Are Internet Companies Overvalued (Again)? by Raul L

Are Internet Companies Overvalued (Again)? by Raul L. Katz and Paul Zangrilli

08/21/2007

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What we can learn from eBay’s acquisition of Skype. 1 by Raul L. Katz and Paul Zangrilli

n September 2005, eBay Inc. acquired Skype company are estimated and then “discounted” to give Technologies, an unprofitable Internet them a present value. But the outcome of the analyses in Iprotocol–based voice telephony company, for many of these deals is often little more than a guess, US$2.6 billion in cash and stock (as well as earn-outs, especially when there is not enough history about the which potentially provide the sellers with additional company being acquired or a sufficient number of com- revenue if the company meets certain financial per- parable firms to determine with any degree of accuracy formance targets; in this deal it could increase the pur- what its next ten years will be like. If the revenue chase price to $4 billion). This transaction marked the assumptions or synergy estimates are too aggressive, beginning of a new wave of Internet industry mergers then the buyer has overpaid. Another way of approach- and acquisitions following a long, painful correction. ing valuation is by comparing previous similar transac- Other major deals since the eBay–Skype deal have tions. But here, too, the record is small or insufficiently included Google’s acquisitions of DoubleClick and applicable to be credible. YouTube, Microsoft’s acquisition of Aquantive, and Therefore, in addition to these somewhat lacking News Corporation’s purchase of MySpace. In fact, models, we recommend that today’s dealmakers also use more than 1,150 technology transactions worth more a real options framework, which seeks to analyze and than $30 billion have closed since — many featuring value the options, or strategic alternatives, that a com- lofty valuations, considering that most of the acquired pany will have once it acquires another company. companies had short operational histories and limited Although this method also depends on some assump- or nonexistent earnings. tions, the rigor of building this type of analytical frame- There is a very strong chance that, to a large degree, work makes it much less vulnerable to pure guesswork acquirers are overpaying either because of limitations in and is an excellent way to determine the efficacy of common techniques for placing a value on mergers and management assumptions. We applied this approach to acquisitions or perhaps because of a lack of investment the eBay–Skype deal because it is the oldest of the recent discipline in firms with excess cash. For example, one of wave, enabling the analysis of several quarters of finan- the more popular valuation methods is discounted cash cial data, eBay management’s long-term plans for Skype, flow, in which all future cash flows from an acquired and Wall Street analysts’ financial projections. strategy+business strategy+business

Raul L. Katz Paul Zangrilli ([email protected]) is ([email protected]), director of business strategy a former product manager at research at the Columbia Yahoo Inc., is a research analyst Institute for Tele-Information at the Columbia Institute for and an adjunct professor in Tele-Information. the finance and economics division at Columbia Business School. Formerly a vice leading president and partner at Booz Allen Hamilton, he is president of Telecom Advisory Services

