Mercator Capital is a privately-held investment bank focused on mergers & acquisitions, private placements, and strategic advisory services. Mercator's IP Communications Newsletter is a monthly analysis and commentary on the major business stories impacting the convergence of voice, video, data, and wireless communications.

1. Spring VON 2006 – Where IP is Headed

The 2006 edition of Spring VON took place in San Jose during March 14-17. VON – Voice on the Net – is the premier conference focused on VoIP and the broader spectrum of IP communications. Jeff Pulver is the creator of VON, and this show is widely viewed as the bellwether of the state of VoIP and where it is headed. The VON conference is entering its 10th year, and its longevity is a testament to Jeff Pulver’s commitment to this market, along with his multifaceted activities as a guru, innovator, investor, entrepreneur and tireless advocate of all things IP.

For the investment community, VON has become an increasingly important event. Most telecom conferences are primarily trade shows, geared around bringing buyers and sellers together. That element exists at VON as well, but the event is equally driven by content, with a focus on thought leadership and emerging technologies. As a result, it has become a showcase event for IP-related launches, announcements and demonstrations.

This is a conference where you see a lot of startups as well as established IP-based companies looking to strengthen their ecosystem of partners. These elements combine to make VON attractive to bankers and VCs, as they get a chance to meet directly with early stage companies and hear from the leading exponents about the latest trends shaping the industry.

For anyone attending Spring VON, the first thing that stands out is the scale of this year’s show. The 2006 Spring show was their largest ever, with over 320 exhibitors, and reportedly more than 8,000 attendees from over 50 countries. This may be modest compared to monster shows like Globalcomm/Supercomm or ceBIT, but for a show with a pure focus on IP communications, the size was quite impressive.

Riding the IP convergence wave, the last few VON events have become increasingly bigger, and the company itself, Pulvermedia, has undertaken its own aggressive expansion campaign. Previously, VON events were mainly based in the U.S., with just a few others in Canada and Europe. In 2006, Pulvermedia has ramped up considerably, and is staging VON events in Mexico, across Europe, Russia, China and Japan.

If there were one message to focus on for the show, it would be the rise of video as the trend driving IP in 2006. As Jeff Pulver noted in his opening address, the “V” in VON may soon give way to video instead of voice, which has been the essence of VON from the beginning. VoIP has certainly come a long way. In much the way IP has transformed the business of voice, Jeff’s message was that IP is doing the same thing now to the video and broadcasting sector. This has fundamental implications on many levels, posing real threats to the established players, but also creating opportunity for savvy companies that understand IP’s potential. Two notable examples at the show were Sling Media and Brightcove, both being fairly new companies that are now attracting both capital and interest from early adopters. Building on this, it will not be long before a host of other startups will follow with businesses built around IP and video, and several will no doubt have merit.

A related theme of note at the show was the focus on Web 2.0 and how the Internet has matured to the point of becoming the platform of choice for a new generation of businesses. Tim O’Reilly is the Jeff Pulver of the Web 2.0 world, and his conferences have become core destinations for the latest visions from Google, Microsoft, Yahoo, etc.

At VON, Tim spoke about Web 2.0 success stories like Amazon, eBay and iTunes, explaining how they are really in the information business, and they understand how to harness the Internet to create value around this premise. Voice in his view is really no different, and the likes of GoogleTalk are just the earliest examples of how Web 2.0 and Voice 2.0 will become intertwined sooner rather than later. For investors, the key is to find companies that truly understand these principals, as the market has moved beyond the simple click-through models we have seen to date.

Aside from these high level trends, Spring VON was also a valuable forum for the latest thinking on other issues driving IP communications in 2006. Net neutrality was the most topical subject, and VON showcased two important voices, namely Stanford Law Professor Lawrence Lessig, and Qwest CEO Richard Notebaert. This is a watershed issue for the IP sector, and will have far reaching implications once the FCC issues its policy decisions. Both speakers presented positions of fairness with the main concern being that carriers should not have a totally free hand in controlling both access to services and the unimpeded delivery of these services to subscribers (also known as Internet Freedoms). If this comes to pass, the investment prospects for IP will be much brighter, and our view is that longer-term positions in this market should be contingent on which side of the fence the FCC comes down on.

