MicroSkype is a trillion dollar company

Microsoft is to buy Skype for $8.5 billion. Let’s analyze the price Microsoft paid for Skype, the reason why Microsoft bought Skype and how we should trade our Microsoft now.

First off, let’s talk price. $8.5 billion is a lot of money and as a Softee shareholder, I do wish they’d only paid the $7 billion plus as was originally reported by the WSJ last night. But $8.5 billion, including debt, appears to be the price that Softee’s paying for this wildly successful Voice-Over-IP company that has 100 million more registered users in its network than even the vaunted Facebook. So, $8.5 billion dollars is:
About 10x Skype’s sales
About 35x Skype’s EBITDA
Less than 20% of Microsoft’s current cash balance
Equal to about four quarters of cash flow at Microsoft
Three times more than the loss of market cap valuation that Microsoft has suffered today as the market takes the stock down 1.5% or so
About 1/10th as much as Facebook, which as I noted above, has 20% fewer members in its network than Skype does in its VoIP network

Let’s put it this way, this isn’t an insane dot-com kind of valuation that Microsoft has just paid. At 10x sales for a company that’s got the critical mass and network effects, the distribution and the lock-in and outright growth potential that Skype has, I don’t think Softee has overpaid at all. Let’s call it a fair to good price.

By the way, you can sign up for TradingWithCody.com to find out how I trade it along the way to my trillion dollar price target (more on that below) as I to try to maximize our portfolio profits with smart common and option trading, analysis, tactics and strategies.

And the fundamental reasons that Softee bought Skype are hinted at above — namely, Softee is buying Skype:
Critical mass (meaning that because the company has so many members and because you have to be a member to talk to other people on Skype for free, that the network keeps getting more valuable as more people come onto it, adding to its critical mass, etc). Microsoft will quickly work to integrate their other product offerings, especially the still-holding-its-own-vs.Google, Bing search engine into Skype helping it drive towards a bigger critical mass for itself too. And more importantly, Skype will be fully integrated into the next gen of Microsoft Windows handsets, though Softee will have to make concessions to carrier concerns about people bypassing the cellular network charges and just using Skype on the data network. That’ll all get worked out between Microsoft and the carriers though.
Distribution. Microsoft is already distributed the world over. But now its voice software is going across the iPhone, the Android and the Windows platforms. That’s big for Softee. And let’s face it, Skype’s known well by somebody in every coffee house in every country on the planet.
Lock-in (once you start using Skype, and get it on all your gadgets and PCs and your contacts are in there, and you get used to it, ie, “locked in”). Microsoft, with its dominance in so many of its billion dollar industries, knows all about locking customers in to your platform/network.

As for trading Softee now, well I’m a buyer of Softee because over the next few years I expect that its traditional PC software businesses will remain hugely profitable if low growth, while its Xbox network and living room platforms continue to grow and Kinect platforms becomes a new de facto standard, and that the combination with Nokia gives its Windows mobile platform a chance that it didn’t before the deal. At less than 7x next year’s earnings estimates when you include cash and less than 10x when you just look at the P/E, I think it’s safe to say that any meaningful upside in any of the above is not discounted in the current MSFT price.

As I told my subscribers on TradingWithCody.com in real-time as I was doing it, instead of Microsoft common stock, today I bought some Microsoft call options, mostly with the $25 strike price, that will expire in January 2013. It always shocks me how cheap the premium for call options in Softee can be at times, especially when the stock flatlines for a few months as it has been of late. I fully expect that Microsoft will head into the $30s in coming months and that we’ll see Microsoft trade into the $50 in the next three years.

And yes, I do believe that Microsoft could generate a full $5 per share in earnings in five years or so from now and that with its cash balance at that point, along with the growth it will have shown to get there, that we could see this stock with a 20 P/E multiple on that $5 in earnings. And that, seriously, would make Microsoft a trillion dollar company. Sign up for TradingWithCody.com to find out how I trade it along the way to try to maximize profits with smart common and option trading.

At time of publication, Willard, author of Revolution Investing and Trading With Cody, was net long Microsoft although positions can change at any time. None of the information in this column constitutes a recommendation by Willard of any particular security or that any security or trading strategy is suitable for any specific person.