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Skype Goes IPO - What Should Service Providers Do?

Last week’s news about Skype’s planned IPO brings a renewed focus on what constitutes a service provider these days, and perhaps more importantly, what forms the basis for its valuation? We all know how the advent of IP has turned the economics of telephony on its head, and the drivers of value continue to shift from the physical world of network infrastructure to the virtual world of software, the Web and now the cloud.

There’s little doubt that Skype’s continued growth has made them an attractive vehicle for investors. Having customers is key for any company’s success, and having lots of customers raises the bar on what success could look like. Skype doesn’t have everyone on the planet as a customer, but they’re as close anyone is likely to get. According to their S-1 filing, the current user base is 560 million, and this has increased by 163 million from last year. Although “users” aren’t true customers in terms of being paying subscriber or tied to contracts, anyone who can add this many in one year must be doing something right.

We all know that many “users” have multiple identities or aren’t really active, so a subset of this is needed to get a more meaningful read on what Skype actually has. One metric would be “connected users”, which averages out at 124 million per month. This is still a substantial community, although the majority is not using any paid services. In fact, the paid segment is a fraction of this, at 8.1 million.

While 8.1 million is a far cry from 560 million, Skype generated $406 million in revenues during the first half of 2010, and with this being a 25 percent bump from 2009, the company is on track to hit $1 billion in revenues next year.

In some ways, Skype has the best of both worlds. They are generating decent revenue from a small portion of their base with hardly any marketing expense. On the other hand, free is hard to beat, and they keep building a massive user base from which they keep trying to upsell. This is a very different model from conventional service providers who only offer paid services, and do not have a feeder pool of free “users” they can convert to paying subscribers. Of course, their operating expenses are much higher than Skype, and they could never survive on the relatively small ARPU that Skype generates from their calling services.

Skype hasn’t yet become very profitable, and the thinking is by going public they’ll have enough working capital to find new ways to increase ARPU, develop new revenue streams, and convert more free users to paid. Whether the $100 million they expect to raise will be enough is open to debate, but I see their IPO as being a strong validation for a new model and a different kind of service provider.

Of course I’m using the term “service provider” loosely, since Skype is Web-based and has little control over the last mile connection. Their technology is not as open as other operators, which limits their ability to interwork with other user communities and achieve a more universal federation to grow the user base. Furthermore, their ability to extend Skype beyond desktop telephony depends heavily on partnerships with other operators and vendors. Skype may have strong brand recognition, but little leverage when it comes to entering new markets from a position of strength.

Two such scenarios were noted in their IPO filing. One is their dependence on smartphone vendors—primarily Apple—to get Skype featured as a downloadable application. This can provide a broad entrĂ©e into the mobile VoIP market, but only to the point that the vendor feels it is worthwhile. There is no exclusivity here, and the vendors are free to offer other comparable services or even limit the features that Skype can provide.

The second scenario would be the partnerships Skype has developed with wireless carriers. Verizon is the most notable here, and again, there is a delicate balance that both parties must strike. Verizon will gladly support Skype so long as the relationship helps retain subscribers, drive network usage, and develop new sources of revenues. However, once Skype starts to cut into established revenues, they become more of a competitor, at which point the relationship can sour quickly.

As such, Skype does not hold all the cards, but neither does anyone else. With the right partnerships and market positioning, Skype has many paths to growth. Their user base is attractive to any operator, especially those seeking global coverage. Skype recognizes the challenges of growing in both the video market and the business market, both of which are large untapped opportunities. Video already accounts for 40 percent of their calls, but they have not yet been able to monetize this. The fact that they’re considering subsidizing free video calls with advertising says a lot about how important this opportunity is to them. In the early days, this would never have been an option, but the stakes are higher now, and market forces may leave them little choice.

Skype certainly has an attractive product mix, and with such a large user base, their main challenge is mainly around market positioning and creating the right business models to capitalize on their strengths. This is a very different problem set from what conventional service providers must contend with, and whether Skype goes it alone or as a complement with other operators, their IPO should give them enough resources to get to the next level. Skype is certainly not going away, and as these pieces come together, they will start to look more and more like more like these operators. At that point, service providers will have some complex decisions to make, and depending on where Skype is having success, they may well end up working more as equal partners than being a minor add-on to stay competitive.

This article of mine originally ran on Friday in my Service Provider Views column on TMCnet.

By Jon Arnold, Principal, J Arnold & Associates

Jon is also co-founder of Intelligent Communications Partners that focuses on the smart grid space.

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