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Skype Gets 40% Markup as Microsoft Surprised Owners: Real M&A

Microsoft Corp. (MSFT) is paying a dot-com era price for Skype Technologies SA, almost 40 percent more than the world’s most popular Internet calling service itself says the business is worth.

Microsoft, the world’s largest software company, agreed to pay $8.5 billion for Luxembourg-based Skype, which lost money in four of the past five years even as it quadrupled sales. The takeover, the largest for an Internet company since May 2000, is 32 times Skype’s adjusted earnings before interest, taxes, depreciation and amortization, according to data compiled by Bloomberg. That’s 39 percent more than the multiple Skype used to value its own equity in an April regulatory filing.

Microsoft Chief Executive Officer Steve Ballmer is betting the biggest acquisition since the company was founded in 1975 will help reverse past failures and enrich owners who lost out as shares of Google Inc. (GOOG) and Apple Inc. (AAPL) quadrupled Microsoft’s gain in the past five years. By buying Skype, Microsoft may lure more users to its mobile-phone platform and narrow Google’s lead in Internet advertising after reporting its worst two-year stretch of sales growth. Shareholder Hank Smith of Haverford Trust Co. says the investment isn’t worth the price.

“I just thought, ‘You’ve got to be kidding me,’” said Smith, chief investment officer at Haverford Trust, which oversees $6.5 billion in Radnor, Pennsylvania, and owns about 1.96 million Microsoft shares. “They don’t have a great track record of ‘investments.’ It almost brings you back to those crazy valuation metrics in the late ‘90s.”

‘Frittered Away’

You can make a case that Microsoft has “frittered away capital,” said Smith, who wants Microsoft to use its $50.2 billion cash pile on dividends and buybacks. “It’s definitely because of the competition with Apple and with Google.”

“It’s not low for sure,” Ballmer, 55, said of Skype’s acquisition price in a telephone interview yesterday. “It requires we do good work both within the Skype division and in creating value elsewhere in the company.”

Ballmer added that Microsoft didn’t overpay and the transaction values Skype at “not a lot higher” than some publicly traded companies. He expects the deal will add to Microsoft’s profit in the year after it closes.

Jennifer Caukin, a spokeswoman at Skype, didn’t respond to an e-mail requesting comment.

Microsoft’s reserves give it the ability to pay for what it needs and Skype offers a way for Microsoft to diversify its products to compete with Apple and Google, according to Matt McCormick, a money manager at Cincinnati-based Bahl & Gaynor Inc., which oversees $3.6 billion including Microsoft shares.

‘Another Hamburger’

“$8.5 billion in cash for a Microsoft is like you and I paying five bucks for another hamburger,” McCormick said. “Microsoft right now is trying to do things to keep up with other faster growing technology companies. This is the way to do it. I will give them the benefit of doubt.”

Microsoft, based in Redmond, Washington, is buying Skype from investors including private-equity firm Silver Lake and the Canada Pension Plan Investment Board, which took a controlling stake in November 2009 that valued the company at $2.75 billion.

Microsoft’s offer is more than twice that amount and includes the assumption of Skype’s debt. Skype had about $725 million in borrowings and a revolving credit line of $30 million, a Securities and Exchange Commission filing in April showed. Skype had planned to raise money in a U.S. initial public offering this year, according to the prospectus.

Fair Value

The acquisition values Skype at about 32 times its $264 million in adjusted Ebitda in 2010, a 39 percent markup to the company’s own assumptions. At the start of the year, Skype used a trailing 12-month Ebitda multiple of 23.2 times to determine the “fair value” of its common stock, its filing showed.

While Skype had a total of 663 million users, it has only converted 8.8 million users of its free PC-to-PC phone services into paying customers, according to the filing.

Skype reported a net loss of $6.9 million last year, its fourth money-losing year since 2006, its filing showed.

“Well it’s certainly an amazing amount of money for a strategy that looks like a long shot,” said Eric Johnson, a professor at the Tuck School of Business at Dartmouth College in Hanover, New Hampshire. “Microsoft is desperate to become relevant. They’re so far behind that they need something significant to jumpstart themselves.”

“Skype’s a cool company, but putting this together into something that’s actually going to be generating significant revenue is going to take work on their part,” he said.

Takeover Price

Skype’s owners refused to entertain offers of less than $7 billion, the value they expected to get from the planned IPO, according to people with knowledge of the discussions, who asked not to be identified because the talks were private.

Microsoft paid a premium in part because it expected Skype to increase in value after going public, meaning a deal would cost more down the road, two of the people said.

