Thoughts on eBay-Skype

Many investment analysts and technology industry observers are scratching their heads about eBay’s announcement last week that it would acquire Skype for $2.6 billion (and possibly as much as $4.1 billion if performance targets are met). Skype, for those who don’t know, is a software-based peer-to-peer VOIP company, started by the same team that created Kazaa, a leading P2P file-sharing application. Skype offers free phone calls between Skype users, and is particularly popular in Europe and Asia.

From the eBay side, spending that much on a startup with negligible revenues, in what seems to be a completely different industry, sounds like the height of dotcom bubble wishful thinking. At the same time, Skype supporters who reveled in the company’s rebellious image see enhancing online auctions as a huge comedown from their dreams of revolutionizing the global telecom business. What’s going on here?

It’s hard to look at the numbers and not think eBay overpaid. There is just no way to justify the price tag under traditional financial metrics. eBay’s management clearly wanted this deal badly, felt concerned that another well-heeled acquirer (Google? Yahoo? News Corp.?) would snatch it away, and had to make a spectacular offer to convince Skype to sell out.

On the other hand, Skype has grown in less then two years into far more than a group of Scandinavian and Estonian hackers thumbing their noses as the telecom industry. Skype came out of nowhere to become not just the leading VOIP company, but the dominant player in an exploding market. While Vonage just passed one million lines in service, and Japan’s YahooBB claims roughly four million VOIP customers, Skype has over fifty million registered users. At least two million of those pay Skype for services, such as the ability to dial in and out of the public switched telephone network.

One of the striking slides in eBay’s 78-slide PowerPoint presentation justifying the deal compared Skype’s revenue ramp ($7 million last year, $60 million this year, $200 million anticipated next year) with eBay and PayPal. And remember, there are still nearly twice as many phone users worldwide as Interne users — some two billion. By some measures, Skype may already be the world’s largest phone company, and in a few years it could have more users than any other company on the Net. Whether Skype is really on that kind of growth path remains to be seen, but the point is that this isn’t just a free piece of software with lots of users, like Kazaa or ICQ; it’s a serious business.

And on the other side of the deal, eBay is already a behemoth, with a market capitalization north of $50 billion, a stable cash-firehose business, and an outstanding balance sheet. It can afford to take some risks. As a Legg Mason report noted, investor concerns about the rumored Skype acquisition knocked more than the actual purchase price off of eBay’s market cap by the time the deal was announced. The implication is that the market values Skype’s potential contribution to eBay’s business as zero. That’s clearly an over-reaction. It’s based on a misunderstanding of the two businesses involved, and a lack of creative vision about the future of e-commerce and communications.

Don’t get hung up on the fact that eBay is an “auction company” and Skype is a “VOIP company.” Think about eBay as a radically efficient virtual platform for moving goods between people, and Skype as a radically efficient virtual platform for moving real-time communications between people.

I see two ways to justify the deal. eBay has tried to articulate the first one. Real-time communication has always been an important component of commerce, and eBay sees opportunities to enhance its particular form of electronic commerce with the voice, messaging, video, and presence capabilities Skype brings to the table. Add to that the low-hanging fruit opportunities for pay-per-call advertising, in which eBay would take a commission for generating leads that turn into Skype-powered phone calls, and the potential connections between Skype and eBay’s subsidiary PayPal, not to mention Skype’s potential for continued organic revenue growth through eBay’s user base, and you’ve got some solid opportunities for real synergies.

Frankly, in hindsight, there may not be a more logical acquirer for Skype. Any established telecom company would be cannibalizing its own business. Most of the other top Internet players, like Yahoo! and Microsoft, are better positioned to build VOIP platforms internally, leveraging their instant messaging clients and strategically acquiring technology that can enhance them. And then there’s the PayPal angle. eBay’s presentation justifying the deal was called “The Power of Three” — eBay, Skype, and PayPal. The company clearly sees PayPal not just as a template for the Skype deal (it faced similar questions when spending $2 billion for a peer-to-peer payments intermediary), but as the real linchpin for integrating Skype’s VOIP capabilities.

Traditional telecom companies face two huge economic anchors that prevent them from innovating and growing new revenue opportunities. (They also have to struggle with regulation and internal cultural limitations, but I’ll put those aside for the moment.) The biggest economic challenges for a telecom carrier are the costs of its physical infrastructure and its billing system. Skype solves the former, by virtualizing the network into peer-to-peer links between end-users riding on top of the broadband Internet. And PayPal solves the latter, by virtualizing the financial system into similar peer-to-peer links. If Skype wants to realize its potential for generating real revenue and profits, it’s going to need a cutting-edge billing infrastructure capable of scaling to hundreds of millions of users. It just got one.

It’s also possible to look at the acquisition in broader terms. And that’s when things get especially exciting, not just for Skype-eBay, but for entire world of e-commerce, communications, and digital media.

The “primary accumulation” phase of the Internet economy (to borrow a phrase from the ever-quotable Karl Marx) is now over. There are still plenty of opportunities for entrepreneurs and niche players, but the major powers are set: Amazon.com, eBay, Yahoo!, Google, and perhaps IAC/InterActiveCorp, if you consider the latter as one entity, plus a handful of non-pure plays such as Microsoft and AOL. Those companies dominate the application layer of the Internet: the services and tools delivered through the network. One one side of the application layer is content, a market far more fragmented and beset by conflicts about intellectual property and pricing. The companies listed above do some content development of their own, but what’s striking is that the vast majority of lucrative “content” they leverage is created by their own users.

On the other side of the application layer is the network infrastructure that moves bits from here to there. It’s the communications sector, along with some under-appreciated companies like Verisign that focus on addressing and identity. Telecom is a trillion-dollar global business… and it’s about to undergo a traumatic transformation.

Communications and the Internet are converging. As a result, the idea of paying per-minute for basic telephone calls is quickly becoming an anachronism. The telecom industry as we know it will be replaced by a converged broadband environment with very different economic drivers. The major communications infrastructure providers — telephone, cable, and wireless companies — think they will dominate this new world. By controlling the pipes, they hope to extract a share of profits from the applications running on those pipes.

eBay-Skype represents an end-run around that “walled garden” vision. Skype is a self-contained communications platform, effectively designed to circumvent both traditional government regulation and private efforts to constrain applications. Given its huge user base, it could become the dominant Internet communications ecosystem, just as eBay has become the dominant ecosystem for person-to-person transactions online.

eBay isn’t alone. There are persistent rumors that Google is putting the ducks in line to create its own global communications platform. Yahoo! has multimedia capabilities in its instant messaging client and it recently acquired DialPad, a significant consumer VOIP player. And Microsoft has understood for several years that communications will be an important part of its future, albeit not as a traditional telephone company.

No one knows how exactly this story will play out. What is clear is that every major player will want to have communications capabilities as part of its toolkit. Users will get converged communications services from multiple providers: it will sound as awkward to talk about “your phone company” as it would to identify “your e-commerce company” or “your search engine company.” Get ready for some creative disruption!