eBay (Nasdaq: EBAY ) took a big swing at a home run when it purchased Skype a few weeks back. And based on what I've read, the general consensus seems to be that eBay paid too much. I haven't, however, read much analysis to show why, other than quoting Skype's tiny current revenues of $60 million.
So, then, let's cut right to the question at hand: Considering that the price could be as much as $4.1 billion, did eBay pay too much for Skype?
"Network effects" may sound more like the stuff of Rule Breakers, but value investing is just as applicable. A "network effect" occurs when the value of a network increases when additional nodes are added to the network. You're no doubt familiar with the telephone system network, which has little value in and of itself. But when people with telephones can use the network to talk to anyone else, it creates a great deal of value.
eBay's marketplace is a combinatorial network -- that is, one user can access many other users at one time. If I want a special set of golf clubs and thousands of people sell golf clubs on eBay, then eBay's network is valuable to me because someone in the group is likely to have what I'm looking to buy. This type of network is very strong and can attract tons of people.
Skype, like the traditional telephone network, is a radial network in which users interact on a one-to-one basis (like a phone call). It's still valuable, but the interaction value is not as large.
Is Skypeworth $10 billion?
Let me get this out of the way: I cannot, with any confidence, evaluate this on a going-forward basis. I have no idea which value-capture ideas from eBay and Skype will work and which ones will not. So let's follow the advice of Charlie Munger, vice chairman of Berkshire Hathaway, and work backwards to try to make sense of this.
I want to know what it would take for Skype to be worth $10 billion. Because eBay carries no debt, I will assume that Skype will not carry any debt. If Skype is successful, let's assume a TEV/EBIT (total enterprise value to earnings before interest and taxes) of 25 -- less than eBay's current multiple, which is near 40. Hey, Skype ain't eBay, so it doesn't deserve the same multiple.
Under these assumptions, Skype would have to generate $400 million of EBIT to earn that multiple. In the corporate pitch about the acquisition, CEO Meg Whitman says operating margins should come in at around 25%. Therefore, $1.6 billion in sales would generate $400 million in EBIT.
Now we need to translate this into per-user metrics to see whether they pass the sanity test. Skype's software has been downloaded more than 170 million times to date, and 54 million members generate approximately $60 million in revenue for the company. In sales terms, that's about $1 per user.
eBay currently has 157 million users and 79 million PayPal users. So let's create a minimum and a maximum case and see what they tell us. For the maximum case, let's assume that 75% of PayPal users will use Skype and that the 53 million current Skype users will roughly double to 100 million. That adds up to about 160 million users. And let's say it takes five years to reach that number.
For the minimum case, we'll scale back those numbers. Let's say that only 30% of the people who use PayPal will use Skype and that the number of new users outside of eBay increases by only 10%. That gives roughly 80 million users. The table shows our results:
To me, it doesn't seem too far-fetched that Skype could have between 80 and 160 million users in five years, each spending roughly $10 to $20 per year. People pay a heck of a lot more than that for toll-free numbers, local and long distance calling capability, and cellular connectivity. And if it takes five years for Skype to generate these kinds of numbers to be worth $10 billion, then the return on investment is 19.5% per year.
But the world of VoIP (voice over Internet protocol) is extremely competitive right now, and there are no guarantees as to how this will play out in the future. That said, I don't think my results are outrageous. Let's look to history to see how things have played out before in the land of network effects.
Meg takes Janus and Niklas bowling
In his Technology Adoption Lifecycle, Geoffrey Moore outlines an interesting framework for how these situations might play out. One of the most important steps Moore identifies is when the company "Crosses the Chasm" and heads for the "Bowling Alley." This occurs when a technology has enough strength to start becoming an actual business entity. Success is not guaranteed just because one rolls a few frames, but it is a good start.
And this is what I think eBay did for Skype. It made eBay a viable entity, one that is able to "go bowling." In Moore's model, the bowling alley is a metaphor for an actual "going concern" that could last for years. And during this time, the company sees the potential markets and the products or services that can be sold into those markets. In addition, there is investment in infrastructure to start knocking down pins, otherwise known as attracting more and more of the late adopters.
Without eBay, it would have been much more difficult for Skype to go bowling. Powerful competitors are battling it out right now. You may have even heard of a few of them: Google (Nasdaq: GOOG ) , Microsoft (Nasdaq: MSFT ) , AOL, Vonage, and Comcast (Nasdaq: CMCSA ) are just a few. In fact, Skype's current advantage is not durable yet. Any one of these companies could come across and get in the "tornado" before Skype.
The key is the tornado
The network effect really takes off in what Moore calls the "tornado." This is where customers get locked in because of how the network is used, not just because of how big it is. In the tornado, the network is sucking in all of the late adapters who waited for the standard to be selected. If Skype can become the standard on eBay and get its tornado going before any of its competitors, the advantage is likely to tip in eBay's and Skype's favor. Remember that Microsoft Windows became the standard when everyone started using Microsoft Office, even though there were better operating systems and word processors available. The tornado is the prize that eBay CEO Meg Whitman and Skype founders Janus Friis and Niklas Zennstrom recognized during their meeting in China.
The Foolish bottom line
So let's revisit the looming question: Did eBay overpay for Skype? It doesn't seem like it, but it's too early to tell, and the stakes are too high for any competitor to quit. Competition could cut into the number of users and the sales/user figures. And why would people who use the system for free suddenly want to start paying for it?
I'm not sure what the outcome will be, but I think eBay put Skype in the lead. And if the price tag scares you, let's remember that eBay is not betting the farm on this transaction. It's a big swing, but eBay will not die if this fails.
Competitive advantage is based on positions and capabilities. Right now, eBay has a superior position -- it's using two networks to start a third network with demand-side increasing returns. To top it off, eBay has the capability to extract value from network effects. So right now, Skype looks like a reasonable purchase. But the fat lady is not warming her voice up just yet.
Value can come from anywhere. You just have to recognize it and understand how to evaluate it. Philip Durell's value radar is always active. To see where he sees great bargains today, try hisMotley Fool Inside Valuenewsletter free for 30 days.