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. Genband Takes Switching Business From Tekelec

On March 20, Genband formally announced it was acquiring Tekelec’s ailing switching business for $1 million. At face value, this is too small a transaction to warrant an Art of the Deal story. However, we feel the deal speaks to the broader state of the switching vendor market and is worthy of discussion, especially given the fact that Tekelec had invested over $500 million into building this portfolio over the past few years.

The details alone tell an interesting story, whose roots go back to 2003, when Tekelec decided to diversify from its legacy business into the nextgen switching business. Over the course of a year or so, they made three acquisitions in this space – VocalData, Santera and Taqua. Tekelec was an established leader in the SS7 signaling market, and at the time, these moves appeared to give them a more complete solution that traversed both IP and TDM networks.

The acquisitions never really led to any tangible synergies, and Tekelec was never able to successfully integrate these distinct companies under one roof. Santera in particular was a challenge, given they had raised a substantial amount of venture funding, and had bet too soon on the Class 5 replacement market. Taqua had similar challenges, and VocalData was always considered a distant competitor to Broadsoft and Sylantro. In essence, Tekelec was an early consolidator, but they may have invested in the wrong properties, so we consider them fortunate to have found a buyer for such a nominal amount.

We see this deal as a handoff of assets from an unsuccessful consolidator to an aspiring consolidator, who may or may not have a better plan. Genband seems to be following Tekelec’s footsteps in pursuing the IP switching market, and they have an equally unconventional story to tell. Tekelec was largely known in the industry as a bottom feeder, having acquired companies who many consider weaker than other competitive offerings. It appears that Genband may be taking a similar approach, and this latest acquisition follows other deals over the past two years.

Previously known as General Bandwidth, this company has gone through its own transformation recently, also having made three deals with very different companies. Two were acquisitions – Syndeo and BayPackets, and one was a deal with Siemens – a long-running technology partner – to acquire their legacy Digital Central Office switching business. The only common thread we see here are various components that will help strengthen Genband’s IMS story across the full spectrum of service providers, namely wireline, wireless and cable operators. This is an ambitious agenda, but also necessary for a vendor of Genband’s size to remain competitive with the incumbent vendors as well as the other nextgen consolidators like AudioCodes and Cantata.

Where does this leave both companies? Tekelec may now better positioned than Genband, at least in the short term. The switching business reportedly lost $70 million in 2006, so it will no longer be a drain on Tekelec’s financials. Aside from gaining $1 million in cash for the deal, they also got Genband to assume an unspecified amount of their switching liabilities, and on the other hand gained a 19.9% equity stake in Genband. While the switching business may have generated $110 million in revenue last year, our assessment is that Tekelec has significantly reduced its risk, and still stands to benefit from any upside to Genband’s strategy via their equity stake. Going forward, Tekelec can return to their roots and focus on the core signaling business.

We are less certain about Genband. Their aggressive plans to consolidate all of these companies into a one-stop-shop IMS solution may be in line with market trends, but seems too heavily driven by financial objectives, namely a quest for an IPO. Genband was a $40 million company, so taking on the $110 million dollar switching business from Tekelec certainly bumps them up to another level, but we see considerable risk to this strategy. First is the simple issue of this being a money-losing business since there is no indication from Genband how they are going to turn this around. The deal is also coincident with an additional $15M financing round from Genband's investors, though this amount appears to be low given the unit's previous losses. Interestingly, Genband's CEO, Charlie Vogt, was also the CEO of Taqua, and then ran the combined Taqua-Santera switching business within Tekelec before leaving for Genband.

There are two other issues to consider here as well. Perhaps most important is the fact that a considerable amount to Tekelec’s switching revenues came from a long-standing reseller agreement with Alcatel-Lucent. This traces back to an early partnership where the SanteraOne media gateway was sold into the switching platform offered by Spatial Wireless, which was acquired by Alcatel. Longer term, however, this is a diminishing business, as Alcatel has been developing a wireless gateway of their own that would gradually replace Santera.

