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. Clearwire’s WiMAX Strategy

On July 5, Clearwire announced a dramatic change in fundraising plans to support their ambitions to be a leading player in the emerging WiMAX market. Just two months earlier, Clearwire filed for a $400 million IPO, but have now changed course in favor of a direct equity investment from two companies with significant commitments to WiMAX. Instead of raising $400 million from public investment, Clearwire is now receiving $900 million in private equity investment, with $600 million coming from Intel Capital, and $300 million from Motorola Ventures.

While this investment makes them beholden to two of the dominant WiMAX vendors, it provides them with ample capital now to establish Clearwire as a leading WiMAX network operator. WiMAX is not yet commercially viable, but its future is promising. Clearwire likely recognized that it was premature to tap public markets for WiMAX, especially with Vonage’s poor IPO showing just two weeks after announcing their IPO plans.

In addition to this financing, Motorola will be purchasing Clearwire’s WiMAX equipment subsidiary, NextNet Wireless later this year (financial details have not been provided yet). Considering Intel’s previous investment in Clearwire, and that the three companies plan to collaborate on R&D, this trio now has the pieces in place for a powerful consortium to drive WiMAX adoption, especially in the U.S.

Undoubtedly, these three companies have a shared vision for WiMAX, and they see how favorable market conditions are starting to line up. Most importantly, the mobile WiMAX standard, 802.16e is set to emerge as the defacto architecture around which future WiMAX networks will be built. The current standard, 802.16d only supports fixed applications, which work well for cable or DSL providers to extend their broadband footprint, but are limited for mobility applications.

Mobile WiMAX – the “e” standard – supports both fixed and mobile applications, making it more versatile and desirable. The ability to roam between base stations opens up the market for WiMAX considerably, and puts it in direct competition with high-speed cellular technologies, especially 3G, CDMA and EVDO. Essentially, mobile WiMAX will work best in dense, urban markets, whereas fixed WiMAX is better suited for sparser, rural markets.

Wireless spectrum is the next important driver for opening up this market. It is widely believed that the 2.5 GHz band will be the spectrum of choice for 802.16e WiMAX in the U.S. Clearwire and Sprint Nextel hold most of the spectrum licenses here, with Clearwire being focused on rural markets, and Sprint Nextel covering the urban markets. Potentially, their combined coverage could create a national WiMAX footprint, which we see as a necessary condition for mass deployment.

This raises the chicken-and-egg issue of what needs to happen first for mobile WiMAX mass adoption. The triumvirate of Clearwire, Intel and Motorola are clearly betting that creating the network is the first step, following which demand, revenue and profits will follow. Mobile technology has evolved considerably since the ill-fated Cometa Networks WiFi initiative in 2002, and the expectation is that mobile WiMAX provides far greater opportunities for operators like Clearwire.

That said, Clearwire cannot serve the U.S. market alone, and Sprint Nextel is a critical wildcard since they have not made a definitive commitment to WiMAX. The Sprint-Nextel merger is conditional on their deploying services over the 2.5 GHz spectrum by 2009, and WiMAX is just one wireless technology they could support. Another is CDMA, which they have been trialing on a small scale. Mobile WiMAX appears to be the likely choice, however, and this would go a long way to jump-starting the U.S. market.

As with any emerging market, there is a lot at stake up and down the food chain once the first domino is set to fall. If Sprint Nextel embraces mobile WiMAX, the investment in Clearwire gains validation. With committed network operators for both rural and urban markets, mobile WiMAX vendors have an addressable market to serve. Intel would have a ready market for its “ Rosedale 2” chip, which supports both “d” and “e” WiMAX standards. Motorola, in part by virtue of acquiring NextNet, along with its existing Sprint Nextel trials, gains a large-scale deployment for its WiMAX equipment.

Other large incumbent vendors such as Nortel and Lucent-Alcatel have also invested heavily in mobile WiMAX, while Nokia and Ericsson have dabbled in the technology to a lesser extent. Moving down the line, the market would also open up for a host of specialized WiMAX equipment vendors such as Alvarion, Aperto Networks, Adaptix, Airspan Networks and Soma Networks. Aside from the U.S., there are even greater mobile WiMAX opportunities abroad, where existing infrastructures are much more limited. Motorola has set the pace via their recent agreement with Pakistan’s Wateen Telecom.