A final thought on Spring VON is whether or not the IP sector has peaked. Clearly, the size of the conference speaks volumes for the health of this sector at present. As the focus shifts from voice to video, and IP continues its march across all modes of communication, the case can be made for more growth ahead. On the other hand, as one surveys the sea of vendors exhibiting there, and the lack of IPO activity among IP-based companies, it is difficult to see how they can all be sustained. Barriers to entry remain low, and startups continue to make noise about being the next Vonage or Skype.

The AT&T/BellSouth merger will trigger further consolidation among carriers, which inevitably will spill over to the vendors. This is a recipe for market contraction, not expansion, and unless Vonage has a very successful IPO (and their prospects are getting weaker), many of these vendors will either exit or need to fold in with more established companies. In short, we would exercise caution on the investability of this sector despite the sheer number of companies vying for attention.

2. Place Shifting – Latest Disruptive Force in Broadcasting

Going back to the early days of the VCR, broadcasters have had to accept the reality that they could not maintain 100% control over their content. If the VCR was TV 1.0, TiVo became TV 1.5, with the advent of time shifting. As much as TiVo was a breakthrough development, it still kept viewers tethered to their TV sets, much like the desktop phone or PC has kept people tethered to their workstations. In the last couple of months, we have seen the emergence of place shifting, which takes us to TV 2.0, especially in the sense that it owes its existence to the broadband revolution.

The paradigm shift that makes this so disruptive is that control over content is slipping further away from broadcasters as the focus moves from viewing TV any time to viewing it anywhere. Subscription-based access to live TV has been available for some time, but place shifting is far more profound as the broadcasters are cut out of the loop beyond providing the original content to the home cable feed.

Sling Media is the company creating the most attention around place shifting, but there are others as well. First off, Sling Media is noteworthy for attracting capital. On January 31 they announced a new round of funding - $46.6 million. Aside from this being a large amount for a small company, most of the raise came from two media companies – EchoStar and Liberty Media. Media companies are interested in Sling Media because they essentially enable a new channel for content providers to reach viewers.

Their product is called the Slingbox, and it is rapidly growing in popularity. It sells for about $250 and is available in over 3,000 retail outlets. They have sold well over 100,000 units, and have caught the attention of Jeff Pulver, who has become one of their biggest fans (see Spring 2006 VON article in this issue). On March 30, Slingbox became commercially available in Canada. Perhaps most significant of all, on March 23, they announced SlingPlayer, their beta program for mobile access over wireless networks.

Sling Media is a great example of a company that understands the opportunities arising from the anyplace, anytime possibilities of broadband, combined with our ever-increasing mobility. The Slingbox allows viewers to tap into their cable feed remotely over a broadband connection, to either watch live TV, or to access their TiVo or DVR stored content. Being hardware-based, there are no fees involved – just buy the Slingbox and use it any way you like. Considering how much Cisco spent to acquire Scientific-Atlanta, the stakes are clearly getting very high for devices that enhance the viewing experience. Sling Media is betting there is a market for people who want to view TV outside the home.

That said, there might be a limited window for Sling Media as a standalone offering. As adoption grows, set top OEMs will recognize the power of this technology, and develop their own version that is built into their box – or simply acquire companies like Sling Media. It is not difficult to see how Sling Media would be attractive to the likes of Sony, Motorola or Cisco, not to mention the lead investors in their current funding round. Just as Tivo innovated by creating the first DVR functionaility, their solution was quickly integrated by both set top box makers as well as network-based DVR solutions turned Tivo's innovation into a commodity. The same fate could be in store for Sling Media.

