EBay's Skype Bubble Bursts

The shakeup and $1.43 billion charge confirm eBay's irrational exuberance as well as Skype's struggling Web-calling business model.

By Olga Kharif (October 1, 2007)

When eBay (EBAY) bought Skype Technologies for $2.6 billion in late 2005, few could fathom why the online auction company saw so much in a money-losing Internet phone service. Two years later, eBay is admitting it made a mistake.

On Oct. 1, eBay confirmed that it overpaid for Skype—by nearly $1 billion—and that the popular Web-calling business has not performed up to the rosy forecasts set back in 2005. In announcing a $1.43 billion charge against profits, eBay also revealed a broad management reshuffle in which Skype co-founders Niklas Zennström and Janus Friis will be leaving their posts.

About a half-billion dollars of the charge is for a payment to Zennström, Friis, and other early Skype investors. Although it might sound like a plump farewell present, that payout is well short of the $1.7 billion those shareholders stood to receive from eBay if Skype had met the targets for users, revenue, and profits set in the 2005 buyout agreement.

Management Shuffle

While Zennström is leaving the CEO post immediately, he'll become nonexecutive chairman of Skype's board of directors. Friis, who has been working on new initiatives at Skype part-time for the past year, will no longer have a role in the company. The executive shuffle doesn't end there: Geoffrey Prentice, who developed Skype's original business plan and found the seed financing that got it off the ground, will leave his post as overseer of strategic partnerships, corporate development, and business operations. And Skype's president of only 10 months, Henry Gomez, will return to eBay as senior vice-president for corporate affairs.

EBay stresses that Zennström's departure was his decision. "This was his choice. He could have stayed and run the company," says eBay spokesperson Hani Durzy. No doubt Zennström's newest venture, a Web TV service called Joost that is set to launch within the next week, will keep him busy. But given the magnitude of the other decisions that accompanied his departure, it appears eBay is less than satisfied with Skype's direction.

Considering Skype's rapid growth since the acquisition, it can't be an encouraging sign that its founders and early investors are cashing out well before the clock has run out on the original performance goals. When eBay bought Skype, it agreed to pay Skype shareholders as much as $1.7 billion extra if Skype met certain user growth and financial targets in 2008 and 2009. In accepting $530 million, those investors agreed to forgo any future payments, suggesting that none were likely. eBay plans to record that payment, plus $900 million more, as an impairment charge recorded in the third quarter.

Diluted Market

A major strategic change may be needed to turn the company—now profitable but generating less than $100 million in sales a quarter—into the moneymaking machine eBay envisioned. The way the business is run today, "they are not making their numbers, and they are not going to," says Henry Dewing, an analyst at consultant Forrester Research (FORR).

Perhaps none of this would be an issue if Skype were fulfilling eBay's grand plan to meld the technology with its auction listings and PayPal payment service. "A couple of years ago they said there'd be synergies, and it's not happening," says Tom Taulli, an expert on mergers and acquisitions. Complicating matters, the market for making calls with a computer over a broadband Internet connection has gotten increasingly crowded since Skype blazed the trail. Free calling has become a standard feature of instant-messaging services from the likes of Yahoo! (YHOO) and Microsoft (MSFT) as well as an array of startups.

Some analysts suggest eBay may need to dramatically alter Skype's business model, perhaps focusing on advertising rather than user fees. One problem is that Skype's seemingly rapid user growth—registered users nearly doubled in the second quarter—is somewhat deceptive.

Chances are that less than 20% of Skype's 220 million registered users, as of the second quarter, are actively using the site, estimates Stephan Beckert, research director at consultant TeleGeography. In contrast, in early 2006 about 30% of Skype's roughly 95 million registered users were actively using the service. That would mean the active-user base grew only from 28.4 million to 44 million from early 2006 to mid-2007 even as the total number of registered users more than doubled.

Little Cash in PC-to-Phone Calls

Another worry is that Skype has yet to figure out a way to get more of its users, most of whom make computer-to-computer calls for free, to pay for premium services. In fact, Skype appears to be struggling with one of its main revenue sources: per-minute fees for calls to traditional phone numbers. "One of the things that alarms a lot of people" is that SkypeOut minutes were flat in the second quarter compared with the first three months of 2007—and down vs. the fourth quarter of 2006, says Beckert. On average, he estimates, Skype's users pay just 12¢ to 13¢ per month. Despite its legal troubles, Vonage (VG) generates $28.38 a month from subscribers to its Internet-based phone service.

That eBay is slashing its valuation of Skype now comes as a timely reminder of the still unique perils of trying to place a price tag on an Internet business. It has been almost exactly a year since Google (GOOG) paid an eye-popping $1.65 billion for YouTube, a video-sharing site with explosive popularity and little revenue. And these days there are reports that Microsoft may acquire a small piece of Facebook in a deal that would value the online social network at $10 billion (BusinessWeek, 9/25/07). Facebook, like Skype before it, has grown to more than 40 million users in an Internet minute but has little to show for it in the way of revenue. As eBay has learned the hard way, it's easy to overpay for all that excitement.

Originally appeared in BusinessWeek.