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Microsoft Corp (MSFT) announced that it has entered into a definitive agreement for the acquisition of Skype for $8.5 billion in cash. The boards of directors of Microsoft and Skype have approved the deal and the two companies expect to obtain regulatory approval before year's end.

Skype will operate as a separate business division and its CEO Tony Bates will remain at the helm, reporting directly to Microsoft CEO Steve Ballmer.

A number of companies, including Google Inc (GOOG) and Facebook have been considering the purchase, which is probably the reason for the extremely attractive offer.

Skype owners eBay Inc (EBAY) with its 30% share, co-founders Niklas Zennstrom and Janus Friis with their 14% stake, and Silver Lake Partners, Andreessen Horowitz and the Canada Pension Plan Investment Board (CPPIB) with their 56% percent stake, have been eager to sell off Skype after its IPO got delayed.

Goldman Sachs Group Inc (GS) and JPMorgan Chase & Co (JPM) acted as advisors for Skype, Microsoft’s advisors remain undisclosed.

Microsoft gains because...

The company now has access to Skype’s peer-to-peer networking technology, which could help revitalize its collaborative capabilities. Skype’s voice, video and sharing technologies would complement Microsoft’s Lync, which is an application integratingits email, instant messaging and voice communications.

Microsoft stated that Lync grew 30% in the last quarter. In the enterprise market, the acquisition could improve its competitive position versus Google and/or Cisco Systems (CSCO). In the consumer market, it would help connection with other Microsoft communities, such as Xbox Live, enhancing interaction between users. The Skype brand name could also be beneficial.

Microsoft has also lagged Google and Apple Inc. (AAPL) in the smartphone segment. Google Voice and Apple’s soon-to-be-launched Facetime indicate that Microsoft is really far behind in the race for mobile collaboration. Although the company has introduced an attractive OS (Windows Phone 7), it has not seen any significant market share gains.

Microsoft also partnered with Nokia Corp (NOK) to increase penetration, but Nokia has its own problems and significant revenue contribution is not on the horizon yet. Skype immediately gives Microsoft a competitive offering.   

Skype brings a huge customer base, which is currently estimated to be 170 million. Moreover, customers range from colleagues to family, friends and social contacts, making the platform ideal for Microsoft’s web-based offerings.

Of course, there is also some risk...

Microsoft’s position versus telecom carriers becomes a bit cloudy. While it is a fact that some carriers are thinking of partnering with Skype as they transition to LTE-based networks, they are fully aware of the threat the technology brings. Skype’s technology enables free calling from computer to computer and on some phones.

If Microsoft brings a version for its Windows Phone 7, they could essentially enable users to make free calls through IP networks without paying the carriers anything. Integrating this into Windows Phone 7 could make the OS more attractive, but it would probably increase resistance to Microsoft phones, since it could result in a loss for carriers. Therefore, there is a real chance that Microsoft would lose out despite a significant product enhancement.

Skype has not been doing well financially. The company has been around for eight years and has generated little profit in all that time. In 2010, Skype generated just $264 million in operating profit and $7 million of net losses on revenue of around $860 million. Debt levels are very high at around $686 million.

Another concern is that Microsoft, with its sprawling operations and bureaucracy, could scare off the opportunistic engineering talent that remains at Skype. If the company does not keep up the pace of innovation at Skype and instead tries to integrate it into its own system, much of the advantage related to the technology would be lost.

Moreover, Microsoft needs to continue supporting Skype on all platforms -- even if they belong to a competitor -- if Skype’s appeal is to be sustained despite the obvious pull to integrate. Microsoft’s success with the acquisition will depend on its ability to strike a balance.

The acquisition does look very expensive. It is the largest in Microsoft’s 36-year old history (Microsoft has not been a great acquirer, it has acquired few companies and has usually not reaped a whole lot of benefit).

Conclusion

We think the odds are fairly balanced, so a lot will depend on execution, i.e. what Microsoft does with the acquisition. Whatever the outcome, Microsoft has taken a serious initiative, which is likely to determine its web and mobile image in the near future.

The deal value does come as a surprise (Skype was looking to sell for $5-6 billion). But big acquisitions seem to be the rule of the day, what with Intel Corp (INTC) picking up McAfee and Texas Instruments (TXN) grabbing National Semiconductor (NSM).

We note that while Google shares have appreciated just slightly and Microsoft has been edging down, eBay shares are appreciating nicely at the prospect of acquiring a chunk of cash.

The rating for Microsoft is Za#3, implying a Hold rating in the short term (1-3 months).

 
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