LLC, a strategy consulting firm. IDEAS

Several premises drove eBay’s acquisition of Skype. large Internet companies, and incumbent telecom/cable companies enter the industry. For example, eBay assumed • eBay was facing a slow-down of its core business 20 to 25 percent long-term operating margins versus a in a maturing online auction market. more realistic 15 percent. We also took Wall Street ana- • eBay management had achieved previous success lyst projections for the Skype unit and conducted multi- in its diversifying acquisition of Paypal, which ple discounted cash flow analyses that covered several allows purchases and money transfers to be com- potential scenarios, from best case to worst. pleted online. Because the discounted cash flow analysis clearly • “Convergence” would rapidly eliminate differ- showed that eBay’s rosy forecasts had led the online auc- ences among separate Internet-based businesses. tioneer to a higher valuation than Skype was likely • Direct competitors were rumored to be interest- worth, we then examined whether a combination of real ed in buying Skype. options for the future, including potential growth in • Skype’s Voice over Internet Protocol (VoIP) com- new business areas such as pay-per-call services and munications capabilities would transform the mobile payments, as well as the possibility of eventually way people make and receive calls. combining and divesting assets, could be used to justify the additional $1.1 billion that eBay paid. Consequently, eBay management was convinced However, the real options analysis was less than that Skype would accelerate trading on eBay by letting promising: We found only a limited chance that Skype buyers and sellers communicate over the Internet; would help eBay grow its business beyond what it Paypal integration on the Skype system would allow would be without the acquisition or that the combina- easier payment methods for users; Skype could pro- tion would allow eBay to streamline its operations. mote eBay services, and vice versa; and the acquisition Given the gap between our discounted cash flow and would enable eBay to pursue entirely new businesses real options value and what eBay paid, even aggressive such as pay-per-call. synergy assumptions representing 5 to 10 percent of the In our assessment, a discounted cash flow analysis of purchase price, or $130 million to $260 million, were the core Skype business, under fairly aggressive assump- not enough to justify the premium. In addition, this tions, yields an enterprise value of only about $1.5 bil- amount would be offset (partially or fully) by the costs lion, $1.1 billion short of the purchase price. To arrive at associated with diversification and the cross-border this, we conducted a strategic analysis of the VoIP land- nature of the deal. (Skype is based in Luxembourg.) scape to review eBay’s assumptions for long-term operat- We thus concluded that in the eBay–Skype deal ing margins as discussed in publicly available merger reality fell short of the hype. The premium could be jus- materials. Our review identified significant areas where tified only if very dubious assumptions were used and eBay appears to have been overly optimistic — especially competitive dynamics were ignored — the latter espe- given the highly competitive VoIP landscape as startups, cially questionable in a volatile industry such as Economic (Springer, + The New Investment Theory of Real Investment The New (2nd ed., John Wiley & Sons, 2005): A Sons, & Wiley (2nd ed., John Real Options in Capital Investment: Models, Strategies, Models, Investment: in Capital Options Real Real Options Analysis: Tools and Techniques for Valuing for Techniques and Tools Analysis: Options Real (Praeger, 1995): An in-depth examination of the value of 1995): An in-depth examination of the value (Praeger, , vol. 50, no. 1 (January 1996): How management behavior may 1 (January 50, no. 1996): How , vol. , Summer 2003: What happens when demand myths, faulty forecasts, What happens when demand 2003: , Summer transformative promise. Irrational exuberance, the Irrational promise. transformative may once Alan Greenspan, phrase made famous by head. again be raising its frothy be altered under a variety of capital structure situations. of capital structure under a variety be altered http://www.sciencedirect.com/science/article/B6V84-3VWPNX0-J/2/ 0471747483/ ed., Lenos Trigeorgis, and Application options. http://amazon.com/dp/0275946169/ real The mandate of this academic organization site: Web Group Options Real on uncertainty using real is to help managers embrace and capitalize by on hosts an annual conference The group decisions. options in investment the subject. http://rogroup.com/ Resources eds., Noam, Alleman and Eli James Economics Telecommunications for Implications and Its Options options can be applied to the telecom- real 1999): An examination of how munications landscape. http://amazon.com/dp/0792377346/ The original announcement 12, 2005: September Skype,” to Acquire “eBay site. http://about.skype.com/ Web deal, on the Skype of the eBay–Skype 2005/09/ebay_to_acquire_skype.html Astray,” Went Industry Telecom the How Exuberance: Raul Katz, “Irrational s+b http://strategy-business.com/article/21873and financing traps converge. in Money with the House “Gambling Moon, Philip and Keasey Kevin Analysis,” An Experimental Decisions: Capital Expenditure Letters 720fe98125de7640ab8136f6b3564afb (subscription required). Mun, Johnathan and Decisions Investments Strategic description of the methods used in evaluating and quantitative qualitative applicable. http://amazon.com/dp/ options and why and when they are real It was precisely this syndrome that fueled the first that fueled the this syndrome was precisely It We are not arguing that all the recent Internet trans- Internet not arguing that all the recent are We Internet bubble. We should remember that a sign of the should remember We bubble. Internet transac- end of the first bubble was highly speculative pertinent to ponder whether some is now tions. It their realize era will ever acquisitions of the current telecommunications. Furthermore, our analysis con- telecommunications. Furthermore, forming a partnership with a com- cluded that merely VoIP auction-related or building pany like Skype, to provide been sufficient might have services internally, with entryeBay into new that it hopes to gain businesses of the sustainability Finally, acquisition. the Skype from guaranteed, was far from advantage any competitive Therefore, the logic of the deal. which also undercuts embodied an although the acquisition might have the assump- strategy for eBay, acceptable diversification price appear to be the purchase tions used to validate any difficult to justify through and are aggressive overly models. combination of valuation actions are flawed. The acquisitions of DoubleClick and The acquisitions of DoubleClick flawed. actions are been smart appear to have moves. in particular, MySpace, the question whether overpay- raising are we However, shareholder ment in many of these deals is destroying as has happened in wonder whether, fact, we In value. cash and nonoptimal cap- industries, excess other mature a lack of management disci- fostered have ital structure management hubris. Another potential pline or even in these deals could be the explanation for the high values intense competition for assets among a small number of in technology companies must Executives large players. make fast and risky M&A decisions in uncertain envi- industry because so intense. But ronments are rivalries namely trade-offs that must be considered, real are there syndrome. with house money” the “gambling

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