Two other companies vying for share in the place shifting market are Orb Networks and SnapStream Media. Each has its own variant on the technology, but unlike Sling Media, these are software-based offerings that are not standalone solutions. Being a single product, the hardware-based Slingbox may be easier for people to understand. Also, given the importance of mass-market retail channels, this may provide an inherent advantage for Sling Media over these alternatives. Conversely, the advantage of a software-based offering is that it can be more easily white-labeled, making it easier to work with for pursuing wholesale routes to market. Sling Media also has both existing and pending patents, which should help create first-mover advantage when the OEMs decide they are better off to buy than build their place shifting technology.

It is also important to note that the mobile market is a wild card in the place shifting growth story. Mobile operators have not welcomed the likes of Sling Media because there is no revenue for them, and video consumes vastly more bandwidth than voice, email or SMS. It is too early to tell if Sling Media’s mobile offering will succeed, as the carriers have their own plans for fee-based video and TV content. There are several competing forces at play here, but the underlying technology is too compelling to hold back.

At the surface, the current place shifting approaches that these companies are taking seem inherently inefficient. They are essentially adopting a point-to-point approach to accessing content, yet this content was originally delivered (and potentially stored) in a point-to-multipoint (broadcast) configuration. Longterm, will it make sense to have these complicated workarounds to accessing content remotely, or will network providers simply integrate the tools into their centralized network to let consumers access content any time and any place? We will continue to monitor the place shifting space as we recognize the opportunity and potential for companies who are in the right place at the right time.

3. Mercator Spotlight: Kayote Networks

As an occasional feature, we turn our focus to an up-and-coming company that is showing promise and leadership in the IP communications sector.

As many readers are aware, within the VoIP sector, peering, interoperability, and security have become topics of great interest as both carriers and enterprises struggle with the practical real-world challenges of migrating voice traffic to IP networks. Israel-based Kayote Networks is one of several companies focused on these exciting new areas, and their technology has evolved to the point where they can now offer practical solutions for service providers of all sizes.

Kayote Networks was founded in 2003, by several VoIP industry veterans from Deltathree and IDT, who started out offering voice termination services to VoIP service providers and resellers. Over time, the team realized that most service providers, especially those with limited IT resources or those new to the voice business (such as cablecos or Internet telephony service providers / ITSPs), lacked the expertise to properly address issues around VoIP interoperability and security. Not only was there a fundamental lack of understanding, but a lack of recognition of the vulnerabilities that arise with VoIP.

Kayote continued to operate its primary business, VoIP termination services to over 500 carrier partners, as a way to gain valuable insight on the real-world issues to operating a VoIP network. However, the team quickly realized that this priceless expertise was better offered as a packaged service to its carrier customers, and as a result, in 2005 Kayote made the strategic decision to build their business model around this opportunity, from which their flagship VoIP Traffic Management platform has emerged.

The VTM platform has been developed around three related problem sets that Kayote sees as being integral for service providers as they interconnect VoIP traffic with each other.

1. Interoperability - This is the most fundamental requirement of peering between networks. Protocol conversion is one element, and includes variants within one protocol (SIP to SIP), as well as across different protocols (SIP, H.323 and MGCP). Transcoding is another key element of interoperability, and relates to the DSP-intensive processing required when voice traffic goes from one codec to another, such as G.711 to G.729. Finally, NAT (Network Address Translation) traversal must be facilitated for voice traffic to enter an IP network in packetized form. These are all necessary conditions for interoperability between voice networks.

2. Security - Most carriers believe security is simply limited to installing a session border controller in their network. However, VoIP security much more than just a firewall to protect the network from untrusted or unknown sources. Aside from this, VTM addresses many other important security elements, such as topology hiding, denial of service (DoS) prevention, stateful packet inspection, intrusion detection and SPIT (spam over Internet telephony) detection.

3. Peering - Once the groundwork has been laid for a clean handoff of traffic, the peering process itself must be managed. This primarily involves ENUM services (Electronic Number Mapping), as well as policy enforcement. The latter becomes increasingly challenging as the number of networks peering with each other grows. To ensure consistent peering policies, carriers are federating with each other for a common framework to exchange VoIP traffic.

