What's Behind Microsoft's $8.5 Billion Acquisition of Skype?

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Outline

General Information

Motivations towards the acquisition

Pros and Cons

Values behind the deal

Valuation

Internal and external impact

Benefits for Microsoft2

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Microsoft

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The company was founded by Bill Gates and Paul Allen on April 4,

1975.

The world's largest software maker measured by revenues. It is also one

of the world's most valuable companies.

As for 2010, Microsoft record revenue of $62.48 billion, up 7%

from last year.

Operating income in 2010 was $24.1 billion, up 18% from fiscal 2009 and net income was $18.76 billion, while earnings per share were $2.10, up

30% from 2009, according to a company statement.

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Skype

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Skype was founded in 2003 by two software writers, Niklas Zennström and

Janus Friiswhose.

On 12 September 2005, eBay Inc. agreed to acquire Luxembourg-based

Skype Technologies SA for approximately US$2.5 billion in up-front

cash and eBay stock, plus potential performance-based consideration.

Skype had revenue of $860 million in 2010, which was up 20%, but a net loss

of $7 million.

It had 663 million registered users as of the end of 2010.

On 1 September 2009, it was announced that eBay was selling 70%

of Skype for US$1.9 billion to investment group led by Silver Lake,

valuing Skype at US$2.75 billion.

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Motivations

• In 2010 Skype had filed for an IPO and was going to do about a billion dollars in revenues. So why sell?

• The company had bet heavily on is video sharing service and they failed.

• They were aware of the fact, that they cannot fully use the Skype’s potential, as the Microsoft can.

• The high price offered by Microsoft.

• A boost in the enterprise collaboration market, thanks to Skype’s voice, video and sharing capabilities.

• A working relationship with carriers.

• A lot of potential. Combining Skype's software with the Xbox Kinect and an HD television set.

• The biggest reason to buy Skype is Windows Phone 7 (Mobile OS) and Nokia. They need a competitive offering to Google Voice and Apple’s Facetime.

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Pros and Cons behind the acquisition

PROS

• Boosting Microsoft’s products

• Keeping away competitors

• Skype brand name • Brand-buzz

CONS

• Valuation• Marginal possible

earnings• Similar functionalities

already reached

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$2.5Billion

$2.75Billion

$8.5Billion

SEPTEMBER 2005 SEPTEMBER 2009 SEPTEMBER 2011

--- +10% +309%7

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Microsoft’s valuation of Skype

$14.2032x

Operating Profits User 8

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Skype ValuationRevenue and EBIT

  `06 `07 `08 `09 `10Net Revenues 193.696 381.551 551.364 718.903 859.815 Revenue Growth Rate

  97% 45% 30% 20%

EBIT -143.119 -1.433.981 22.862 -364.619 20.649 EBIT margin -74% -376% 4% -51% 2%

  Y1 Y2 Y3 Y4 Y5 Net Revenues 1.031.778 1.238.134 1.485.760 1.782.912 2.139.495 Revenue Growth Rate

20% 20% 20% 20% 20%

EBIT 53.254 98.076 158.695 239.640 346.615 EBIT margin 5% 8% 11% 13% 16%

  Y6 Y7 Y8 Y9 Y10 Terminal ValueNet Revenues 2.507.488 2.868.566 3.201.320 3.483.036 3.692.018 3.913.539 Revenue Growth Rate

17% 14% 12% 9% 6% 6%

EBIT 475.435 623.066 783.693 948.784 1.107.605 1.174.062 EBIT margin 19% 22% 24% 27% 30% 30%Assumptions:

Net Revenue Growth Y1-Y5: 20%, then linear decline to 6% (Industry Average)EBIT Margin: linear incline to Target Margin 30%

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*Monetary Values in Thousand USD

FCFF

Assumptions: Reinvestment Rate 47% (Average Sales to Capital Ratio in Software Industry: 2.14)

  `06 `07 `08 `09 `10

EBIT (1-t) 18.061 -288.049 16.313

Depreciation, Amortization   75.534 79.049 161.297

ΔNet Working Capital 43.632

ΔNet Working Capital (approx.) -26.442 116.140 -199.712  

Capital Spending 1.952 -3.035 7.198 23.285

FCFF     -19.510 -16.486 110.693

  Y1 Y2 Y3 Y4 Y5

EBIT (1-t) 42.071 77.480 125.369 189.316 273.826

Reinvestment 80.823 96.987 116.385 139.661 167.594

FCFF -38.752 -19.507 8.985 49.654 106.232

  Y6 Y7 Y8 Y9 Y10 Terminal Value

EBIT (1-t) 375.594 492.222 619.118 749.540 875.008 927.509

Reinvestment 172.957 169.707 156.394 132.407 98.222 104.115

FCFF 202.637 322.515 462.723 617.133 776.787 823.394

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*Monetary Values in Thousand USD

