'Skyped'---Microsoft-Skype Deal: An Analysis

Skeptics are panning Microsoft's decision to acquire Skype, arguing that the price of $8.5 billion (more than 30 times earnings) is too expensive. But with Skype, Microsoft vaults itself into the world of "free products" in a significant way. How Microsoft leverages those product users going forward — and whether it can retain and grow them — will be the true test of success for the acquisition.

The potential here is significant. Cloud services are considered to be the future of computing. For 170 million product users, Skype provides an on-ramp to Microsoft cloud offerings and other products. It gives to Microsoft a brand-aware user base keen to communicate, in the cloud, across a richly connected social network. It provides significant opportunities to up-sell, cross-sell, advertise, or bundle paid offerings. And by integrating Skype with its free cloud offerings — such as its free version of Office software — Microsoft multiplies the linkages and the revenue potential.

At the same time, Microsoft envisions deep integration with existing pay products, such as Office and its corporate communications offering, Microsoft Lync. Clearly, the company aspires to move into the stream of demand flow toward increasingly ubiquitous face-to-face communications across all devices.

But the acquisition also presents a significant conundrum: How will Microsoft integrate and leverage Skype without destroying what has been successful thus far — the free business model and the potential of the user base? Can the company simultaneously manage a world of free users supported by advertising and premium service offerings — and a world of paying customers looking for best-in-class communications applications?

The challenge is not an easy one, as Microsoft's own experience makes clear. While it has launched free versions of its Office software to the cloud, the dependencies of these offerings on the pay product remain strong and the pay product seems to get all of the support. Meanwhile, both cloud and pay Office are under heavy assault from free product threats such as Google Docs.

Fortunately, in Skype, Microsoft is buying a company that has figured out how to make money off of free products. That's why appending Skype onto the Microsoft organization structure as a separate, autonomous division makes a lot of sense. However, while this approach promotes the free products business model, it makes tight integration with other products more difficult

Some may argue that integrating Skype with Microsoft pay products has the potential to deliver greater incremental revenue than does supporting the free business model, so Microsoft should just let that model die. But the Skype unit is approaching $1 billion in revenue with free products already and much more may be on the way. With competitors using free products to rapidly stake claim to territory in the cloud, this may be Microsoft's best chance to leap forward with a serious presence in that space.