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. Sprint Nextel and Clearwire Combine Forces on WiMAX

The two largest owners of WiMAX spectrum in the U.S. announced on July 19 they were pooling resources to create a national network for WiMAX services. Sprint Nextel owns the largest swath of 2.5 GHz licenses, and Clearwire is the next largest; together they will effectively operate the world’s largest WiMAX network. This is a rather bold move, especially for U.S. wireless carriers, who are not generally the market leaders on the global mobility stage.

Each operator has been on a clearly defined and divergent WiMAX path for some time, which Mercator examined in the August 2006 issue, following Clearwire’s $900 million funding injection from Intel Capital and Motorola Ventures. The paths are divergent in the sense that Sprint Nextel is focused on mobile WiMAX, whereas Clearwire is primarily built around fixed WiMAX. Furthermore, Sprint Nextel’s spectrum is mostly in urban markets, and Clearwire’s is more rural.

In evaluating the impact of this partnership, we need to consider whether these companies are better off competing or cooperating. The case could certainly be made for separate courses, where each would readily dominate their respective markets, at least initially. Under that scenario, meaningful competition would only come from other, smaller wireless operators who cobble together alternate networks by sharing spectrum among themselves. On the other hand, Sprint Nextel’s recent financial performance has been weak, and they are losing ground to their main competitors, Verizon Wireless and a reinvigorated AT&T. Clearwire is no better off, given their soft IPO and long-term debt that is fast approaching $1 billion. Not surprisingly, their share price surged a telling 21% after the news with Sprint Nextel was announced.

Considering just these basic elements, a cooperative path is far more appealing, but also fraught with risk. Together, they would create a truly national wireless broadband footprint, with joint branding and seamless roaming between networks. Sprint Nextel’s coverage would reach 185 million people, and Clearwire’s would cover 115 million; and together, they project being able to serve 100 million with service by the end of 2008. Given the cartel-like state of the U.S. wireless market, it stands to reason their chances of success are greater working together, and is very much in line with the current consolidation trend in telecom.

That said, our view is that these two carriers need each other, but for different reasons. Sprint Nextel has the stronger hand, although they continue having their own challenges finding synergies from the Nextel deal. Sprint is a distant third to Verizon and AT&T in the cellular market, and by virtue of their smaller size, they have less leverage with handset vendors. They also lack the installed base of landline subscribers their rivals enjoy, and are more reliant on pureplay wireless services.

Clearwire helps them achieve critical mass in terms of network coverage, which is important, but they bring a relatively small subscriber base, so the upside for Sprint Nextel is really tied to the growth potential of WiMAX rather than any additive revenues that come today. This begs the question as to whether Clearwire should be acquired, but that package would bring more debt than anything else, and with Nextel being such a recent addition this would be very challenging, even if just to acquire their spectrum licenses and WiMAX engineering expertise.

At the heart of the matter, both companies are betting their futures on WiMAX, and if things go well, then the strategy to partner will pay off in spades. WiMAX is still unproven, not widely supported by endpoints, not tested on a large scale, and business models have yet to emerge. On the other hand, Tier 1 vendors Intel, Motorola and Samsung are strong backers of WiMAX; especially Intel, since they now have a large enough addressable market to achieve economies of scale for chipsets, which is a critical factor for building WiMAX support into a wide variety of endpoints.

Adding to this momentum are two recent announcements that we think add considerable richness to the WiMAX ecosystem. On July 26, Sprint Nextel announced a partnership with Google for mobile search and social networking. We see this as an early indicator that WiMAX’s success will be tied as much to mobile broadband services that 3G networks cannot effectively support, as much as it will be to devices that are 4G enabled. Interestingly, the Google news did not include Clearwire, as fixed WiMAX is less relevant to them, and it remains to be seen if this arrangement will change as things progress.

Secondly, on July 17, Sprint Nextel announced a deal with ZTE to supply them with WiMAX PC cards and cable modems. This will help accelerate market adoption for both fixed and mobile WiMAX by enabling existing PCs that do not already have Intel WiMAX chips, as well as the residential market looking for broadband alternatives to their telco or cable operator.

Ultimately, for this partnership to succeed, Sprint Nextel must at minimum, hold its own against Verizon and AT&T. They cannot beat them on size, but superior technology may prevail, and that is the promise of WiMAX. This is why Sprint Nextel chose WiMAX over CDMA to retain the right to use their wireless spectrum. Being a 4G solution, mobile WiMAX offers faster access speeds, and the networks are far cheaper to build out than 3G. With WiMAX, Sprint Nextel can offer services that EV-DO cannot support today – especially video – which would give them a competitive advantage over both AT&T’s GSM network and Verizon’s CDMA network.