This brings us to the second issue, which also raises further questions about Genband’s strategy. Given Tekelec’s close relationship with Alcatel, there had been speculation about a potential acquisition of Tekelec by Alcatel. Since Tekelec has shed one of the key pieces of the business which could be attractive to Alcatel, perhaps both parties felt that such a deal was not in the works. This leads us to believe that the media gateway business with Alcatel-Lucent will likely become a very small piece of future business for Genband.

In addition, another incumbent vendor – Ericsson – was reportedly in talks with Tekelec about their switching business. This deal would have made sense by providing Ericsson with some strong North American business that had been lacking in their portfolio. Since it appears that they too passed on the Tekelec switching assets tells us that Tekelec's switching business may have limited value and more downside than upside.

All told, we see this deal creating a mishmash of businesses where the synergies for Genband are not readily apparent. In other words, Genband is becoming the Zhone of the VoIP world. It is not clear just how Genband will turn this switching business into a success beyond creating enough critical mass to warrant an IPO, which itself has been a risky proposition in the IP communications market. In our view, much of this rests on Charlie Vogt’s vision, not just to sell it to the underwriters, but also to create an end-to-end IMS solution that will resonate with the carriers.

To end on an optimistic note, there may be a silver lining in Verizon Wireless’s mega-announcement during CTIA of a $6 billion infrastructure spend. Genband has gateway business of their own with Verizon, but Alcatel-Lucent is the primary beneficiary of that deal, and perhaps Mr. Vogt knows something that Tekelec missed. Or maybe not. Only time will tell.

2. Microsoft Acquires Tellme

Acquisitions continue to be a dominant theme for 2007, and March was no exception. On March 14, Microsoft made its latest move by acquiring privately held Tellme Networks, in a deal estimated to be worth between $800 million and $1 billion – Microsoft’s fourth largest deal ever. Tellme has developed leading applications in areas that are fast becoming mission-critical for Microsoft, namely speech recognition and voice search.

Tellme was founded in 1999, and raised $239 million in its early days. They claim to be profitable and processing some 40 million calls per month on their hosted platform, which includes a 411 information search application. Given the reported purchase price, this represents an attractive exit for the company’s investors. This amount is also in line with what both Microsoft and Cisco are spending as they jockey for position to become the vendor of choice for enterprises converging their networks and adopting powerful unified communications platforms.

We see a few drivers behind this deal for Microsoft, but the key factor summed up in two words – mobile search. First off, this is an important space for Microsoft to achieve early success, as they have not been able to match Google in desktop search, where most of today’s action is. Mobile search is just opening up, so there is more of a level playing field here. Furthermore, the mobile market represents far more endpoints than the desktop market, and continues to grow at a healthy pace. As such, the market opportunity is enormous, and learning from how they missed out on the browser market early on, Microsoft is determined not to let this happen again. A speech-based interface is a natural fit for a mobile device since many phones have tiny screens, cumbersome navigation, and can be used in conjunction with a hands-free headset or in-car device when the user is multi-tasking.

With applications such as 411 information search, concierge capabilities, and subscription-based services, the commercial potential for Tellme inside Microsoft is easy to see. Voice-based search, whether offered by a carrier or a call center, creates efficiencies for both the caller and the provider, and when married with IP networks, opens up new possibilities for value-added services. Aside from the intrinsic benefit of the information provided by voice-based search, these services can make money for carriers in two distinct ways. One is simply on a user-pay basis, where callers either pay piecemeal or by subscription, and there are certainly business cases to be made for both. Secondly, Microsoft can build on the Google model by offering some services for free, but have them subsidized by advertising and sponsors.

