eBay Rolls the Dice

Investors seem willing to believe in the Skype acquisition, but it brings a new set of challenges.
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Updated from 2:11 p.m. EDT

The reaction to

eBay's

(EBAY) - Get Report

$2.6 billion, half-cash, half-stock purchase of Internet-phone provider Skype splits observers into two camps best summarized by these two questions: Is eBay losing its mind? Or is it saving its future?

Now that Wall Street has had a chance to take in the details that eBay provided in a conference call Monday morning there is a slightly increased sense that Whitman & Co., which has pulled many an unlikely rabbit out of the eBay hat, may after all know what they're doing.

eBay's stock, which dropped 4.5% in the two days following initial reports of the Skype acquisition, was up 60 cents, or 1.6%, to $39.22 Monday, suggesting that investors were willing to give eBay management a bit of breathing room in using VoIP to make a stronger, more competitive e-commerce company.

"The difference in whether this a good or a bad idea lies in part in the strategy but also the execution," said Rajiv Dutta, eBay's chief financial officer. "I remember vividly our discussion with investors and analysts about PayPal. About half the audience at the time thought we were nuts. They said, 'What is eBay doing getting into the banking business?'"

,So what was eBay thinking this time? Its core message is that the company, which has evolved from an auction site to a global marketplace for merchandise, is now an e-commerce

and

communications company. That is, it's closer to a traditional marketplace where buyers and sellers can haggle and press on little details that can make or break a sale.

Just as important, eBay is better positioned to handle higher-cost items and services such as travel and real estate that didn't thrive in HTML-based transactions.

"Many are looking at this acquisition, much as they are with all eBay endeavors in this current period of heightened eBay scrutiny, with a flawed understanding of the opportunity," said Scott Devitt of Legg Mason, which has no underwriting relationship with eBay but owns a 15% stake in it. Devitt noted that last week's decline erased more in eBay's market cap than it's paying for Skype, creating a buying opportunity.

Still, eBay's purchase - half in cash and half in stock, with another $1.5 billion to be paid a few years on if things work out - is fraught with risk. Initial responses to the deal suggested it smacked of the devil-may-care approach to acquisitions in the late 1990s that left so many companies scrambling headlong into a big fat mess.

Today, more are feeling this is a high-risk deal with potentially high returns in coming years. "The acquisition positions eBay to be a primary beneficiary if, and when, online transactions begin to migrate toward voice communication," said Mark Rowen of Prudential Securities, which has no underwriting relationship with eBay.

But, Rowen adds, "the deal is risky, given the high acquisition price, and the fact that eBay is now entering a complicated and highly competitive business.

The unwritten rule of successful technology companies is to never invest in technology simply because it's new and sounds like a good idea. The boulevard of broken dot-coms is littered with ideas that sounded good at the time but never found an audience. Instead, invest in technology that meets a need so strong people will pay for it.

eBay has been one of the most disciplined about focusing only on technology that met its customers' needs. In its conference call, eBay hammered on the theme that the Skype deal is going to improve its two core businesses, the global auction-driven marketplace that launched its success ten years ago and PayPal, the company's hope for becoming the Internet's ubiquitous currency.

What's not yet clear is how Skype will help eBay. According to eBay, the answer is fourfold, but most of them bring a set of challenges that eBay's management will have to address.

First, Skype will allow buyers and sellers in eBay's global marketplace to talk to each other. eBay members already exchange 5 million emails a year, and the voice calls could easily help smooth out the details involved in higher-ticket items such as cars, jewelry and industrial equipment. It could also strengthen eBay's hand as it moves into a marketplace of services as well as merchandise.

This could encourage more buyers to use eBay since they'll have instant access to potential sellers, but it could also create a nightmare for sellers if they are inundated with calls from flaky buyers. And if eBay isn't careful, sellers may avoid paying eBay fees if they use VoIP for secret negotiations with buyers.

Second, Skype is an important addition to the arsenal of services eBay offers small businesses, especially the 700,000 merchants with shops on eBay's site. Longer term, however, eBay and other VoIP providers may fall under regulation that would require them to chip in on the costs, such as 911 services and universal service taxes.

Third, cheap voice calls among eBay members could improve and monetize some of the new e-commerce areas eBay has moved into, especially

Shopping.com

,

Rent.com

and its Kijiji classified sites.

Fourth, and perhaps most significantly, Skype plus PayPal will create a pay-per-call model that fits seamlessly with existing PayPal accounts. To pull this off, eBay will need to persuade Skype's 50 million customers to pay for what is essentially a free service for them and prepare for a number of free, open-source Skype clones that will inevitably arise now that VoIP is going mainstream.

Longer term, there are other potential benefits, such as allowing online auctions to be conducted by voice and translating voice calls in what would be a truly global marketplace. Tantalizing as those possibilities may appear, they will require a good deal of work to pull off without hitches.

eBay is hoping that even more value will come from the so-called network effects of joining three communities: marketplace members plus PayPal subscribers plus Skype users. Skype, which like PayPal will function as an independent entity inside eBay, is free for calls to Skype members but charges a modest fee for outside calls. That creates another strong incentive for people to join and stay inside the eBay network.

"There is no question that communications is moving to the forefront of the Web," said Dutta. "In many ways communications and e-commerce are inextricably linked and tightly connected. There are things we could do together that we couldn't do separately."

Google

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,

Yahoo!

(YHOO)

and

Microsoft

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all have their own Internet-phone initiatives in the works, each one designed to trap users into their family of sites and services. eBay's edge against them is that its network is strongly grounded in e-commerce, not content and search. But if an open-source VoIP platform allows Google members to talk free to Yahoo! or eBay members, it may undermine the loyalty all of these companies are seeking to cultivate.

Buying Skype may have given eBay a lead over its rivals in customers and technology, but it's costing a pretty penny - or rather, 1.3 billion pretty pennies plus 32.4 million eBay shares. In return, eBay's getting a company that took in $7 million in revenue last year. Sure, Skype estimates revenue will grow more than 750% this year and another 233% in 2006. But even so, the company is paying 13 times that 2006 revenue. eBay itself is trading at 9 times its estimated 2006 revenue.

There is also the sense that eBay is on a three-way collision course with Google, Yahoo! and

Amazon.com

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. Right now, the tradewinds are favoring Google and Yahoo because online-advertising is growing much faster than e-commerce. Recall that two years ago, the situation was the exact opposite, and you can understand why these four companies are making moves today to prepare for a potentially different market a few years on.