These early stage deployments are critical, as they become the test cases for gaining WiMAX Forum certification. As with all IP-based technologies, standards-based certification is the key for cost-effective and rapid deployment regardless of scale. Once this occurs, mobile WiMAX becomes attractive for all types of operators – mobile, cable, DSL and even satellite. This scenario may take two or three years to materialize, but we expect it will come to pass, and in so doing will prove out Clearwire’s strategy and make winners out of Intel and Motorola.

2. eBay’s Q2 Earnings – Was Skype Worth It?

With Skype now integrated as part of eBay, the company’s earnings calls have recently taken on added significance, especially in light of how competitive the VoIP space is. For better or worse, Skype is widely perceived as a key provider in two distinct markets – residential VoIP and PC telephony, and so their financial results serve as a barometer for both sectors.

Residential VoIP is primarily about landline replacement, and is the domain of the MSOs, the pure plays like Vonage, and now the RBOCs. Skype may siphon valuable minutes away from these providers, but they are really more of a complementary service than a competitive one. Even today, few people completely drop their age-old TDM service in favor of Skype.

PC telephony is another phenomenon, where Skype is the pioneer and dominant player. Several peer-to-peer competitors exist, such as Gizmo Project or Fusiontel, and despite having some advantage over Skype, they lack sheer ubiquity and ever-expanding community. In addition, the instant message (IM) and web-based platforms, such as MSN, AOL, Yahoo! and Google have been adding voice to create a Skype-like experience for their user communities.

By all accounts, these companies have had limited success with voice so far, but given what is at stake, their efforts will no doubt be intensified. Most players understand the strategic value of voice and are attempting to duplicate Skype’s success. Although voice may not be a highly profitable application in the IP world, it is the key for so many other lucrative offerings that will only come once you have it. In that regard, peer-to-peer communications – led by Skype – is really making the voice pie larger. Total revenues may not be growing, but total minutes of use are.

The net result is that Skype competes in a complex environment, and this needs to be understood for a fair assessment of their performance. Many questions have been raised about the rationale behind the Skype acquisition, and eBay has provided few clues to date. Their Q2 earnings report, held on July 19, provided the most clarity so far, and we are finally seeing some signs that justify eBay’s acquisition.

Earnings reports should always be read with caution, especially for new acquisitions, and even more so for a company as mercurial as Skype. The good news is that revenues increased 25% since Q1, up from $35.2 million to $44 million. Presuming they can maintain their current growth rates, Skype is on track for $200 million in 2006.

In terms of users, the growth track is comparable. Q2 saw 19 million new users, a 19% increase, and the overall total is now 113 million. Small revenues aside, the sheer number of users added every quarter alone may justify the price paid for Skype. That said, it is not clear how many of these new users are active users of Skype. Most probably are, but this was not clarified by eBay. Similarly, we do not know how many are unique users as opposed to those having multiple accounts or identities on Skype. As such, the numbers should not be taken fully at face value.

However, for a company barely doing $50 million when it was acquired in September 2005, their organic growth has quickly taken them to critical mass among the VoIP providers. In its August 1 earnings call, Vonage provided guidance that its revenues will be in the $600-615 million range for 2006, but also said it is spending $360-380 million in marketing for the year. Despite being part of eBay, Skype’s marketing spend remains nominal, which allows these revenues to quickly become bottom line contributors.

On the other hand, the average revenue per registered user is just 39 cents, up marginally from 37 cents in Q1. In absolute terms, this seems nominal, but in a sector where ARPU is rapidly declining, any form of growth is good news. Of course, one could look at this another way and ask if an ARPU of 13 cents a month makes Skype worth $4 billion?

Clearly the economics of IP and peer-to-peer are very different from the PSTN, and measuring value in such a fluid market is challenging to say the least. Skype’s recent offer of free SkypeOut calls within North America is accelerating growth in that market, and it will be interesting to see how this impacts the Q3 numbers. Currently 86% of Skype’s revenue is outside North America, so the revenue impact will likely be small. Subscriber growth will be difficult to predict as well, since other VoIP operators have countered by offering free calls within North America and in some cases Europe. So even when fighting for the scraps of revenue, this market remains fiercely competitive.

So is the glass half empty or half full? We see evidence of both here, but are leaning on the positive side of the ledger. This is the best accounting of Skype’s performance to date, and we can only hope that the reporting detail will improve. The expected synergies with PayPal and eBay are taking longer than anticipated, but we recognize this is uncharted territory, and overall, eBay is quite profitable.

