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. Cable – Winning The VoIP Battle But Losing The Video War?

November has not been a good month for the major U.S. cable operators, and reflects some changing realities that we think will have a significant impact on the entire communications landscape going into 2008.

Starting at the top, the Q3 2007 results from the major cablecos have had a consistent theme, primarily decreases in video subscribers. This includes the two majors – Comcast and Time Warner Cable – but the story was similar for two other cablecos who have been early adopters of IP technologies – Charter Communications and Cablevision. Comcast and TWC are by far the largest cablecos in terms of broadband, with 12.9 million and 7.4 million subscribers respectively. Cox Communications is number 3 at 3.9 million, but having gone private in late 2004, their results are not publicly shared.

There are two fundamental issues and both are legitimate causes of concern, not just for the cable operators, but their telecom brethren as well. First is the fact that cablecos are losing video subscribers to competitors, primarily satellite and telecom operators. Second is the broader trend of slowing broadband growth in the U.S. It has been widely reported that the net additions for U.S. broadband subscribers will be lower in 2007 than 2006, and is the first time we have seen declining growth. The deceleration is occurring for both cablecos and telcos, and is particularly worrisome for the latter, as fiber deployments are still in their early stages. Whatever gains are coming from fiber are being more than offset by declines in DSL.

On a broader scale, the slowdown in broadband may be the first sign of market saturation, and if true, could have a ripple effect through the entire ecosystem of vendors and developers who support the infrastructure and service delivery capabilities for operators. This will also intensify competition among the service providers as they will now be fighting over a pie that is not getting much bigger, as opposed to chasing demand and rolling out service as fast as possible.

The sub-prime credit crisis also may become relevant, both for existing/former homeowners as well as for the next wave of home buyers that may not materialize now. When people are losing their homes or cannot get financing for new homes, broadband becomes more of a luxury item than a necessity.

Against this backdrop of growth uncertainty, cablecos are facing similar competitive pressures on their video business that telcos did on their voice business with the advent of VoIP. Initially, the telcos lost subscribers to the VoIP pureplays – Vonage, SunRocket, 8x8, etc. In our October issue, we concluded that this threat has passed, and more recently residential VoIP has become the domain of cable. They are the only operators with the right mix of assets to win this business in that they have the network, they have a base of subscribers, they can offer VoIP as a loss leader, and they do not have a native base of legacy subscribers to cannibalize. Cablecos have dominated residential VoIP growth for some time, and in our view they have won that battle.

The larger picture is more of a concern. With the roles reversed, cablecos have been losing ground defending their core business, not just to telcos, who are just ramping up with IPTV and fiber, but to the satellite operators. It is always more difficult to fight a war on two fronts, especially when each enemy is so different. While it may be easier for cable operators to offer telephony than it is for a telco to offer video, the telcos who are building out fiber networks now hold the upper hand.

Verizon has bet heavily on its costly fiber-to-the-home (FTTH) strategy, and are now well past 1 million FiOS subscribers. IPTV will inevitably come to the U.S., and combined with fiber, telcos will have a competitive advantage over cable. Compounding this are the aggressive inroads satellite operators have been making, particularly in providing superior HD service – which is a key driver for video now – and securing content deals with top tier partners such as the NFL.

Cable operators have been talking about increased speeds via DOCSIS 3.0, but these capabilities will not come to market in time for the initial wave of fiber deployments that may poach cable broadband subscribers looking for faster speeds or even lower prices. Furthermore, cable operators are fighting an image of poor customer service, and for unhappy subscribers, such an offer from their telco may be reason enough to switch.

This has become particularly contentious over the recent allegations of traffic shaping, that cablecos – namely Comcast – claim is needed to provide acceptable service in the face of rampant downloading from bandwidth-intensive services like BitTorrent. Aside from traffic shaping, this touches on Net Neutrality, a highly charged issue that nobody wants to be on the wrong side of.

If that was not enough, the cablecos are facing an imminent FCC decision on the “70/70” rule, which could impose pricing regulation on them for the first time. The rule stipulates that this could come into effect once the 70/70 threshold has been crossed. For this to happen, cable service must be available to 70% of all households, and that 70% of households are subscribing to cable service. Cablecos passed the first threshold long ago, and have reached or are approaching the second threshold in many urban markets.

The criteria for defining this second threshold are being vigilantly debated on both sides, but the FCC is viewed as being pro-telco. Their position maintains that cable prices have done nothing but increase, while the cost of other communications services has been going in the other direction. This leads the FCC to conclude that more competition is needed in the cable market, and one way to do that is to regulate pricing.