Ballmer offered more than $7 billion to cover Skype’s debt and keep a competitor from gaining a business that would add calling features to games, e-mail and software on computers and mobile phones. While Google expressed interest, neither it nor other bidders made formal offers, the people said.

The size of the deal surpasses Microsoft’s $5.5 billion takeover of AQuantive Inc. including net cash in May 2007 as the company’s largest. In May 2008, Microsoft abandoned an effort to buy Sunnyvale, California-based Yahoo! Inc. for $47.5 billion.

Internet Acquisitions

Skype would also be the biggest Internet takeover since the height of the dot-com bubble 11 years ago, when Spain’s Terra Networks SA agreed to buy Internet search service Lycos Inc. for $13.8 billion in May 2000, data compiled by Bloomberg show.

The all-cash agreement for Skype, which Ballmer sealed after his initial overture to New York-based Silver Lake just over a month ago, comes after Microsoft was unseated by Apple as the world’s most valuable technology company.

In the past five years through yesterday, shares of Microsoft have gained 8 percent, versus a 395 percent surge for Apple of Cupertino, California. Google, based in Mountain View, California, has advanced 35 percent. Today, Microsoft fell 1.2 percent to $25.36. Apple slipped 0.6 percent, while Google dropped 1.3 percent.

Revenue growth at Microsoft, which dominates the personal computer operating system and office applications software markets, has also lagged behind its competitors. Sales increased 6.9 percent last year after dropping 3.3 percent in 2009, the worst two-year span since at least 1987, data compiled by Bloomberg show. Apple’s sales jumped 52 percent in its last fiscal year, while Google reported a 24 percent increase.

Deal Rationale

“It’s clearly the laggard,” said Philip Orlando, the New York-based chief equity market strategist at Federated Investors Inc., which oversees $358.2 billion. “One of the reasons that the stock has lagged in this rally that we’ve seen over the last couple of years is the fact that you don’t have the underlying organic growth.”

Microsoft is buying Skype, which has 170 million active users, to connect the service to its Outlook e-mail, Xbox game console, Windows mobile phone and corporate-phone software.

Ballmer is aiming to revive Microsoft’s Internet advertising revenue. The company’s online services division had an operating loss of almost $2.6 billion in the 12 months ended March. Losses at the unit have widened in each of its past four fiscal years, data compiled by Bloomberg show.

Microsoft plans to add Skype to its Windows-based mobile phones to lure more customers after losing ground to Apple’s iPhone and Google’s Android devices.

Product Appeal

Skype can help boost the popularity of Windows-powered devices such as tablet computers, according to Colin Gillis, an analyst with BGC Partners LP in New York.

Apple has increased its share of the global phone market and is the biggest seller of tablets. Last quarter, Apple’s net income surpassed Microsoft’s for the first time in 20 years.

“Apple, for the last five or 10 years, has had the sexiest new product development story in technology,” said Federated’s Orlando. “You look at Google, which has some cache in the Internet space. Then, you look at someone like Microsoft. They are post the rapid growth phase of their development.”

The company also trails Google in Web search and related advertising, while Skype, which has a lead on late-entrant Google Voice, announced in March that it would start showcasing advertising on its website.

Google had 66 percent of the U.S. online-search market in March, according to Reston, Virginia-based researcher ComScore Inc. Microsoft’s Bing search engine had about 14 percent.

Squandered Opportunities

Not all of Microsoft’s acquisitions have propelled growth as much as it forecast. In 2001 and 2002, Microsoft spent more than $2 billion to acquire small-business software makers Great Plains Software Inc. and Navision A/S, predicting the businesses would generate $10 billion a year in revenue by 2010.

At the end of last year, the efforts were bringing more than $1 billion in sales a year, still short of Microsoft’s initial estimates.

The Skype deal is “just a continuation of basically squandering a lot of opportunities with the cash and not doing very good things with it,” said Donald Yacktman, president of Yacktman Asset Management Co., which manages about $10 billion in Austin, Texas, and owns more than 21 million Microsoft shares. “I can’t believe he can continue to strike out every time he goes to the plate,” he said, referring to Ballmer.

Instead, Microsoft should focus on returning more money to its shareholders, according to Yacktman.

“‘Expensive’ is putting it mildly,” Yacktman said of Skype. “This is a very poor use of cash. The kingdom’s bigger, but the residents are poorer. It just kind of boggles my mind.”

To contact the reporters on this story: Tara Lachapelle in New York at tlachapelle@bloomberg.net; Dina Bass in Seattle at dbass2@bloomberg.net.

To contact the editors responsible for this story: Daniel Hauck at dhauck1@bloomberg.net; Katherine Snyder at ksnyder@bloomberg.net; Tom Giles at tgiles5@bloomberg.net.

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