastructure.
• Offer 911 service. That would require significant investment in infrastructure while adding no revenues.

What Ebay really bought Skype for

Primarily, transactions that Ebay doesn’t currently have access to. Skype’s latest software, released after the sale was announced, offers the first clue to the new direction. It can download ringtones and pictures, hoping to tap into the $3Bn worldwide ringtone market. This is a new transaction marketplace for services that don’t play well in an auction, which could include games, music and video-clips, initially to the PC, mediated by Paypal rather than SMS charges.
The first potential synergistic service is mentioned in Ebay’s presentation to investors of the 5th of September. This is call charges for lead generation. Ebay already knows exactly what each bidder is looking for, from the items they bid for. A bidder that has just lost an auction is probably an exceedingly tempting target and fertile ground for a sale. This creates an opportunity to sell those leads at a premium for both on-site advertising and telephone marketing. Also on the cards is a move into more complex transactions, perhaps using Skype’s conferencing capabilities to carry out auctioneer-led auctions on very high value products like houses or artworks.

Skype’s best interests are served by growing its customer base as fast and as far as possible, taking as much revenue as possible from Skype-Out and Skype-In services with local operators while NOT investing heavily in infrastructure.
I expect considerable effort to go into two key markets for Skype, business telephony and mobility. These would allow Ebay to extend its reach into B2B transactions and tap into the huge potential in mobile transactions, including things.
Skype’s open API will allow the integration of Skype into lots of new services. Expect to see Skype becoming part of directory enquiry services, presence services, business systems and much more. The API has already excited a lot of developer interest, with 400 products from approximately 260 developers recently competing for a prize to select the best add-on product. The prize of €2,000 went to Jyve for a plug-in that allows call forwarding and auto-response features. Ebay may be tempted to extend the API to include features from both Ebay auctions and Paypal, leading to further opportunities.

Impact on the telecommunications industry – the death of long distance.

Although disastrous for long-distance operators, who are already seeing VoIP services eating into long-distance revenues, this could be good for local operators. I wouldn’t be surprised to see local operators making their user directories available on Skype.

As voice revenues were declining anyway the operators have been looking to provide other services using their engineering skills and infrastructures. Some operators have been spending billions on creating IP-based networks capable of delivering advanced services via open API’s. Many services can only be delivered over the right infrastructure, and Skype could be an easy interface to promote, deliver and monetise those services.

Conclusion

It is early days yet, and execution is everything. However, adding it all together it seems there are plenty of growth opportunities created by the Skype acquisition to help Ebay’s continued growth. I believe there is sufficient potential value there to justify the purchase price.