2. VeriSign – Rightsizing, Not Downsizing

On November 15, at their annual analyst day, VeriSign announced some major changes in operational direction in a bid to regain favor with investors and to focus on strategic growth. Although their stock has done well in 2007 – up roughly 40% – the growth is attributable more to two remedial actions than their overall financial performance. Specifically, there was the resolution of a stock option accounting issue, and the resignation of their long-standing CEO in May. He was the architect of a series of costly acquisitions that were not related to VeriSign’s core businesses.

While VeriSign is synonymous with the Internet registry business, the company is over diversified with no unifying direction. To address this, VeriSign announced plans to divest several business units and focus on the business that is making money and that shareholders understand. The news has been well received, and since November 15, VeriSign’s share price has increased 23%, increasing $7.69 over the last two weeks of the month.

In the midst of this much-needed corporate housecleaning, VeriSign rated very highly in CIO Insight’s 2007 Vendor Value Survey. The results were published on November 14, and VeriSign ranked second for overall vendor value, tied with Google and Hewlett Packard. They also ranked first for security and meeting ROI expectations. Security is a primary IT issue these days, and receiving this industry-based validation has coincided nicely with these changes in business direction.

In terms of the changes, VeriSign plans to shed several business units and retain focus in three core areas. Details have not yet been finalized, but at minimum, they plan to divest operations focused on business communications, billing, commerce and communications consulting. The business communications group is the largest of these, accounting for almost a third of current revenues. Many of these companies are in the mobility sector, such m-Qube and LIghtSurf Technologies. Another area likely to be jettisoned is content delivery, built around acquisitions such as Jamba and Kontiki. VeriSign is also likely to abandon its legacy SS7 signalling business that it built through the acquisition of Illuminet in 2001, and perhaps its budding VoIP peering business. We don’t want to speculate on who the buyers of these businesses could be, but in our minds there are definitely a handful of likely candidates.

These businesses have no apparent connection to VeriSign’s core strength, and we see these moves as being the right ones to make in the current environment. The consolidation trend among vendors is showing no signs of abating, and companies with market leadership positions cannot afford to venture into new sectors unless they can leverage their strengths to create leadership there as well. To date, this has not been the case with VeriSign, and was likely a strong factor in the decision to replace their CEO.

From all accounts, what will remain for VeriSign are three basic operations – Naming Services, Web Certificates and Identity Protection. These are businesses that VeriSign can dominate and maintain for revenue and profit growth. This is where their brand resonates most, and where investors look for VeriSign to have continued success. Naming services is the most important of these – this is the Internet registry business, where VeriSign holds a virtual monopoly on the most popular domain suffixes, namely .com, .net and .tv. The other two focus areas are important aspects of Internet security, which has strong growth prospects given how central the Web is becoming to managing our personal lives.

As with any business built around a monopoly position, VeriSign’s greatest risk comes from threats to the status quo. They have an exclusive agreement for .com and .net domains for the next seven years, which is granted by the non-profit industry body ICANN – Internet Corporation for Assigned Names and Numbers. Not only is this an exclusive arrangement, but VeriSign is allowed to raise its prices up to 7% for each of these seven years.

The most recent fee increase went into effect on October 15, when the charge for registering, renewing or transferring a .com domain went up from $6.00 to $6.42. According to VeriSign’s Q3 filing, they currently have some 77 million active .com and .net domains. Given the dominance of .com domains, assuming 50 million of these are .com domains, that represents $21 million in pure margin. With their tally of .com and .net domains being 25% higher than a year ago, it is clear that VeriSign has a very lucrative deal with ICANN.

Other domain registries like GoDaddy have been trying to challenge this monopoly as an antitrust issue, and present a strong argument that the cost of these services should be going down, not up. There is no value-add associated with the fee increase, and with the steady growth of domain registrations and changes, there should be more meaningful economies of scale that filter down to the consumer. If they are successful, even a small degree, this would open the market to price competition, and would jeopardize VeriSign’s business model and earnings outlook.

We will continue follow this issue with interest, as it could have more bearing on VeriSign’s prospects than the divesture of their non-core businesses. If they can successfully defend their deal with ICANN, then the financial picture becomes more certain, at least for the next seven years. Should the playing field be levelled, prices are certain to fall, and VeriSign will need to focus even more on the things helped them score so highly on the Vendor Value Survey.

3. SMB VoIP Market Update

The SMB market has been attracting considerable attention from a variety of vendors and service providers this year, and with the variety of solutions visible at recent conferences, an update is in order. As the worlds of conventional telephony, Internet telephony and Web services come together, the choices are proliferating, not just for SMBs, but the service providers trying to sell to them.

