Investors slam Microsoft's Skype deal

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Microsoft Corp's move to buy money-losing Internet phone service Skype for $8.5 billion was immediately skewered by critics and investors, who questioned the logic of the deal and suggested the software giant is paying far too much.

The price is about double the expected value of Skype if it had gone ahead with its planned initial public offering, leaving investors puzzled over how Microsoft will make the deal pay for itself.

"I wish they had not done it," said Whitney Tilson, founder and a managing partner of T2 Partners LLC, which owns Microsoft shares.

"Initially when I first read about it, I hated the deal. Now, I don't like it," said Tilson, who is a long-term buyer of Microsoft shares and still sees them as a great cash-generating business and an undervalued stock.

"Everybody I know uses it and I am glad Microsoft owns it. They just probably paid too much for it," said Tilson, who did not buy or sell Microsoft stock on Tuesday.

Shares of the world's largest software company fell 1.4 per cent, anchored at the same level they have been for 10 years.

The latest deal was a fresh reminder that Microsoft has no record of making acquisitions pay off. Its 2007 deal to buy online ad firm aQuantive for $6 billion was a flat-out failure.

"They really have to do some explaining as to how this company merited that price and how they'll return the value to shareholders," said Kim Caughey Forrest, senior analyst at Fort Pitt Capital Group, which holds Microsoft shares.

"We have to see the path to profitability. It smacks of that 1999, 2000 time period when valuations were granted on eyeballs, not revenue and earnings."

Skype made a net loss of $7 million last year on revenue of $860 million, even as its user base grew nearly 40 per cent to 145 million.

Microsoft Chief Executive Steve Ballmer said the deal would add to the company's profits from the first year, preferring to focus on the $264 million Skype made last year, excluding interest, tax, depreciation and amortization.

He stressed that Skype, which will be a separate unit within Microsoft, will help sales of its other products such as Xbox game console and Kinect motion-sensing system, and add luster to its Office suite of applications.

"Will we sell a few more Kinects when we get these things hooked up? Yeah, I think so. Skype can help where we are in the enterprise by getting those customer bases to work well together," said Ballmer in a phone interview.

"I think there's a lot of value in here that we can drive, we've just got to go get it done when we get through the regulatory (approval)," he added. Microsoft aims to complete the deal this year.

LACK OF SPECIFICS

Microsoft is hoping that more business users would be willing to pay for Skype if it is integrated with Outlook e-mail, which hundreds of millions of people already use, or that more gamers will pay to join the Xbox Live network if real-time video and voice services are added.

It should also allow its new Windows Phones to compete directly with Apple Inc and Google Inc smartphones, which already feature video chat.

But some investors carped that Microsoft already had the technology to do this, or should have developed it itself, and may soon be overtaken.

"They paid a headscratcher of a valuation," said Patrick Becker Jr., a principal at Becker Capital Management, which owns 1.5 million Microsoft shares.

"One of my big fears is that by the time they design this into Outlook, Xbox and their phone software it's going to be overtaken by Google and Apple from a capability standpoint," he said.

Becker said buying a software company should cost more like a multiple of five times revenue, which would imply a valuation closer to $4.3 billion based on the company's 2010 revenue.

"It points to them playing follow the leader, which is a very difficult game to play," said Becker. "My disappointment is that I thought this was an area (in which) they had a fair amount of expertise. To go out and spend $8.5 billion makes me wonder about internal execution. They obviously felt they didn't have the product in house to compete with Skype, Google and Apple."

One factor in favor of Microsoft: it is using cash from overseas to buy Luxembourg-based Skype, which means it won't have to pay U.S. tax on that money, as it would if it had repatriated the money to the United States.

The majority of Microsoft's $50 billion cash and short-term investments are held overseas, where most of its revenue is generated.

"They can't return their offshore cash to shareholders so this might be reasonable use of that," acknowledged Tilson.

But even that could not persuade investors that the deal was a bargain.

"It does strike me that by almost any dimension Microsoft is overpaying," said Andrew Bartels, an analyst at Forrester Research.

"There's some strategic benefits but I have a hard time seeing them being anywhere close to what they're paying," he said. "I'm sure shareholders are saying that Microsoft should have given a dividend to shareholders rather than spend it on this."