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eBay: What to do with Skype?

The auction king is forced to reassess the value of the company it acquired for $2.6 billion--and its larger strategy for making money with VoIP.

Don't call it a bust just yet, but it's fair to say eBay executives aren't thrilled with what they're getting out of Skype, which the auction king bought for $2.6 billion two years ago.

On Monday, eBay said it would take a $900 million so-called impairment write-down against the value of Skype. This means that eBay has been forced to reassess the value of the Internet telephony company relative to its overall business today. By recording a charge, the company is essentially saying that it has taken a loss on its original investment.

In what looks like an attempt to shake things up at Skype and move the division in a new direction, eBay also said Monday that Skype co-founder and Chief Executive Niklas Zennström has stepped down.

His departure was expected. Zennström, who helped start Skype in 2003, has joined forces with Skype co-founder Janus Friis to start an Internet television service called Joost. And it has long been anticipated he would take more time to work on that endeavor.

From the time that the Skype acquisition was announced in September 2005, analysts and investors on Wall Street shook their heads wondering how the company could pay such a hefty premium on a company that essentially provided free or low-cost voice minutes in a market that is dominated by large incumbent telephone companies.

"The Skype service has been tremendously popular as a free service. But at some point, free doesn't work anymore. It's not a management problem. It's a business model issue."
--Jordan Rohan, analyst, RBC Capital Markets

When the merger was announced, eBay, which owns and operates the most well known online auction service, said it saw great potential in using Skype's peer-to-peer voice over Internet Protocol technology to connect buyers and sellers in the eBay marketplace. There were grand plans to integrate eBay's PayPal payment system with Skype's VoIP network.

But nearly two years after the acquisition closed, there is little integration between eBay's auction Web site and the Skype voice service. Even though Skype has grown into the largest voice over IP provider on the planet, the bottom line is clear--it still hasn't made enough money to justify the hefty $2.6 billion price tag.

"The Skype service has been tremendously popular as a free service," said Jordan Rohan, managing director and Internet analyst at RBC Capital Markets. "But at some point, free doesn't work anymore. It's not a management problem. It's a business model issue."

That said, Skype has been a success story of sorts in the voice over IP arena. Its subscriber base has grown from 57 million registered users in 2005 to 220 million users at the end of June 2007. That's an increase of more than 160 million registered users in less than two years. The division also recorded its second quarterly profit in a row on July 18 on revenue of $90 million.

But despite this success, eBay's CEO Meg Whitman said when the results were released, she was still not happy with Skype's usage levels.

The big question now is, what's next for Skype?

Making money
Clearly, the current business model is not enough to satisfy eBay in light of how much the company spent on Skype. And the reason is simple. Even though Skype has done a very good job of getting users to download its software client, most people who use the service do so to make free Skype-to-Skype phone calls.

The only way that Skype makes money from its subscribers is when people use its Skype-In or Skype-Out services. Skype-In allows users to pay to rent a phone number, which people on regular phones can call. Skype-Out allows users to call traditional phones or cell phones for a fee.

Skype and eBay don't break out how many subscribers use Skype-In and Skype-Out, but Rohan said there is evidence in Skype's numbers to suggest its Skype-Out usage is actually declining.

"Skype-Out usage is way down," he said. "But regardless, Skype's core business isn't much different from a really cheap calling card business. The margins are really thin."

It's clear that the dream of massive integration between eBay's auction site and Skype won't be realized anytime soon. But the company still sees big potential in Skype's voice services.

"We feel like we can do a lot more with Skype as a stand-alone VoIP provider," said Hani Durzy, a spokesman for eBay. "Skype has been focused on user acquisition, and it's done a great job. But we also feel like we can find new ways to monetize those users."

For example, Durzy said the company is looking at ways to integrate e-commerce into the Skype client itself. Exactly how this would work is still unknown, but for the 220 million users who have Skype on their desktops, eBay could integrate tags to purchase goods and services.

Advertising is another avenue that eBay is exploring, Durzy said. With 220 million registered users, Skype has a big enough audience to attract large advertisers. Some analysts agree that this would be a logical opportunity for Skype to explore. But supporting a service through online advertising isn't necessarily a slam dunk for the company.

"It could be as easy as showing Skype subscribers advertisements when they use the VoIP client," said Sally Cohen, an analyst with Forrester Research. "The challenge will be in making sure that eBay can match the advertisements with the subscriber base."

Adding advertisements to its service could also pit Skype against Google. The king of online advertising is also in the voice over IP market with its GoogleTalk application.

Mobile opportunities
Some analysts speculate that Skype and eBay's biggest opportunity is in taking their applications to mobile devices. Specifically, this would mean embedding the Skype client on cell phones. Today, the client is very processor intensive, so the Skype mobile client is only able to run on more expensive smart phones, such as devices running Windows Mobile.

Scott Devitt, a managing director at the investment firm Stifel Nicolaus, said that he also sees Skype and eBay leveraging the mobile platform in the payment arena as well, combining eBay's PayPal service with the Skype client.

"Wireless is the key to their future," he said. "In my eyes, that is the only future opportunity that justifies the price that eBay paid for Skype."

Durzy said the company is primarily focused on addressing desktop users, but eBay is committed to putting the Skype application in the hands of its users on whatever device they're using.

But mobile has its own challenges. The wireless industry is completely controlled by the mobile operators, and in the United States, the four major carriers exert great power in deciding which applications they allow on handsets and which they do not. Verizon Wireless specifically spells out in its user agreement that its 3G wireless data service is not to be used with a VoIP client.

"Verizon and the other phone companies can (see) what Skype traffic looks like," said Charles Golvin, an analyst with Forrester Research. "So if it gets to a level that takes away from their business, they can shut it down."

The other problem with Skype on mobile devices is that it requires a high-speed data connection to work. And barring the use of VoIP in a free Wi-Fi hot spot, there is little economic incentive for cell phone users to use a Skype client instead of their carrier's own voice service. The reason is simple: Subscribers still have to pay for voice minutes. And if they use Skype, they also have to subscribe to a data plan. Even with an unlimited data plan, there is still no real reason to use a VoIP service unless you're trying to call overseas.

And here is where Skype could find an opportunity. Even as a desktop service, most people use Skype for international calls, because the rates between continents and countries are often still expensive. On cell phones, the price is even higher. In the U.S., most operators require subscribers to sign up for an international service package that costs more than the standard domestic package.

For U.S. cell phone subscribers who want to use their cell phones overseas, the costs are even higher. Many operators provide roaming services that allow people to make calls while traveling overseas, but the rates are high.

VoIP, and Skype's service in particular, offer cheap calling for people traveling or calling internationally from their cell phones. But Skype isn't the only company addressing this market. There are a slew of new start-ups like Jaxtr and Jajah that are getting into this market.

Unlike Skype, these companies don't require a client to be downloaded on the device, so they can be used with any cell phone. But because there is no client on the phone, these services often rely on a laborious set-up process that sometimes requires users to access the network first on their PC, and then the network itself calls the user's phone to set up the call.

Golvin believes that wireless and mobile services will likely be controlled by the carriers, at least for the foreseeable future. Some of the mobile operators such as T-Mobile and Sprint are already moving toward voice over IP services. And he envisions wireless operators soon integrating some of the other communication features Skype offers--like presence information and instant messaging--into their own service. T-Mobile for example, could easily add additional features to its Fav Five application to tie its users together more tightly.

"The wireless carriers already see a long term opportunity in providing voice over IP and integrated communications services," said Golvin. "But they will control the service. And it will take a long time for them to migrate toward this."