5 Reasons I Won’t Be Investing In Skype’s Anticipated 2011 IPO

It’s one of the hottest and most anticipated IPOs of 2011, and in our wireless technology and communication-driven lives, it could raise a tremendous amount of capital and support. But does that mean it’s a good investment?

Skype Technologies S.A., a Luxembourg-headquartered packaged software and VoIP software provider headed by former Cisco executive and YouTube board member Tony Bates, filed their ADR prospectus with the SEC in August of 2009 and sparked a flurry of interest from all corners of the investor playing fields.

The company is the epitome of the successful technology startup. Founded in 2003 by the same two Swedish Entrepreneurs behind Kazaa, the peer-to-peer file sharing program, Skype is a software application that allows users to make free phone calls over the Internet, and the growth has been so explosive it could make a Facebook founder’s cheeks blush.

There were a total of 276 million registered users by just 2007, about 400 million by the end of 2008, and today, Skype has logged an estimated 560 million individual accounts.

Lest the dot-com bubble just a decade ago, now would be a good time to remind ourselves and other technology investors that relentless growth is not always an indication of a bulletproof opportunity.

Here are 5 reasons why I won’t be investing in Skype when shares hit the public market:

The business model is fundamentally flawed. Let’s be realistic and put Skype’s business model into perspective. For more than 100 years, companies that go public offer a product or service in exchange for an explicit fee. In other words, if you plan on buying a car from Henry Ford, you’re already expecting to pay X number of dollars before you even approach a salesman. Skype’s business model is counter intuitive to the fundamentals of a solid business plan.

The principal software offering from Skype is called Skype Out, a free video, chat, and VoIP conferencing platform that allow users to make international and local calls with anyone, anytime. The revenue model is based entirely on up sales. For a monthly fee that totals around $96 a year per user, the company offers premium support and video chat services. That’s a unique and in many ways successful business model that indeed many of the most popular companies on the Web are exclusively built on, however, we saw what happened in the Dot-com boom and bust. Public Internet-based companies who were embracing the “freemium” model soared in valuations then crashed and burned when the party was over.

There’s no guarantee Skype will ever release anything worth paying for with even modest popularity. Now, that’s not a bash on users who are currently paying for their Skype services. But the conversion rates the company releases as part of the IPO registration process aren’t exciting me. Of Skype’s estimated 560 million users, only 1.4% pays for its premium services. Even more challenging for the company, only a small portion of those registered users are active users, categorized by those that use the service, on average, once a month. If the company cannot entice or encourage the non-active to use the service regularly, their chances for new revenues suffer.

Likewise, its nerve wrecking to think of the damage those 7.8 million users who are active and paying for their premium services could do if they simply decided to stop paying for Skype. Granted those paying users will come to Skype’s defence with the benefits they enjoy – the saved money from traditional phone bills, the ability to video chat with friends, family, and colleagues, etc – but I’m not convinced the revenue stream is all that protected.

Competition is heating up – and fast. Google already offers completely free video chat and conferencing services and Google Voice, a free VoIP client available through its Gmail platform. Sure there’s no support, but who cares? I have used both Gmail and Skype frequently and for quite some time now and have never once had to troubleshoot an issue. Google is well capitalised to complete with Skype anyway. The search behemoth recently bought Global IP Solutions, a company that sells voice and video VoIP conferencing hardware and software for $68 million – 68% of the proposed $100 million Skype will attempt to raise with its IPO – in cash. Anything you can do, Google can do better.

Skype’s technology is under fire. In the days leading up to Christmas 2010, hundreds of millions of Skype users opened their laptops, set up their cameras, then logged onto the chat client to connect with friends and family – and couldn’t. For days, Skype engineers scurried to identify a bug that caused a massive outage, and on the Christmas Eve, slowly began to put bring the service back online. The company hit the press citing faulty “super nodes”, a vital connector that ties together all of the computers Skype’s chat and VoIP technology relies to run on, as the source of the colossal failure.

Adding insult to injury for Skype, in the days following the outage, a company called Gradient Enterprises filed a patent infringement suit against the company in New York relating to the super node network Skype employs to run its software. Who knows what could happen with that; just add it to the list of enormous challenges facing Skype. The company practiced some credible damage control by offering vouchers to its paying users as a condolence for the outage, and I think that was a sufficient move. It’s understandable – after all, outages happen, right? But just because I accept that widespread product malfunctions happen doesn’t mean I’ll be investing in them.

The numbers just don’t add up. For the fiscal year ended in September of 2010, Skype reported revenues of $830 million, which is pretty impressive considering the weak conversion rates for paying vs. free customer usage (optimal conversion rates for these kinds of companies is said to be somewhere around 5-8%, compared with Skype’s 1.4%). However, the gross margin is a measly 20% as the company only pulled in $170 million before interest, depreciation, taxes, and amortization. Should the company take a hit to paying user loyalty or expensive fees relating to super node legal battles, that margin could get pummelled. With no other products to sustain the bottom line, so too would the stock price.

The case for sustainable and profitable growth from a public company like Skype looks uncertain. With cutthroat competition coming from well-funded and established VoIP and mobile communications technology players, a one-way and vulnerable revenue model that relies too heavily on a single product and offering that has no assurance of actually being paid for, and legal battles swooning around the company’s primary technology driver, this is one IPO I’ll be watching from the sidelines.

NOW WATCH: Tech Insider videos

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.