Skype’s business model

Last October, I discussed the acquisition of Skype by E-Bay. My main conclusion was that this acquisition made economic sense for E-Bay. Since then, I gained a much better understanding of how Skype’s business model works. It came not from a heavy number crunching but from a direct personal experience. An intangible but major consequence of the acquisition was to put a stamp of legitimacy on Skype. Many people who had considered it as not ready for the prime-time upstart, now decided that if it was good enough for Ebay, it was worth a try. This was my case and I installed Skype on my computer. Of course, the idea was to use it for long free chats with buddies. But as my use increased, I got tempted to try the Skype-out, a paying service, which allows users to call any number on either fixed or mobile network. The temptation was further exacerbated by my mobile telephone bills, which, despite all the discounts by the phone companies, just kept expanding every month.

So I bought some credit and started dialling. The service worked like a charm: straightforward dialling, rapid connection and good quality communication. And the price was right. Although it was not as cheap as advertised (a cent a minute), on the average my per minute cost was about 10 (euro) cents. This was maybe due to my call mix, heavily skewed toward mobile phones, and the choice of countries (Poland and Luxembourg in particular). But in any case, it was 80 to 90% cheaper than mobile-to-mobile or fixed-to-mobile calls. So Skype-out gained a satisfied customer, to the tune of about 20 euros a month.

Now, consider that

(a) As unique as I am, mine is not an isolated case. It looks like since the the transaction closed the number of actual users (as opposed to people who just download the software) has increased by 60% from about 3 million a day in October 2005 to about 5 million a day in January 2006. Assume that some 10% of the users become paying Skype-out customers like me. This means a gross revenue stream of 10 million euros a month.

(b) This may not sound like much (less than 2% of overall EBay revenues at present) but it is not a static data. Using this back-of-the-envelope calculation and the current rate of growth of Skype usage (350% per annum), one arrives at 2006 annual revenues of 200 million euros. And, guess what, this is a number forecast in official press releases on Skype acquisition in October 2005. Things are getting more interesting if one looks into the future. Should Skype usage continue to grow at current rate for the next three years, its revenues would swell to over 2 billion euros by the end of 2008. This rate of growth may sound over-optimistic, as it would imply close to 90 million paying customers. This compares with 170 million registered users of Ebay. On the other hand, using the same basic numbers, Skype needs slightly over 40 million customers to reach 1 billion in revenues. Is this a really unachievable target within next two to three years?

(c) While revenues look enticing, in the end it is the profitability that matters. Here, the outlook is not bad, to put it mildly. The main cost factor for Skype-out are the access charges paid to telcos for call delivery. These are variable costs, only incurred when a call is made. Furthermore, they are likely to decline under a combined impact of regulatory and competitive pressures on telcos. In particular, access charges exacted (that is the word for what they do unless one prefers “extorted”) by mobile operators should drop dramatically. Also, as its traffic volume grows, Skype should be able to obtain better terms from telcos (including fixed cost deals). Thus, the operating margin objective of 20 to 25% appears, if anything, rather conservative: I would expect at least 40%. Skype profitability should be higher than that of other Ebay segments, not only because operating infrastructure and customer services requirements are considerably lower but also because Skype operations are inherently less risky: Skype-out operates on a pre-paid basis and incomplete telephone calls are considerably less contentious than bad payments or fraudulent transactions.

(d) This analysis may appear based on over-optimistic paid use assumptions but on the other hand, I have not considered any other potential sources of Skype revenues, such as transaction support for both E-Bay and PayPal (through an Instant Messaging system for instance), content acquisition, etc.

All this reinforces my earlier assessment that Skype acquisition does make sense for E-Bay. Market remains sceptical and E-Bay stock has underperformed the broad indices since the acquisition. A buying opportunity?