Microsoft betting Skype keeps it ahead of Google, Apple

Here's why Microsoft's $8.5 billion acquisition of Skype makes sense: Microsoft, still a laggard on the Internet, has landed one of the most popular brands on the Web with a deeply engaged base of users. And it can bake Skype's widely used technology into its communications products, making them better.

At least, that's the bet. Microsoft says Skype has more than 170 million connected users. According to a regulatory filing, Skype claims its users made 207 billion minutes of voice and video calls last year. Microsoft wants to capitalize on that loyalty, putting Skype technology into various products, hoping that it can spin Skype's users into other Microsoft products.

"The Skype brand is a verb," Microsoft CEO Steve Ballmer said at a press event in San Francisco this morning, several hours after the acquisition plans were announced. (And just as the keynote address at the Google I/O developer conference was about to get started just a few blocks away.)

There are plenty of questions about whether paying $8.5 billion makes sense. But for Microsoft, which at the end of the most recent quarter reported that it was sitting on $50 billion in cash, it's not really the right question. Microsoft has poured billions of dollars into businesses over the years to find new markets. Some are starting to pay off, such as its Xbox video game business. And others are still a long way away from making money, such as its online services division.

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For Microsoft, the question is whether Skype allows it to get ahead of rivals, particularly Google and Apple, in key consumer market. Skype offers that potential.

"Today's announcement underscores who we are as a company," Ballmer said in an e-mail to employees. "We are ambitious and forward looking. We have big goals and aspirations. And when we look into the world and see opportunities to do more with technology, we'll drive toward them and keep pushing."

The regulatory filing, which Skype sent to the Securities and Exchange Commission in advance of an initial public offering that won't happen now, said that the company lost $7 million on $850 million in net revenue in 2010. And earnings before interest and taxes, a measure growing companies use to view profits, was $246 million for the year. In just the most recent quarter, Microsoft posted $5.7 billion in operating income.

But Microsoft doesn't have to turn Skype into a standalone profit center. It has businesses that can be improved by baking Skype technology into them. At least, that's the bet. Microsoft can add Skype to a portfolio of real-time communications products, that include Outlook, Messenger, Hotmail, Xbox Live and Lync. And it can add Skype into Windows Phone.

"We dream about building experiences that aren't limited by distance and device," Ballmer said at the San Francisco event, speaking about things like distance learning and family gatherings via video. "Microsoft and Skype together will define this future and what it looks like."

Ballmer talked about a recent conference at his son's school, and how he battled traffic to get there in time. As he was racing there, he thought about the camera that was inevitably on a computer in the school and its wireless network. He could have done the meeting from his office. "There's a better way to do these things," Ballmer said.

Just as important, Microsoft can try to sell Skype users on other Microsoft products, connecting them to one another through products such as Outlook. The deal has the potential of making Microsoft's existing communications products more valuable. It also could give those customers less of a reason to use rival technology from Google and Apple.

Microsoft plans to bake Skype's technology into a variety of products--everything from its Lync unified communications software to its Kinect motion-sensing device for the Xbox. As widely used as Skype is, Microsoft thinks it can build an even bigger base of customers. Microsoft can help push Skype into everything from business meetings to distance learning to family get-togethers. "We want to extend the reach of Skype," Ballmer said.

And it has a bit of history in weaving acquired technology into existing businesses. In 2007, Microsoft acquired speech recognition company Tellme Networks for $800 million. It currently uses that technology to let users search the Web with Bing by speaking a query into their mobile phone. Kinect uses Tellme technology to let gamers control their Xbox with voice commands.

That's why Ballmer gushed that the deal is "much more than the sum of its parts."

And it's why Microsoft is willing to shell out more than it's ever paid for an acquisition. (It's $6 billion deal for Aquantive is now ranked number two.) Unlike Skype's previous owner, eBay, Microsoft actually has some synergy with the company. Its real challenge won't be making money from Skype. It will be figuring out how to use Skype to make Microsoft's products better.

Updates at 9:12 a.m. and 10:12 a.m. PT: Added comments from Ballmer at the San Francisco event, along with a photo of Ballmer and Skype's Tony Bates.