Did Microsoft Overpay For Skype?

18 May

When the Valuation Doctor (literally!) says so, there is a very, very good chance the answer is “yes.”  If you don’t know who Aswath Damodaran is, you need to find out, NOW.  I would not bet against him with your account.

What is the value of Skype? The question is rendered more difficult to answer because Skype is a private business and we know little about the insides of the financial statements. It is widely reported, though, that Skype had operating losses of $7 million on revenues of $ 860 million in 2010. Taking those numbers as a base, I tried to value Skype, making what I thought were very optimistic assumptions:

– Continued revenue growth of 20% (which was what they had last year) for the next 5 years and a gradual tapering down of growth to 3% in ten years.
– A surge in pre-tax operating margins to 30% over the next ten years; this margin is at the very upper end of the technology spectrum (where companies like Google reside).
– A decline in the cost of capital from 12% now (reflecting the uncertainty associated with young, growth businesses) to a cost of capital of a mature company in ten years
With those assumptions, I estimated a value of $ 3.8 billion for Skype. It is entirely possible, however, that I am wrong on my key assumptions – revenue growth rates and target margins. In fact, changing those base inputs gives me the following table:

$3.8 billion.  Microsoft paid $8.5.  Or overpaid by 2.2x.

What we don’t know is whether any other buyers expressed interest in Skype, and if so, how much they were willing (and able) to pay, or if they even existed.  Remember, a little over a year and a half ago, Ebay sold Skype for $2.75 billion.  If we assume Microsoft paid a fair price for the acquisition, then we’re accepting that Skype has increased in value by over 200% in 18 months.  Seldom do firms grow so fast, in so little time.  If we use Damodaran’s valuation, the increase is about 38% or about 25% annualized, which sounds far more reasonable to me, even for a high-growth business.

Some have (attempted to) make the case that while the price Microsoft paid may be a little rich (to put it gently), once MSFT integrates Skype’s offerings with its existing products/services, the “synergies” and “strategic rationale” will be more than apparent.  Whether that happens is another conversation for another time, but given MSFT’s less-than-spotless history of squeezing value out of acquisitions, and to say I’m skeptical would be a bit of an understatement.  Remember Web-TV? What about Hotmail?  Anyway…

Damodaran, for his part, has this to say (generally speaking):

It has always been my contention with acquisitions that it is not the strategic fit or synergistic stories that make the difference between a good deal and a bad one, but whether you buy a company at the right price. Put in more direct terms, buying a company that is a poor strategic fit at a low price is vastly preferable to buying a company that fits like a glove at the wrong price.

Unfortunately – unless Skype’s private financials paint a different picture – it looks like MSFT may have screwed this acquisition up on both fronts…

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