If Sprint Nextel executes well, they will be a much stronger competitor on the wireless front. The real wildcard, however, is with the cable operators. WiMAX creates both opportunities and threats, as Sprint Nextel can now compete directly with the MSOs for broadband subscribers, and having both fixed and mobile services, they will be able to offer very compelling service bundles. On the other hand, they already have existing partnerships with major MSOs to provide wireless services to their subscribers, so it remains to be seen how this plays out. We anticipate that their relationship with MSOs will change, and in fact, expand, which could be beneficial for both parties. Aside from being the wireless partner for MSOs, the relationship could be reversed with WiMAX, where Sprint Nextel provides the access, and they partner with the MSOs for content.

2. SunRocket Crashes and Burns

On July 16 VoIP upstart SunRocket abruptly shut down its service without notice, and U.S. consumers got another taste of how difficult it is for VoIP pureplays to survive in the telecom business. This move suddenly left some 200,000 subscribers without phone service, and no doubt caused many, if not all, to second guess their faith in VoIP as well as the decision to leave their incumbent in the first place.

SunRocket seemed to start out on the right foot, with a healthy $33 million funding round and a seasoned management team culled from MCI. In early 2004, Vonage was the dominant residential VoIP provider, as the cablecos had not yet come to market. Pureplay VoIP operators had most of this market to themselves, and truly represented a disruptive threat. In this milieu, SunRocket had as good an opportunity as anyone to follow in Vonage’s footsteps and stake their claim in the VoIP gold rush. Subscriber growth was steady, and add-on financing rounds were not hard to come by.

This would seem to be a recipe for success, but along came the cablecos, and all VoIP pureplays had to contend with the bundle, and by now it is clear they are fighting a losing battle. Customer acquisition costs and retention are the metrics that make or break a VoIP pureplay, and SunRocket was subject to the same economics that have made Vonage a money-losing proposition from inception. The reason why Vonage is still operating and SunRocket is not is scale. Vonage was first to market on several fronts, and was able to acquire a critical mass of subscribers to generate sufficient capital to keep the business moving forward, albeit on an endless treadmill of mass marketing spending just to stay still.

By comparison, in their three plus years of existence, SunRocket had only accumulated one tenth of Vonage’s customer base, and without the benefit of an IPO, simply ran out of money before they could reach critical mass. By analogy, the rocket ship did not have enough fuel and engine power to get into orbit, and in short order, came crashing down to earth.

Over that period of time, SunRocket raised some $80 million, and even though their customer acquisition costs were half of Vonage’s, they were still in the $150 - $160 per subscriber range. With a base of 200,000 subscribers, it is not difficult to see how the vast majority of their funding was spent on marketing, rather than technology or R&D. On a product level, SunRocket offered little in the way of innovation, and in a price-sensitive commoditized market, margins must be high to survive.

The only innovation we can point to was in their flat rate pricing plan, where subscribers received an unlimited use for one year for an upfront payment of $199. This works out to $16.58 per month, which is well below the going rate for VoIP, so the service appeared to be a good deal for subscribers. It was initially good for SunRocket too, as they would accrue all their revenue at point of sale, and lock in customers for a year. From an ARPU perspective, though, this strategy makes it very difficult to upsell subscribers to premium plans or value-added services. On that note, it should be added that SunRocket did little but replicate POTS, so this was very much a Voice 1.0 offering. Furthermore, service outages were common and quality was inconsistent, and either would have given subscribers good reason to go elsewhere when their term was up.

All told, SunRocket did not offer much to get people excited or to look beyond cost for a reason to switch to VoIP. And in the end, 200,000 is barely a blip in the U.S. market, and SunRocket will leave no legacy to speak of. However, this still leaves a lot of unhappy customers, and not surprisingly, a host of VoIP operators were all too pleased to take their business no questions asked, such as Vonage, Packet 8, Nuvio, Lingo and Broadvoice. For those who still want the benefits of VoIP, but the stability and quality assurances of an incumbent, they can choose from AT&T’s CallVantage or Verizon’s VoiceWing services. And for those who are never going back to their telco, the cablecos are happy to oblige so long as you take their bundle.

As such, the void created by SunRocket will quickly be filled, and life will move on. The telcos and cablecos will likely gain a healthy share of these orphaned customers, and they will have one less competitor to worry about. With Vonage on shaky ground, and their closest rival gone, the VoIP pureplays have essentially been marginalized, and we see the road ahead for these operators becoming increasingly difficult.

3. Ooma – Now For Something Completely Different

In the wake of SunRocket’s demise, the last thing one would expect is a new entry into the residential VoIP market. And just when it appeared that eBay had the market cornered for companies with nonsensical names as in Skype and Joost, along comes Ooma. While the name has a soothing tone, trying to understand their business model is anything but that. Ooma believes they have a better value proposition than the VoIP pureplays, and given the precarious state of this market, their vision – and perhaps audacity – warrants further analysis.