3. Nortel/Microsoft – Not-So-Strange Bedfellows

Our July issue included an analysis of the Siemens/Nokia deal and the broader implications for legacy vendors. This included Nortel, and their most likely options. Market forces have been dictating the need for Nortel to keep pace during this wave of consolidation, but there has been a strong determination from senior management to follow their own course and implement a GE-style leadership culture. This does not leave much room for a pure play merger or acquisition scenario. In this light, the strategic alliance with Microsoft – announced on July 18 – is really the next best thing for a company that cannot afford to stand still.

The “Innovative Communications Alliance” is a four-year deal where the two companies will collaborate closely to address the unified communications market opportunity. Essentially, Microsoft needs Nortel to help keep the PC dominant in the enterprise by integrating voice and advanced multimedia communications at the desktop. Conversely, Nortel needs Microsoft to maintain relevance as communications applications continue to move away from hardware to software-based platforms. In short, a software company needs help from an established hardware vendor, and vice versa.

So long as software-based architectures remain dominant for enterprises, this alliance is a good idea. Momentum for both Open Source and browser-based enterprise solutions continues to grow, and longer term, could well displace the software giants like Microsoft and Oracle. However, for the duration of this alliance, we do not envision such a scenario, at least at the high end of the enterprise market.

The interesting aspect of this alliance is the shared vision for integrating real time communications onto a common platform, and making multimedia applications seamless and intuitive. To this end, the companies will engage in joint product development and the cross licensing of patents. A Nortel R&D team will even be based in Redmond to work in concert with Microsoft’s own unified communications group. This is not really the Microsoft way, and it signals a greater willingness to share, rather than dictate the process of bringing new products to market. It also validates Nortel’s stature as a voice leader and their long-standing tradition as an R&D powerhouse.

Going forward, they are even planning on joint selling, meaning that both direct sales or channel-based sales can be made from either company. This could raise some revenue recognition challenges, but the strategy is clear – get as many salespeople as possible pushing their offerings to as many companies as possible. There is certainly a risk for such a shotgun approach to backfire, but given Microsoft’s footprint we only see a minor issue here. On the back end, Nortel will establish a new professional services operation to support this offering.

Aside from a shared technology vision, there is another common denominator at work here – Cisco. As good as each company is in their respective spaces, Cisco really is the gold standard for IP-based enterprise communications. The other legacy vendors have made their moves, and Nortel does not have all the pieces to truly compete with Cisco in this market. Nortel may have its share of legacy customers, but Cisco has proven more adept at winning new customers and developing effective sales channels. With unified communications, Microsoft is also after the Cisco brass ring, and while they lack the credibility of a hardware vendor here, they have a strong channel infrastructure that Nortel can leverage with them.

So, is there a market driver behind this alliance, or is it just corporate gamesmanship for two companies that are under pressure to stay competitive? We think both. There is little doubt that we have two willing and able dance partners here, and the timing is good for both to make a move like this. However, we also see this as a strategic response to shifting realities that impact both hardware and software vendors alike. First there is the shift of voice away from traditional phones to the PC. With the advent of VoIP, an increasing proportion of voice calls are taking place via the PC, and end users are quickly adapting to this change in habit.

Secondly, we now have a multitude of communications options, and today, when people start their day, they are more likely to check their email inbox or mobile voicemail first, and then their PBX voicemail. Additionally, people typically have multiple PC-based inboxes to check, especially for regular IM users. With the PC gaining ascendancy as the center of communications, it only makes sense to integrate all channels and applications there – and not on the PBX. Clearly, this is not what the Nortel we have known would prefer, and there is a substantial opportunity for any vendor to address these needs with the right IP-based solution.

This shift of control from PBX to PC also means that the end game is more about software than hardware. Hence, the fit for Nortel with Microsoft. With it still being early days, the alliance makes even more sense. If the companies can truly find a chemistry, their shared R&D ambitions should pay strong dividends as the demand for new applications will only grow as unified communications takes root.

In fact, we see an opportunity here for Microsoft and Nortel to redefine the value proposition for unified communications. This could be based on homegrown applications, and possibly augmented by third party best-of-breed vendors. We could easily see this alliance becoming a magnet for a dynamic ecosystem of developers with advanced software-based solutions targeted at specific pain points for enterprise users. One such company is Iotum, who was noted in the July issue.