CAPM / Cost of Equity

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CAPM = ke = Rf + β(Rm – Rf) + FSP= 0,0319 + 1,1 x 0,1 + 0,006

>> Cost of Equity = 14,79 %

10yr treasury bond rate as of 05/11/11

ß Computer Software:

0.98ß Telecom.

Services: 1.15

Assumed Risk Premium:

10%

Firm Size Premium for Market Value $2.6 – 5.25 bn

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*Monetary Values in Thousand USD

WACC

WACC = ke x + i(1-t) x E DE+D E+D

Cost of Equity:14,79%

Equity:2.246.690

Debt: 686.348

Assumed Interest Rate:

4%

Marginal Corporate Tax Rate Luxembourg:

21%

>> WACC = 12,07 % 12

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SKYPE Valuation (PV)  Y1 Y2 Y3 Y4 Y5

WACC 12% 12% 12% 12% 12%

  Y6 Y7 Y8 Y9 Y10 Terminal

Value

WACC 11% 10% 9% 8% 7% 7%

Assumption: WACC: Y1-Y5: 12%, then linear decline to 7,2% (WACC Software Industry 7,15%, Telecom. Services 7,05%, Entertainment 9,09%)

• Terminal Cash Flow 823.384• Terminal WACC 0,072• Terminal Value 20.533.514

• PV (Terminal Value) 7.575.712• PV (FCFF over 10yrs) 1.029.046

$8.604.75813

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*Monetary Values in Thousand USD

Internal Impact• Microsoft Live Messenger phased out

• Microsoft Lync to be synchronized with Skype

• Additional funding for Skype• More aggressive development of software• Upgrade of infrastructure • Introduction of new version of Skype to Linux

• Skype pre-installed on Microsoft Windows 8

• Introduction of Ads to Skype 14

Live Messenger phased out

Skype and Lync integration will begin in

June 2013

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External Impact• Increasing competition for classic Telecoms

• Prevention of Skype acquisition by other entities (mainly Google)

• Skype has become an advertising platformthanks to „Conversation Ads”

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An example of a „Conversation Ad”

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Benefits for Microsoft• Acquisition of a strong brand

• Access to large large base of Skype users (600+ M) with over 55 millions Concurrent Users Online

• Possibility to enhance other products (Windows Phone, Outlook, Lync, Xbox)

• Extension of Microsoft’s reach across other platforms (i.e. TV sets)

• Possibility to make money 16

Skype’s Concurrent Users Online 2003-2013

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References• http://www.forbes.com/sites/tomiogeron/2011/05/10/microsofts-acquisition-of-skype-internet-and-mobile-plays/  • http://about.skype.com/press/2011/05/microsoft_to_acquire_skype.html • http://www.microsoft.com/en-us/news/press/2011/may11/05-10CorpNewsPR.aspx• http://phys.org/news/2011-10-eu-microsoft-skype-takeover.html• http://www.bbc.co.uk/news/business-13343600• http://www.microsoft.com/investor/reports/ar10/10k_fr_dis.html• http://www.techwell.com/2013/01/microsoft-goes-all-skype• http://www.guardian.co.uk/technology/2011/may/16/ballmer-microsoft-skype• http://aswathdamodaran.blogspot.com/2011/05/is-skype-worth-85-billion-exercise-in.html• http://www.businessinsider.com/numbers-microsoft-skype-deal-2011-5• http://www.forbes.com/sites/chuckjones/2013/02/06/sp-500-revenue-and-eps-estimates-ratchet-down-after-janu

ary-results/• http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wacc.html.htm• http://techcrunch.com/2011/03/07/skype-revenue-up-20-percent-to-860m-in-2010-paid-users-up-19-percent/• http://techcrunch.com/2011/05/09/microsoft-skype/• UNITED STATES SECURITIES AND EXCHANGE COMMISSION. AMENDMENT NO. 2 TO FORM S-1

REGISTRATION STATEMENT. Skype S.à r.l. As filed with the Securities and Exchange Commission on March 4, 2011.

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Thank you for attention!

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