In all cases, Tellme is really about selling services, which is something Microsoft does not have much experience doing. They are very cognizant of the emerging Software-as-a-Service (SaaS) model, and with Tellme, they have an ideal platform from which to gain this expertise. Microsoft currently offers a similar capability – Speech Server – but it follows the established model for all Microsoft products, and is licensed to the customer, and operated on premises. This is in direct contrast to Tellme, which is offered on a hosted basis. As the Web 2.0 world becomes more of a reality every day, Microsoft recognizes it can no longer rely solely on a productized offering that is sold on a licensed basis. Hosted models are fast gaining credence, and they have begun going down this road with limited offerings of Exchange and Office Communications Server.

Building from this out to the mobile market, the integration of Tellme with Microsoft Live Search will give them a strong position in mobile search, particularly among consumers. Microsoft has lacked the speech recognition capabilities of Tellme, and with the wide footprint of their mobile operating system, they can now provide wireless carriers with new tools to add value for subscribers. Complementing this will be mobile search for smartphone users, giving Microsoft added reach into the enterprise market, as well as deeper integration with their Unified Communications Server platform.

The biggest pure play in the speech sector, Nuance Communications, also made a similar move in February by acquiring Bevocal, another hosted speech provider, for $140 million purchase price on revenues of less than $30 million. Looking ahead, the M&A focus will now shift to next in line for speech recognition, and one cannot rule out both Google and Cisco, as both have good reason to keep pace with this move by Microsoft.

3. Mercator Spotlight – Parus Interactive

From time to time, we like to highlight interesting companies who offer a unique business or technology within the IP communications sector. Given the billion dollar Tellme Networks and WebEx deals highlighted this month, along with Nuance’s $140 million acquisition of Bevocal in February, we thought it relevant to focus the Mercator spotlight on Parus Interactive, a unique company that demonstrates many of the attributes of each of these deals.

Parus Interactive is a Chicago-based company that combines the capabilities of Tellme, WebEx, Broadsoft, and IP Unity into a single platform. The company also includes shades of old-world companies like WildfireCommunications, acquired by Orange in 2000, and new-world Web 2.0 companies like Sightspeed and Iotum, which have also received positive press in recent months, and were discussed in previous Mercator newsletters.

Parus Interactive was formed in 2001 through the merger of Webley Systems and EffectNet. Parus is a leading provider of hosted, speech-enabled unified communications solutions for the SMB market, and has won numerous awards for its unique technology platform, which has been developed from day one as an open standards-based carrier-class speech-driven unified communications and hosted VoIP platform for the SMB market. The company has invested over $50 million in its platform, which provides feature functionality equivalent to combining the capabilities of a VoIP feature server, an application server for audio, video and web conferencing, and a speech-driven interactive voice response (IVR) interface.

Parus originally developed its technology to focus on the tier 1 carrier market, and previously had contracts with many of the large carriers including AT&T, SBC, and Verizon. As a result, the platform was designed to be highly robust and scalable into the millions of users. Since 2002, the company has been focusing on alternative channels and vertical markets, and has achieved good success with year-over-year revenue growth and profitability. The company is particularly strong in the multi-level marketing vertical, where companies like Amway (now called Quixtar) use Parus’ platform as their exclusive communications platform of choice for its network of independent business owners. Parus has also achieved success in the mid-market retail sector and healthcare vertical markets.

Parus offers its services under a variety of brands and customized solutions, but the most widely deployed variant is branded “CommuniKate”. CommuniKate is a speech-driven personal assistant with a female persona and voice (aka “Kate”). Kate’s unified communications platform combines voicemail, email, fax, conferencing, calendar, contact management, collaboration and mobility with a broadly patented speech-driven interface that provides a truly differentiated, value-added, sticky service that is difficult for others to match. One of the things we like about the service is that it is truly a hosted service, and can be used from any communication device, from home, office, mobile, or VoIP, or through a web-based interface or email client such as Microsoft Outlook.

