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Skype files IPO – but its model is flawed

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Skype, the internet telephony service, has filed for an IPO on Nasdaq. Grown from entrepreneurial roots, the ever-popular Skype hopes to raise $100m in the offering, according to its filing document.

Skype’s IPO is a milestone for the entrepreneurial company. Skype reported a net loss of $417.5m in 2009, and isn’t expected to turn a profit this year either. Will investors bite?

Since launching in 2003, Skype’s user-base has increased every year. In the past year alone, the number of registered users ballooned by more than 40 per cent, from 397 million to 560 million users. 

While revenues are also increasing steadily – in the first half of 2010 Skype reported revenues of $406.2m with a net profit of $13.1m – Skype has a problem: its model is flawed.

Based on a so-called “freemium” model, where Skype hopes that a percentage of its free users will also pay the company for extra services, it continues to be a risky model.

Of Skype’s 560 million users, 124 million users use it on a regular basis (at least once a month). Of these 124 million, eight million are paying users. This means that Skype has a conversion rate of around seven per cent – an acceptable level. But this also means that eight million users are effectively paying for or subsidising the usage of the remaining 116 millions free users.

What happens if even a small number of paying users switch to a rival product? This hasn’t happened yet (despite new rivals entering the market place, such as Google Voice), but it could leave Skype in a precarious position.

Skype was founded by Niklas Zennstrom and Janus Friis in Luxembourg in 2003. Skype offers free calls between users but charging users to connect to landlines and mobiles. It was the first real peer-to-peer calling system to gain significant traction, hosting 12 per cent of global international calls, with 23 million users online at peak times.

Ebay bought Skype in 2005 for $2.6bn, but is generally considered to have bitten off more than it could chew, selling 65 per cent of the company last year to investors including Index Ventures, Silver Lake, Draper Richards, Bessemer Venture Partners and Mangrove Capital.

Since then, investors have largely expected Skype to go through with an IPO. Speaking last April, eBay president and CEO John Donahoe said: “Skype is a great stand-alone business with strong fundamentals and accelerating momentum. 

“But it’s clear that Skype has limited synergies with eBay and PayPal. We believe operating Skype as a stand-alone publicly traded company is the best path for maximizing its potential. This will give Skype the focus and resources required to continue its growth and effectively compete in online voice and video communications.”

In line with Donahoe’s comments, the company has made it clear that the sky(pe)’s the limit, with a set of ambitious development plans.

Skype hopes to implant its services into televisions and mobile devices – and in fact has already formed plans to partner with companies such as Verizon Wireless, Panasonic, LG and Samsung. Skype also has an app for the iPhone offering free Skype-to-Skype calls over WiFi.

But again, we think Skype’s model is flawed – there is a significant risk that somewhere down the line, it could lose a part of its paying user base, which would significantly impact the freemium model, based on economies of scale.

Will Skype raise $100m in its IPO? Of course it will. Is it necessarily a good long-term investment? We’re not convinced.

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