I consult, write, and speak on running better technology businesses (tech firms and IT captives) and the things that make it possible: good governance behaviors (activist investing in IT), what matters most (results, not effort), how we organize (restructure from the technologically abstract to the business concrete), how we execute and manage (replacing industrial with professional), how we plan (debunking the myth of control), and how we pay the bills (capital-intensive financing and budgeting in an agile world). I am increasingly interested in robustness over optimization.

Friday, May 13, 2011

Microsoft and Skype: The Business Value of Protecting a (Cash-Gushing) Utility

Microsoft's acquisition of Skype generated a lot of comment this week, much of it negative. As an investment, Skype has to put up some pretty juicy numbers to justify an $8.5b valuation. Reuters Breakingviews pointed out that the price is 400 times Skype's operating income last year. To achieve an annual ROI of 10%, Skype has to grow 40-fold. Heady numbers, to be sure.

But the Financial Times Lex column took a contrarian view, presenting the acquisition as a defensive manouever intended to protect the core Microsoft business. The argument goes like this. Microsoft buys Skype to protect the core Office / Windows franchise. E.g., if Google or Facebook bought Skype, they would be closer to assembling a suite of products that would shake users loose from Office & Windows. According to Lex, this isn't a "value-add" acquisition for Microsoft but a "protect the business" move.

And Microsoft will spend a lot to protect that business. In that light, the numbers that matter are vastly different. Microsoft throws off $3/share of free cash flow. That's a lot of cash. It's a cash flow yield of 11%. This acquisition barely makes a dent in that. Do one of these deals every 3 years and the cash flow yield drops only marginally, to 10%. That still qualifies Microsoft as a cash machine.

Lex sums it up nicely:

"What investors are actually getting is a very profitable unregulated utility that must spend freely to keep its core business running. ... Of course, this all assumes that these acquisitions succeed in protecting the core business. But that business is so lucrative, it's worth a shot."

This makes clear three very important lessons in tech investing, be it developing custom software or acquiring a technology firm.

First, not every dollar of business value is the same. We do some things to increase revenue. Some to create efficiency. Some to force competitors to react, to spend money they wouldn't otherwise spend and potentially mis-step. Some things we do are insurance policies to protect ourselves should some event happen. Still others - and perhaps Microsoft's acquisition of Skype is an example of this - are purely defensive, to prevent something from happening. The "value" of preventing an outcome is not the same as the "value" of adding a dollar of revenue or the "value" of sweating a dollar of cost out of business operations. Clearly, "business value" decisions are not so neatly interchangable.

Second is Lex' description of Microsoft as an "unregulated utility". Office suites and operating systems with GUIs were once the "killer apps" for personal computers, but they've become utilities, like water, electricity or retail banking. There's nothing wrong with being in the utility business. Utilities are important. The added benefit of having no regulatory burden to satisfy makes a tech utility a lucrative one indeed. But again, as the Lex analysis points out, the management, economics, and risk profile of a utility are not the same as those of a value-added investment.

Finally, Microsoft's acquisition of Skype might be wildly successful on its own merits: perhaps Skype increases their reach, or achieves a monetizable synergy with other Microsoft offerings. Or it might not: the numbers may never materialize, and Skype fades into irrelevancy. (By way of example, consider that Microsoft Live Messenger has a larger active user population than Skype and offers voice & video calling, yet is not relevant in the current social media / tech bubble.) Regardless the outcome of the investment, the counterfactual - what would have happened had another firm acquired Skype? - is unprovable. Maybe Microsoft has stolen Google's thunder here, and maybe they haven't. We'll never know. 'Twas ever thus with business decisions: their outcomes are unpredictable and, sometimes, their impact unverifiable.

This episode offers us critical insight into the business of technology. Every time we make a prioritization decision in IT - from each investment we add or divest from our portfolio, down to each feature we include or exclude in a project - we must recognize that context is everything. We must also continuously reassess the business rationale - as well as our institutional fortitude - to stay the course of each investment.