In an era where many VoIP offerings have largely been commoditized, Parus has developed a unified communications platform that can truly differentiate a communications service provider. Instead of simply packaging basic voicemail-to-email and find-me/follow-me features that are included in virtually all VoIP offerings, Parus takes their unified communications platform to the next level by including a full suite of applications that are ideal for the SMB customer, particularly those customers who value collaboration and mobility, and also want to give the perception of a larger corporate image. Parus’ natural language speech-driven interface sets the gold standard for ease-of-use, and is particularly flexible for customer service applications – applicable to most any business vertical. The service bundle is apparently highly valued by its customers as well, given the fact that Parus is able to achieve ARPU ranges that are substantially higher than competitive VoIP offerings.

We feel that Parus is most exciting not only for what it has achieved, but for the potential of its platform moving forward. Microsoft purchased Tellme for the value that speech-enabled technologies can bring to mobile and local search, though the combination also has numerous other implications for Microsoft as it further penetrates the unified communications sector to compete with the likes of Cisco, Avaya, and Nortel. On the other hand, Cisco acquired Webex to further expand into the SMB market, and to offer valuable, sticky applications that complement its hosted Linksys One solution and newly announced Smart Business Communications Systems for SMBs. Common to both acquisitions was the notion that hosted applications, the so-called “Software-as-a-Service” (SaaS) model, will be a contributing success factor to both Cisco and Microsoft moving forward.

In Parus, we see many of the capabilities of these two deals with one key difference – the company designed, built, and patented its own integrated platform and relies very little on licensing third party technologies for its platform. The Parus patent portfolio covers essentially any speech-enabled form of user communication regardless of the system specifics, communication devices or transport medium, and includes 5 U.S. and foreign patents and 6 new and continuation applications. While the company has been quite successful commercially, we think this platform in the hands of a larger player such as Google, Yahoo!, eBay, or AOL, could further exploit this technology and dramatically differentiate their IM-based VoIP offerings by adding speech-driven unified communications and mobile search capabilities.

While Google Mobile is great if you have the right mobile device, the right high-speed data plan, and the ability to navigate a less-than-perfect user interface, we think that speech-driven technology is a much more natural fit for the mobility market, and could be the killer app for mobile users. We can envision a speech-enabled Google portal that combines the capabilities of Google’s Gmail, GoogleTalk, collaboration and search tools with a speech-driven interface to simplify access to information whenever a user is away from a computer (think “Google – anytime, anyplace”). If you further combine this with Google’s ability to monetize search, and provide a potentially new avenue for context-specific, location-based audio advertising, we think that a platform such as Parus’ has huge potential value.

A company like eBay could also benefit from adding Parus’ unified communications platform to its Skype offering not only to enable click-to-call capabilities, but also its professional auto-attendant and customer service capabilities would be ideal for eBay Power Sellers who make their living selling products through eBay. Similarly, we see the potential for AOL to further expand its AIM Phoneline offering with additional unified communications and collaboration capabilities, or complement its Advertising.com business unit with localized speech-driven search advertising.

We are probably just scratching the surface here, and there are likely several other companies who would value the intellectual property that Parus has developed. Clearly there are numerous applications for Parus’ technology, and if the M&A market is any indication of industry trends, we feel that the company is definitely moving in the right direction. We’ll continue to monitor their progress to see how things unfold.

4. Art of the Deal - Cisco Acquires WebEx

On March 15, Cisco announced the biggest deal of the year so far in the IP communications market. Cisco acquired WebEx in a cash deal valued at $3.2 billion, and with it, becomes the leading provider of hosted web conferencing and collaboration services. We like this deal for a number of reasons, not the least of which is the last word in the previous sentence – “services”. With WebEx, Cisco is not acquiring more hardware, nor are they acquiring systems or solutions. They are acquiring services – software-based services – which is something we feel will be key to their growth plans.