Service providers basically have three approaches for offering communications solutions to SMBs. It is no longer enough to offer telephony services – as with the residential Triple Play, SMBs are looking for IP-based communications solutions to help them stay competitive and keep their costs down. To do this, service providers can develop their own solutions, or outsource this, either on a hosted or managed basis. With IP technologies continually evolving, home-grown solutions are difficult to justify, especially from smaller operators who have limited R&D resources.

The hosted approach is the most economical, as multiple SMB clients can be serviced by partitioning the softswitch. In these scenarios, the operator would typically partner with a feature server vendor such as BroadSoft or Sylantro. This approach offers a low cost of entry, flexibility to customize features, and quick time to market – for both service launch and new features. The managed approach offers additional flexibility, especially for the service provider in terms of having best-of-breed options for vendor partners. It also turns network management responsibility over to the carrier, so is a more complete form of outsourcing.

We see merit here, for two reasons. First is the need to integrate a wide range of elements across many fields – features/applications, gateways, security, QoS, billing, session border controllers, etc. No single vendor is exceptional in all these areas, and the managed model offers an overall approach to bring these diverse capabilities together into a single offering.

The second reason is the emergence of Web services as an integral part of the overall communications experience. SMBs are beginning to recognize the value of Web services and the Software as a Service (SaaS) model to create highly customized applications that require minimal technical expertise. A growing number of service providers – typically smaller competitive carriers – see this as an important driver for future business, and for this reason, have adopted the managed approach.

New Global Telecom (NGT) is a good example of a wholesale approach using a Broadsoft platform, whereas companies such as GlobalTouch Telecom have developed similar functionality using their own proprietary technology, which may give them an economical edge over Broadsoft or Sylantro based systems. VoIP Logic is another interesting player which utilizes a Sylantro feature server and a number of third party SBCs, and ties their managed service offering together with a proprietary Cortex middleware solution, which may be an indicator of how managed services will evolve for SMBs.

At a high level, SMBs can outsource with well known providers such as XO Communications, Covad (see Art of the Deal in this issue), Cbeyond and M5 Networks. However, for SMBs willing to look beyond this group, there is a wide range of solutions to consider. Some of the more interesting offerings we have been seeing recently included Fustiontel, Panterra (formerly Pandora Networks), Junction Networks , and Vocalocity. Panterra is an example of the pay-as-you-go SaaS model, especially for those seeking a unified communications solution. Junction Networks has their onSIP PBX platform, which builds on Open Source elements, but has reshaped them into an IMS-based architecture that SMBs can afford. Vocalocity claims to offer a flexible, easy to install hosted PBX service targeted at the micro end of the SMB market.

These are just a few examples of the innovation that both vendors and service providers are bringing to the SMB market, and we expect to see more integration of Web services into these offerings in 2008. As social networking platforms like Facebook gain currency as business tools, Web-based applications will become more familiar, and create value for SMBs. This should bode well for Web 2.0-style applications such as Iotum, Jaxtr and Twitter, and we think that as they become more widely used they will become acquisition targets. In earlier issues we wrote about two scenarios that set the precedent for this – GrandCentral being acquired by Google, and Tellme being acquired by Microsoft. For this reason alone, we will be closely following this market in the months to come.

4. Art of the Deal: Covad Goes Private

The privatization trend in telecom continues to remain strong, with Covad being the most recent move of note. At the end of October, Covad Communications announced it was being acquired for $304 million in cash by Platinum Equity; both California-based. Private equity has become increasingly appealing, especially for public companies in one of two situations. One scenario is where industry consolidation forces companies to raise capital to keep pace with larger competitors, and private equity offers a better alternative – and sometimes the only alternative – over public debt or equity markets. Current examples of this would include Alltel on the carrier side, and on the vendor side, Avaya and Mitel/Inter-Tel. To some extent we see Covad falling into this camp.

A second scenario for going private would be cases where a company has not kept pace with changing technology or market conditions, and privatization provides more options and latitude to re-tool than if they remained public. Privatization brings in the capital needed to re-invest in the pieces of the business that have the best potential for profitability, and gives management a relatively free hand to rationalize what’s left without the worry of seeing investors rush to the exits. Prominent examples would include Bell Canada in the carrier space, and Palm among the vendors. Mercator Capital sees this as a stronger driver for Covad going private, and we will analyze this further below.

