Microsoft Works Out How to Play Skype

Wall Street is warming up to Microsoft Corp's $8.5 billion purchase of online chat service Skype.

After initial shock at the price -- more than double its expected public valuation -- investors think Microsoft made a smart move buying advanced communications technology it can put into its products along with a ready base of users.

But there are still concerns the world's biggest software company -- with a patchy record on pleasing consumers and making acquisitions work -- can really pull it off.

"It's got huge potential. It pulls them directly into the telecoms area and they need to diversify," said Nick Landell-Mills at Indigo Equity Research. "But they haven't really made a lot of acquisitions. And Microsoft has noticeably failed so far on consumer. They are essentially an enterprise organization."

Microsoft's headquarters in Redmond, Washington, and Skype's U.S. base in Silicon Valley are buzzing as the two companies start the process of working together.

Skype chief Tony Bates has been in Redmond with his team for much of the past two weeks, after the deal closed.

Microsoft has not said what it plans for Skype -- its biggest acquisition to date -- except to say it is "incredibly excited" about getting the service into its products.

Most expect Skype video chat and messaging will start to appear soon on Xbox game consoles, Windows phones and Windows Live messenger, and later as an expansion to its Lync messaging and video chat service for businesses.


Skype, which popularized the VoIP -- voice over Internet protocol -- method of using a computer as a phone, is the clear leader in the market, with 145 million users who sign in at least once a month.

Its online chat service is free, but it has 8.8 million customers paying for premium services such as placing calls to mobile phones or landlines from a PC and video-conferencing, which it is pitching strongly to businesses.

Microsoft is hoping Skype will enrich its own programs and platforms and become a vehicle for ads, without frightening off Skype's loyal customers.

The most likely first step will be to bring Skype to the nearly 35 million active members of Xbox Live, Microsoft's online gaming setup, allowing players to video-chat while they play games or watch movies.

"They are turning the Xbox form purely a gaming device to being a communications or entertainment console," said Mark Moerdler, senior research analyst at Sanford C. Bernstein. "You can sit at your Xbox and be able to talk to other people through the camera in Kinect."

Microsoft will then look to introduce Skype as an app on its Windows Phones and make it complementary to its PC software, analysts said, helping it battle rival services Google Talk and Apple Inc's FaceTime.

The strategy will be to draw more people into Skype, especially business users, pushing them towards paid services.

"It's a huge installed base and Microsoft can target them with services from Bing, ads and so on," said Jack Gold, head of J. Gold Associates, a telecoms research firm. "Skype can also plug into the Lync environment and give Microsoft scalability way beyond what they can do now, as many companies already use Skype."


Microsoft regularly buys small companies as a way of bringing new technology and talent into the company. But it rarely makes big purchases.

Aside from its failed 2008 bid for Internet giant Yahoo Inc , the company tends not to venture into multibillion dollar deals.

Of the big acquisitions it has done, the record is patchy at best. A decade ago it spent almost $2.5 billion buying business software firms Great Plains and Navision, which now form a central part of its offerings for corporations.

But its $6 billion deal to buy online ad firm aQuantive in 2007 -- its biggest deal before Skype -- was a flat out failure, with aQuantive's managers fleeing the new regime.

On the consumer side of the business, its record is also unconvincing. Microsoft made a great deal buying video game maker Bungie on the cheap in 2000 and used its wildly popular Halo combat game to establish the Xbox as a power in the console market. Despite that success, Bungie split from Microsoft in 2007.

Its purchase of innovative phone-maker Danger in 2008 ended disastrously in 2011 with the unpopular Kin phone, now axed.

A recurring theme is Microsoft's difficulty in getting people who work for young, fast-moving technology companies to adapt to being part of a 90,000-strong company whose revolutionary days are far behind it.

"Skype may suffer as an independent service and brand, under Microsoft's un-innovative culture," said Landell-Mills.


Perhaps for this reason, Microsoft intends to let Skype, with its 900 or so employees, operate as an independent unit.

Skype chief Bates will have an office at Microsoft's Redmond campus and report directly to CEO Steve Ballmer there. But he is likely to spend most of his time at Skype's main U.S. base in Palo Alto, California.

Although headquartered in Luxembourg, Skype's development hub -- employing more than a third of its 900 or so employees -- is in Tallinn, Estonia, where the technology behind the company originated. It also has a large sales and marketing office in the United Kingdom.

Although its employees will not be physically close, Skype will be part of Microsoft's entertainment and devices unit, which includes the Xbox and Windows phone teams.

Analysts expected Skype to add $250 million to $400 million to that unit's sales for the remainder of this fiscal year, pushing the total to about $10.6 billion, about half what is expected for the Windows and Office units.

The busiest part of the year is coming up for Skype, as users in the northern hemisphere tend to use the service more during the dark winter months, especially during the holiday season and Chinese New Year when they want to reach out to friends and relatives.

Despite its million of users, Skype had operating profit of only $20.6 million in 2010. Analysts expect that to cut Microsoft's rich overall profit margins.

Microsoft has made no forecasts of Skype's sales or profitability, but did say last week that it would add about $600 million to operating expenses this fiscal year.

"If you look at what they paid to acquire such a huge user base which they can leverage, it was a reasonable cost to Microsoft for what they got," said Gold. "What they now do with it and how they execute will, of course, be the key determining factor." (Editing by Andre Grenon)