Ooma’s launch on July 19 garnered considerable media attention, not just out of curiosity, but also due to its A-list management team which improbably includes TV star Ashton Kutcher. Early reviews have been mixed, and given how different Ooma is from mainstream VoIP offerings, it is evident that Ooma is not well understood, which we do not take to be a good sign for a mass market product.

Much of the interest in Ooma stems from their ability to raise $30 million since the company was started in 2005, and includes funding from Draper Fisher Jurvetson, one of Skype’s initial backers. Building on this is a management team steeped in nextgen, drawn from companies such as Cisco, Yahoo, Apple and Tivo. On paper, Ooma may be the most promising VoIP mashup to date, and if the hype is to be believed, there is some potential for them to be a game-changer.

To understand Ooma, it must first be stated that it is a product and not a service. This alone is a differentiator, although they are not the first to do so for VoIP. Ooma is basically an intelligent, but expensive ATA that delivers considerable value for customers. For $399, consumers get the Ooma Hub, which sits between your phone and your wall jack, much like the ATA that VoIP subscribers get when they sign on for service.

The main difference is that with Ooma there are no additional subscriber costs. This is a one-time product purchase, and once connected to Ooma, all calls made within the U.S. are free. Customers do not have to switch providers or get a new phone number. They keep using their PSTN service, but now can eliminate most of their long distance charges. Furthermore, being broadband-based, Ooma provides the full range of Class 5 features as well as a Web-based answering machine. These services are all free, and in most cases represent the real cost savings given how inexpensive long distance calling has become.

In addition, Ooma offers an “Instant Second Line”, which we see as their most distinctive feature. When a second call comes into the home, instead of going to voicemail, the call automatically rings through to all the other phones, and can be taken concurrently and independently with the call that was already in progress. As such, the need for a second line is eliminated, creating an additional cost saving. For households paying for a second line, this feature will undoubtedly be appealing.

For those willing to do the math, the $399 investment in Ooma can certainly be justified, especially for those paying for several a la carte PSTN features. Ooma also offers convenience in that broadband households can stay with their telco, and continue enjoying the benefits of PSTN quality, reliability, 411 and 911 services. In this regard, Ooma is actually a friend to the telcos rather than being a competitive replacement service. Ooma would reduce the telco’s ARPU, mainly from high-margin services, but more importantly, they give subscribers a good reason to stay put. We see this as being of particular interest to telcos who are not quite ready to deploy IPTV, and Ooma could buy them valuable time as a bridge until they can.

While there are clearly some attractive elements to Ooma, we see a number of challenges that will have to be addressed for this venture to succeed. First is the economic viability of their model. Ooma is a cross between Vonage and Skype in that they use both landline VoIP telephony and a peer-to-peer architecture. Calls that traverse between Ooma Hubs are free, much like with Skype. To achieve this, they are seeding the market with 2,000 Hubs across the U.S., and this will create a distributed backbone of sorts. As Ooma’s “network” grows, more calls can be terminated at no cost. However, for calls that must be terminated over the PSTN (as with SkypeOut), Ooma is absorbing the cost. Needless to say, this could become expensive if their network takes a long time to develop.

Another concern is that history is not on Ooma’s side. Similar solutions have been in the market before, namely PhoneGnome from Televolution, Internet Phone Wizard from VoSKY Technologies, and to a lesser extent, Jeff Pulver’s Free World Dialup. Another similar product is Panasonic’s recent partnership with Deltathree called JoIP, which integrates VoIP into traditional cordless telephones. None of these have yet achieved mass market success, and it is difficult to see how Ooma will be different.

Related to this is the basic matter of Ooma being a product instead of a service. Virtually all their early revenues will come from sales of their Hubs, and the price-driven VoIP market has never seen a product this expensive before. Even though the big picture economics of Ooma are attractive, we do not envision the masses paying $399 upfront from an unknown company offering free calling for life, especially following the recent failing of SunRocket, which proved that "life" can be short in the VoIP world.

Finally, being a new venture, Ooma faces substantial hurdles to create awareness, gain distribution, and educate consumers about their value proposition. With the market for standalone VoIP service losing momentum, $30 million will not take them very far. At present, consumers can only buy Ooma direct via their website, and so long as this remains their route to market, success will be inordinately dependent on viral and Web-based marketing programs. We do not see this being a viable way to ramp up revenues or establish their brand, and instead think a better course would be a strategic partnership with a major telco who could bring them a built-in subscriber base. They would likely need to accept lower margins, but would at least have a firmer foundation to build on, and with that, a greater chance of survival than those who have come and gone before them.

4. Financial Highlights