Skype IPO Illustrates Growth Potential of New Markets

Story by Steve Wunker
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Today’s filing by Skype of a pre-IPO S-1 contains volumes of interesting data about the company’s potential to tackle new markets. On top of the company’s present accomplishments (among them — 560 million registered users and 1H 2010 revenues over $400 million), the firm seems to have tremendous growth potential.

That growth will come in ways distinct from how the firm has often touted growth in the past. At 560 million, the company’s user base has limits on how much further growth is feasible given the total penetration of PCs/Internet cafes, and limited appeal of the service to people lacking the occasion to call overseas. Rather, growth can come through monetization. With current paying users spending around $8 per month, there is ample potential for these sums to increase, even compared to typical spend of heavy cellphone users in emerging markets. Less than 2% of Skype’s users currently provide revenue to the company, providing vast headroom to expand.

Revenue potential lies not only in the ability of Skype users to call from their PC to phones for a small fee, but also in areas such as:

• Exploiting high-bandwidth cellular networks to undercut traditional tariffs for mobile calls
• Embedding Skype functionality in a broad range of consumer electronics, allowing easy communication and sharing (the firm already has deals with LG, Panasonic, and Samsung)
• Integrating live talk with the web, for instance through click-to-Skype services on e-commerce sites
• Advertising to a network that rivals Facebook’s size (users spent 152 billion minutes on Skype last year)
• Upgrading users to value-added services (currently the firm gives away Skype-to-Skype video calls, resulting in an astonishing 40% penetration, but group video calls are targeted for premium pricing)
• Creating business applications to integrate Skype into the workplace, e.g. through linking it to the corporate PBX or displacing conferencing vendors like Webex

Skype has a business model which provides unique advantages in these quests. It plays “over the top” of existing telecom networks, leveraging their enormous sunk costs in infrastructure and exploiting networks’ temptation to fill use this infrastructure as much as possible, even at cut rates (this is why there is such a disparity between voice and data tariffs on traditional networks). Skype’s own infrastructure is distributed and largely peer-to-peer, creating a distinct cost advantage against established players. Furthermore, many of its services are paid by users in advance, lowering the firm’s need for working capital. Finally, some telecom firms rank among the world’s largest advertisers, but Skype has very modest marketing costs.

In short, this is a very attractive business that seems to be seeing just the beginning of its full potential. Skype’s strong position provides several lessons about new markets:

• Network effects provide powerful advantages although they take time to build. The money is not in the network itself, but in what it can enable once it is deeply entrenched. Skype can monetize this network in a great many ways, and it seems impossible to displace
• Network effects are most enduring when they create both customer experience as well as cost advantages. While large telecom players also have network effects, these mainly create a superior cost position. Skype’s network also creates a superior content position (and their lean business model makes the large firms’ costs seem extravagant)
• Open platforms are one of the most powerful generators of new markets. As the railroad, electric grid, and Internet proved, a platform that facilitates invention can lead to all kinds of unexpected growth and new riches for the platform’s owner. Skype’s integration of Internet and voice communication is a powerful platform that the firm has recognized through creating an open toolkit for software developers
• The center of an industry’s profitability tends to shift during its evolution. In mobile communications, infrastructure vendors used to make a lot of money, then handset makers, then cellphone networks. Now Skype may grab a large share of profits through owning the customer and commoditizing other players

There is one downside for Skype. People who have studied the patterns of new markets should be wary of partnering with this firm, which may become a communications colossus. Although its profits may never rival those of the traditional industry, its global scale and ability to up-end industry business models threaten existing players in many ways. If these players hold back from partnering with Skype, its rapid advance may slow.

Even with this caveat, Skype’s future looks bright. Many observers have focused on the size of Skype’s network, but it is the headroom to monetize this network that is truly enticing.