In developing VTM, Kayote quickly learned that a hosted business model was the best way to leverage both their expertise, as well as their network investment. Their hosted model allows Kayote to build and operate a superior network architecture and at the same time support a greater number of customers. They were able to architect a fully redundant, geographically disperse, high availability network that contains the key network elements necessary to manage a world-class VoIP network, but may be cost prohibitive for smaller carriers. By focusing on the areas of interoperability, security, and peering, Kayote has built a solution that is unique in the industry and is quickly gaining high visibility.

VTM became commercially available in January 2006 and Kayote has already signed up over 10 carrier customers. Their most visible win is as a partner to Xconnect for the landmark cable VoIP peering win in the Netherlands (see February 2006 issue, Art of the Deal). We understand that Kayote is in trials with numerous other carriers as well, and we expect several other high profile announcements in the coming months.

One of the strengths of Kayote's hosted model is its appeal to all sizes of carriers. VTM is very economical for small carriers, as they typically cannot justify the infrastructure investment required to achieve this level of VoIP interconnection on their own. Partnering with Kayote enables carriers to start peering right away without the ramp-up time associated with learning the lessons the Kayote team has already learned, hence immediately reducing their transport costs and broadening their service reach. The value proposition is further extended since Kayote takes care of any new security or interoperability issues that arise over time, allowing the carriers to focus on running their business, and not worrying about their VoIP networks.

Large carriers can also benefit on a more practical level. At present, VoIP peering accounts for just a small percentage of their overall traffic, and most of this is with smaller carriers whose networks they are not familiar with. Since VoIP peering is new to them, these carriers would need to devote an inordinate amount of IT resources relative to the traffic volume in order to effectively address the complexities involved. VoIP has been described by one carrier as "only 5% of my traffic, but 95% of my problems". In Kayote’s view, their hosted model is simply a better business decision in these cases.

Aside from Kayote gaining rapid market acceptance, we have also taken note of several other positives that are the makings of a market leader. Tangible evidence can be seen in the form of recent industry awards, namely:

• VoIP Magazine – 2006 Top 20 Companies to Watch
• Red Herring – Top 100 European Technology Companies
• Pulver 100 – 2005
• Internet Telephony Magazine – 2005 Product of the Year

In terms of innovation and intellectual property, Kayote filed four patents and provisional patents in 2005, and have patented solutions for secure distributed ENUM and server-side NAT detection. They have also partnered with Check Point Software and XConnect to form the SPIT Prevention security initiative (www.spitprevention.net). Kayote was one of the first security vendors to recognize the threat posed by SPIT, especially in terms of lost productivity. Unlike email spam, voicemail spam can be a real time-waster, as the recipient must listen to every voice message to determine its validity. SPIT has yet to manifest itself as a true problem, but the potential is too important to ignore.

Finally, at the heart of the company is a solid and seasoned management team. The co-founders, Dr. Baruch Sterman (CEO) and David Schwartz (CTO) were senior figures at deltathree, one of the true pioneers of VoIP. Rounding out the team is Michael Fischberger (COO), the former COO of IDT, yet another VoIP pioneer.

Taken together, we believe Kayote is well positioned to capitalize on one of the emerging hotspots in IP communications, and we'll continue to watch them as 2006 unfolds.

4. Art of the Deal: AT&T and BellSouth

Once again, AT&T sets the standard for being in the middle of events that truly transform the telecom landscape. To quickly recap, on March 5, news came about the biggest telecom deal since the breakup of AT&T in 1984 – AT&T’s acquisition of BellSouth. ATT’s 1984 monopoly breakup was certainly the most significant story in the history of telecom, as it gave birth to the Baby Bells, which eventually settled out into the four RBOCs who have dominated American telecom up until very recently. Perhaps more significantly, the deregulation of telecom unleashed an era of competition, investment and innovation that continues – more or less – to this day.

As the telecom marketplace evolved around these new forces, AT&T’s historical strengths become liabilities, and in an ironic twist, the company was acquired last year by one of its offspring, SBC. The very idea would have seemed incredulous two years ago, when AT&T aggressively launched its national CallVantage VoIP service, and looked poised to build on its strong brand to keep upstarts like Vonage in check. In both these examples, AT&T was again breaking new ground for incumbent carriers.

