Skype & eBay - an introduction to and case-study in mergers and acquisitions

Earlier today, someone posted on a mailing list an attempt to understand why eBay bought Skype in the first place. For those who have forgotten, eBay, the online auction giant, bought Skype, the VOIP/IM newcomer with around 57MM registered users at the time, for $2.6BN in 2005. The poster wanted to understand why they bought Skype, and how they feared Skype upending their business model. This article is a short introduction to the reasoning behind most acquisitions, in an attempt to improve understanding.

First, one very big caveat. Depending on whose analysis you use, over 70% of mergers and acquisitions fail. The definition of failure here is that they do not achieve their targeted goals, and often end up costing more than if they had just let things be. Why do they fail, and given those statistics, why do they try? That has a lot to do with psychology, and will be the subject of a follow-up post.

In general, there are two reasons for entering into an acquisition: vertical integration and horizontal integration. These sound like business-school-buzzwords, which to some extent they are, but they help categorize and explain why a business buys another one.

Vertical Integration

Vertical integration is the process of buying out your supplier or customer, essentially someone in your supply chain. Let us say you make cars (not a very profitable thing nowadays, especially if you are a US car company). You decide, for various reasons, that it will be more profitable for you to own your own windshield maker rather than buy them from one or more suppliers. This acquisition is known as vertical integration. Similarly, if you are Fidelity, and you sell lots of mutual fund via a network of brokers owned by Charles Schwab, and you decide to buy out part of Schwab's business, that is vertical integration.

Why would a company perform vertical integration? There are several possible reasons:

•  Supply: For whatever reason, you are concerned about supply, and thus you buy a supplier to guarantee good supply. You do not expect cost savings per se; this acquisition is about ensuring a good supply for your business.
• Savings: Each stage of middle-man in a business adds a cost, both cost of operation and profit requirements. If you can perform that function better in-house, then you can realize cost savings.
• Competitive advantage: If there is only one or a few suppliers or customers for a business, buying them can put your competition at a significant disadvantage.

Clearly, vertical integration can be done for cost reasons, but is primarily done for strategic reasons, either to improve your ability to manufacture, deliver and market goods and services, or to make it more challenging for your competitors to do so.

Horizontal Integration

Horizontal integration is the process of buying out another firm that is not in your supply chain, and is either complementary to or competitive to your business. For example, if you are General Motors, and you buy out Ford (difficult to do when you just lost $15.5BN in a quarter), that is horizontal integration. Similarly, if you are Morgan Stanley and you merge with Dean Witter so that each one can feed the other's business, that is horizontal integration.

Why would a company perform horizontal integration? There are several possible reasons:

• Economies of scale: Quite simply, if you produce 100,000 cars at a cost to you of $20,000 each, and your competitor does likewise, it is possible that manufacturing 200,000 cars together will only cost you $15,000 each, leading to a $5,000 cost savings per car, or $1BN a year. This is one example of that awful buzzword, "synergies."
• Economies of scope: Similar to economies of scale, it is possible that although you each manufacture, separate, non-competitive items, together you can manufacture each of them more cheaply. This is very similar to economies of scale, except that you are not manufacturing the same item, but nonetheless gaining cost advantage.
• Fixed cost savings: There is a certain amount of overhead in running a firm of a given size. These costs are not lines. For example, in the second quarter of 2008, Google had general and administrative costs (think executives, some facilities, HR, legal, etc.) of $319MM for just under 20,000 employees, yet it would cost much less than double that, or $638MM, for 40,000 employees. Given Google's notorious inefficiencies in operations, perhaps this is overstating the case, but the principle holds. This is usually what executives of public companies when they refer to "cost savings via synergies" in a vague sense (also usually known as, "we hope we will save some money, else we cannot justify the acquisition").
• Competitive reduction: You buy a competitor. Using the above example, if GM bought Ford (which is difficult, but then again, Ford lost over $1BN in the second quarter of 2008 and its shares are at around $4.62 for a total capitalization of just over $10BN, so perhaps not so far-fetched), it would have the ability to control a greater share of the market, raise prices or reduce output (if the UAW even let them).
• Cross-selling: You buy a complementary company, expecting that you will each use the advantages of the other to build a bigger business. The whole is greater than the sum of its parts. This was the rationale behind most of the "financial supermarket" mergers and acquisitions of the late 1990s through recent years. Morgan Stanley merged with Dean Witter because they each felt that they could use the other's strengths and especially markets to sell more than they could on their own. The same holds true for Citi and Travellers, and all the others. It is important to remember that this is not primarily about saving money (reducing expenses), but about increasing revenue (top-line).

Clearly, horizontal integration can be done for either cost or strategic reasons. 

Skype and eBay

So given the above, what type of merger was Skype and eBay? It is difficult to tell. Two primary rationales have been given for the acquisition at various times.

1. Members: eBay saw a slowdown in membership growth, while Skype had tens of millions of active members (around 57MM as of the acquisition). eBay saw Skype as a way to bring many new members into the eBay fold. Essentially, eBay bought Skype for its users. This is straight horizontal acquisition, with cross-selling as a rationale. 
2. Communications: eBay saw a slowdown in membership growth, and believed that Skype, with its popular instant messaging and voice channels, could act as a strong method of communications between buyers and sellers on eBay. Although eBay could have built an IM or VoIP platform on their own, the technical challenges are not insignificant, and the marketing challenges - how many IM and VoIP systems do most users want - are even greater. Essentially, they bought out a good and well-positioned supplier. This is straight vertical acquisition.

Either way, it did not fare well. eBay bought Skype in 2005 for $2.6BN in September 2005. By October 2007, two years later, eBay had to take an impairment charge of $900MM. Put in more normal terms, eBay is saying, "Oops, we seriously overpaid."

A final note on non-integration acquisitions

As a final note, there is a type of acquisition that has nothing to do with integration. In short, if an investor sees a company that is poorly run, and believes that, without integrating its business with any other business, s/he can run it better, they may buy out the firm to do so. A famous recent example is the 2007 Cerberus Capital acquisition of Chrysler Corp. Chrysler lost $1.5BN on more than $60BN in revenue in 2006 (their last year as a public company). Cerberus took a look and said, "What a mess. We can do better than $1.5BN in losses and growing." They acquired the company, installed new management (Bob Nardelli, deposed for good reason former CEO of Home Depot), and started a turnaround plan. The Chrysler case will be the subject of a follow-up analysis on this site in the coming weeks. Many of these acquisitions were made famous in the 1980s as hostile takeovers, so-called because the existing Board and management resisted the acquisition directly from shareholders. Considering that this is the same Board and management that mismanaged the company in the first place, and were likely to lose their positions and income as a direct result of the takeover, their rejection was not exactly surprising.