At face value, the attraction for WebEx is easy to see. The company has substantive revenues – $380 million – is profitable, and is a market leader. WebEx immediately puts Cisco into the hosted web conferencing business, and is an acquisition they could handily afford. While $3.2 billion is out of reach for most companies, Cisco spent double this amount for Scientific-Atlanta, and the deal is just a small blip in their cash reserves. But at over 8X revenues, the deal certainly represents a significant multiple relative to many other service providers.

Given the degree to which Cisco and Microsoft are becoming direct competitors, this deal is a good move. Microsoft entered the hosted conferencing space by acquiring Placeware in 2003, which made them the market leader at the time. Since then, WebEx has caught up to Placeware, and the companies have switched places as the top two providers.

In this context, we see two good reasons for the acquisition. Aside from getting a market leader in WebEx, Cisco sees what Microsoft did with Placeware, (now known as Live Meeting), and understands the potential that the service brings to its enterprise customers. Cisco has successfully absorbed dozens of companies in the past few years, both larger and smaller than WebEx, and WebEx is a good complement to a rapidly evolving solutions portfolio built around collaborative technologies.

The underlying issue for both Microsoft and Cisco is their ability to compete in the services business. It remains to be seen if this will be easier for a software vendor or a hardware vendor, but both companies are clearly committed to that path. The enterprise communications market is growing quickly, and at this stage, vendors do not have the luxury of time to develop their own solutions. This rationale is driving many recent acquisitions, and WebEx is no exception.

One thing WebEx brings right away is a broadening of Cisco’s real time communications offerings. They already have a collaboration offering called MeetingPlace, which is premises-based, and targets larger enterprise settings. Being hosted, WebEx’s WebOffice caters more to SMBs, but also to enterprises looking for a more affordable conferencing solution. Given Cisco’s recent series of announcements about their unified communications offerings for SMBs, WebEx is a natural extension and should be well received. The service also complements Cisco’s Linksys One hosted VoIP and Smart Business Communications offerings for SMBs, which have yet to make much market traction.

Where things become more interesting is how Cisco will make use of WebEx Connect. While hosted conferencing puts Cisco in the services business, Connect takes this one step further by being a “Software-as-a-Service” (SaaS) platform. SaaS is becoming an important acronym in 2007, and for companies that embrace Web 2.0, this will become the basis for new business models. Cisco recognizes this potential, and WebEx Connect is not too far removed from the social networking direction they have recently taken (see our coverage in the March 2007 newsletter). There are several new and disparate pieces to put together here, and it will be a challenge for Cisco to make all this work. The Web 2.0 and SaaS applications will take more time to develop, but Cisco benefits immediately from the hosted conferencing business.

Over time, perhaps the most valuable part of this deal will be the experience Cisco gains from offering subscription-based services. This is a very different business model from selling network hardware, but is one that can open up new markets and revenues streams, especially for verticals such as government or health care. SaaS can also enable Cisco to offer new services and applications horizontally to all types of businesses, such as messaging, storage or security. In essence, Cisco understands that if they do not gain this expertise, they will lose ground not only to Microsoft, but also to others who adopt this model, such as Google or even IBM.

Speaking of IBM, Cisco has announced plans to integrate their MeetingPlace conferencing solution with Lotus Sametime, which will further strengthen their position against Microsoft in the enterprise market. In time, we would expect the same to happen with WebEx, giving Cisco a strong hand across all sizes of businesses. The caveat, however, is that Cisco may be faced with too many conferencing platforms to integrate, given their existing partnership with Adobe. To make the WebEx acquisition pay off, something may have to go here, and it will likely be Adobe. WebEx gives them the ability to create a consistent interface and user experience for all types of deployments, and supports the overall direction Cisco is taking in delivering complete unified communications solutions.

Aside from Adobe, the other company at risk would be Citrix, the third major conferencing vendor, and now the last one standing on their own. To remain competitive, they may need to form closer partnerships with the other telecom majors, namely Avaya and Siemens. Just as likely, though, we believe it will not be long until these vendors follow in Cisco’s footsteps and make a deal of their own.

5. Financial Highlights