4. Art of the Deal:
AudioCodes Acquires Netrake

On July 6, AudioCodes announced they were acquiring Netrake, a well-known session border controller (SBC) vendor. This was AudioCode’s second recent acquisition, and they appear to be well on their way to becoming an important consolidator in the IP infrastructure market. Not only was the Netrake deal announced on July 6, but also their acquisition of Nuera closed on the same day (this deal was covered in our June issue).

The Netrake deal certainly will make AudioCodes a stronger player, and adds yet another building block to their IMS story, which is becoming increasingly important for selling into larger carriers. This is a good deal for AudioCodes, but it also has interesting repercussions for the struggling SBC sector as a whole, which was evaluated in the May issue.

Before considering the sector implications, the deal itself is notable. Netrake was acquired for only $11 million, a fraction of the $70 million plus invested to date. At this price, the cost was nominal to AudioCodes, and Netrake lives another day. With Netrake, AudioCodes gains a carrier-grade solution, with years of costly R&D behind it. Netrake is well along the IMS path, which gives AudioCodes another market-ready piece of the puzzle for them to sell to carriers as a complete solution. They are already established in the media gateway and media server spaces, with the former being further bolstered by the Nuera deal.

This is a key element of their consolidator strategy – to acquire the pieces they do not have from the weaker vendors, which allows them to compete head-on with the Tier 1 vendors, who are consolidating to keep pace with the carriers who are themselves doing the same thing. Furthermore, AudioCodes is now moving up the food chain, separating themselves from the best-of-breed vendors, and becoming an integrated solutions provider, along the lines of Sonus, Tekelec, or Cantata. As carriers move to adopt the IMS architecture, this capability will become a key competitive differentiator.

For Netrake, there must have been mounting pressure to make a move, as many of their pure play peers were making their own moves. The session border controller space has seen both exits, as in Jasomi and Kagoor, as well as growth stories, as in Acme Packet and NexTone. Netrake has long been an innovative vendor, but the results were not there in terms of major customer deals. This was validated in the details of the deal, which show 2005 revenues to be a meager $5 million. They were not in a position to raise more money, and it looked as if their investors had run out of patience. Netrake does have some marquee customers, such as Telefonica and Level 3, but being a pure play SBC company, their upside was limited. Under the AudioCodes banner, there is far greater potential to expand the business with these types of customers.

Moving forward, AudioCodes will come out stronger, and now becomes one of a handful of vendors capable of delivering a viable IMS solution for large carriers. In this regard, $11 million is a small price to pay. It is clear that session border controllers will be an integral part of the IMS architecture, and vendors do not have the luxury at this point of developing this expertise in-house. Netrake has done the R&D and all the trials to develop a market-ready SBC solution, and now with AudioCodes in the picture, the marketing resources and sales channels are in place to more fully showcase these capabilities. Just as we thought AudioCodes may have overpaid for the Nuera deal, they seemed to have gotten a bargain for Netrake, and overall both acquisitions come at a fair value.

Stepping back, an $11 million exit is another sign that the SBC market may have difficulty sustaining itself on a standalone basis. The market is really left now with two relatively strong pure plays – Acme Packet and NexTone. Acme and Netrake started out being the two strong horses targeting Tier 1 carriers. Both were well funded, and both focused on large-scale, hardware-based solutions. Acme has executed better, with an ongoing string of big wins, and by most accounts is the clear leader, at least among Tier 1s. Their confidence is reflected by their recent IPO filing, which has the makings of a potentially strong offering. Acme’s fundamentals may be attractive, but one cannot help think that Netrake’s low exit price will take the edge off Acme’s valuation, especially in the wake of Vonage’s troubled IPO. The market’s appetite for VoIP IPOs is not strong now, and investors need to look carefully at this story to properly assess the risk.

Aside from Netrake, Acme cannot help but be concerned about another struggling vendor, Newport Networks. Newport has always aspired to the same customer set as Acme and Netrake, but were late to market and have gained minimal traction. In fact, Newport has had more advantages than any other SBC vendor, including the warm shelter of being a Terry Matthews / Wesley Clover company, and a successful IPO despite having no customers or revenues. Their stock value has since declined more than ten-fold, and they have needed to raise additional funding beyond their IPO, further diluting the company’s valuation.

5. Financial Highlights