The pattern continued with the BellSouth news, and with this acquisition, AT&T is effectively coming full circle as a dominating force again in telecom. In the space of two years, they have gone from being the dominant U.S. interexchange carrier, to being a tired brand with few options, and now to becoming a heavyweight again, approximating the old Ma Bell we grew up with for generations.

SBC may have acquired AT&T, but it is the AT&T brand that has lived on, and in fact was recently updated with a splashy rebranding campaign. Now, they have turned around to become a buyer, and with BellSouth, the new AT&T has become a truly formidable force. Valued at $67 billion, telecom deals do not come any bigger than this. The BellSouth brand goes away, and to offset this, BellSouth shareholders will receive 1.325 shares of AT&T common stock for each common share outstanding.

Dollar value aside, consider the numbers in terms of the new AT&T’s total market reach and subscriber base (as of Q4 2005):

• Wireline – 69.4 million
• Wireless – 54.1 million
• DSL – 9.8 million

In all these areas, AT&T would now be well ahead of their closest rival, Verizon. The BellSouth acquisition gives them 100% control over Cingular, which was previously shared with SBC. AT&T’s broadband coverage would become the world’s largest, surpassing all the MSOs, including market leader Comcast.

By combining forces, AT&T estimates there will be an annual savings of $2 billion – but it is not clear yet how that will actually occur. In terms of leadership, Ed Whitacre, who was the main driver behind this deal, will remain CEO of AT&T. Their headquarters will remain where it is now, in San Antonio, Texas. All of these items, of course, are contingent on FCC approval, and so far the regulators have been quiet. Concerns have been raised by consumer protection groups, but recent FCC rulings have been pro-incumbent, suggesting that the deal will go through.

As to the question of why for this deal, wireless looks to be key factor. Although the new entity would have more wireline subscribers than wireless, the latter is the main asset, as this is still a growth market, in terms of both subscribers and revenues. AT&T already had one piece of Cingular via SBC, and the challenges of sharing the other piece with BellSouth was a major reason for the deal. Acquiring BellSouth actually brought two important businesses under one roof that were previously shared with AT&T – Cingular and YellowPages.com. Each of these lines of business are attractive in their own right, but having control of them all creates powerful bundling opportunities that will allow AT&T to compete successfully against the cablecos.

Will this deal be good for consumers? That really depends on how the rest of the industry responds. A deal of this size does not exist in a vacuum, and there are numerous implications for other carriers and vendors who need to keep pace. First and foremost is Verizon. This deal effectively reduces the U.S. telecom market to a two horse race – AT&T and Verizon. On the wireline side, the natural move would be for Verizon to acquire the last remaining RBOC, Qwest. Perhaps more important is the wireless business, where most signs point to Vodafone. Either Verizon buys back their 45% stake, or they make a deal to bulk up with Vodafone and take on Cingular as one entity.

On the VoIP front, the deal has implications for the two largest pureplays, Vonage and Packet8. With the combined footprint of SBC and BellSouth, AT&T is well positioned to focus again on CallVantage and support it on a large scale. This can only mean more intense competition for Vonage, as AT&T will now be able to bundle VoIP much like the cablecos do, especially once IPTV comes on stream. Packet8 also appears vulnerable, as they had recently made a deal to white label BellSouth’s VoIP service. It seems inevitable that this will give way to CallVantage once the dust settles.

Finally, on the vendor front, there are implications from having one less carrier to sell to. The incumbents, Nortel and Lucent are most directly affected, but so is Alcatel, especially for IPTV. It is natural to expect that carrier consolidation will lead to vendor consolidation, and this could even give rise to moves by Asian vendors like ZTE and Huawei, who are determined to crack the North American market.

Many scenarios are possible here, and we fully expect that the fallout from the AT&T deal will provide material for a number of upcoming Art of Deal features.

5. Financial Highlights