Covad has struggled financially for some time, and their sub-$1 share price has reflected this. Platinum’s buyout price was $1.02 per share, which is a 59% premium over the previous closing price of 64 cents. Covad is a classic industry survivor, having overcome bankruptcy while many of their peers in earlier days could not. We think that the price of entry for Platinum is fairly reasonable considering Covad’s long history in this market, their established brand, customer base, and a national broadband network.

While Covad is burdened by a $125 million convertible debt, this financial commitment should be relatively modest compared to some of the other more highly leveraged multi-billion dollar privatization deals announced earlier in 2007. There is also some potential upside for Platinum, as their portfolio includes telecom resellers such as Matrix Business Technologies, who would now have more reason to re-sell Covad services. Another possible synergy lies with DCA Services, an outsourced billing and back office provider that Platinum acquired from WorldCom back in 1997.

Although Platinum is known for buying declining assets, and then cutting costs to milk profitability, another scenario for Platinum may be to provide a cash infusion which will allow Covad to upgrade and possibly expand its network. Not only could this allow Covad to provide a more competitive suite of communications services, but also to attract the range of technology partners necessary to create higher value, more profitable offerings. The network is Covad’s strategic asset, as they provide one of the few practical alternatives for non-facilities based operators to offer subscriber services. They are one of the few operators willing and able to offer their own services as well as be a carrier for others.

Covad’s dilemma is the simple fact that they are both a wholesale and retail provider. They offer an extensive array of Covad-branded broadband communications services, including IP trunking, hosted VoIP and premises-based IP telephony. We estimate that Covad has roughly 50,000 subscribers running on its Sylantro-based feature server, which has grown out of the $48 million acquisition of GoBeam in 2004. At the same time, Covad resellers are also providing their own similar voice services over Covad’s network, creating an uneasy environment where Covad’s direct offerings are often competing against their wholesale access partners.

The impact of these dynamics is evident on Covad’s financial performance, which was most recently updated just days after the privatization news was announced. On October 30, Covad’s Q3 results were announced, and a net loss of $4.9 million was reported. Overall, Covad’s quarterly revenue growth has been flat for over a year, which alone is a sign that help is needed to move the company forward. Q3 2007 revenues were $121.9 million, which is a mere $3.3 million ahead of Q3 2006.

Looking at the mix of business provides more clarity on the above-mentioned dilemma. Retail business – Covad’s direct, branded offerings – accounts for 37% of current revenues, with the balance – 63% – coming from wholesale, or indirect business. While the majority of current revenues come from partnering with other operators, the trend is gradually moving in favor of direct business. We believe this trend is a critical indicator for Platinum in deciding whether to keep the status quo, or to focus entirely on one of these business models.

More insight about which way to go can be gleaned from the type of services being offered in both scenarios. Their financial reporting distinguishes between “growth” and “legacy” products, and is another key indicator where the best returns lie for Covad. The mix is about even, with growth products accounting for 51% of Q3 revenue. More importantly, the balance is shifting rapidly towards growth, as at this time last year, the mix was roughly 60/40 in favor of legacy. Covad’s growth products include T-1 (particularly bonded T-1), line powered voice, VoIP and to a small extent, wireless. Legacy, on the other hand, includes services such as ADSL (asynchronous DSL) and frame relay.

Tying this back to retail/wholesale, their growth products are a mix of both, whereas legacy is mostly with wholesale customers. Taken together, the case appears stronger for Covad to focus on retail, where the sales trend is up, and there is greater exposure to growth products. Add to this the fact that the Covad brand is stronger in the business market, which accounts for about 80% of revenues, with the balance coming from residential subscribers. The business VoIP market is less competitive and has greater opportunity for upselling with new services.

Covad certainly faces strong competition in all markets, and has recently experienced their share of frustration offering hosted VoIP to small businesses. This has been a money losing business for Covad, thanks in part to a national television advertising campaign based on some cryptic who-dunnit movie-themed ads about killing your PBX. Platinum’s investment should help address this, and more importantly help Covad focus on a niche it can profitably defend.

Wireless is a wild card to consider in this equation. Although Covad reported a minuscule $500,000 in Q3 wireless subscription revenue, this is a new space for Covad, and it may hold greater promise than their wireline business. Wireline VoIP faces a wide range of competing offerings and technologies, and few providers have been able to make money in this business. Wireless – especially fixed wireless – is still early stage for broadband providers, and no dominant provider exists, at least in the business market. This is especially true given the recent demise of the Sprint Nextel/Clearwire alliance.

Covad may not be profitable right now, but they have been trimming their losses, thanks in part to a June staff reduction and the impact of new, higher margin growth services on the books. As such, they have been able to maintain a decent cash balance of about $65 million. Taking all this into account, we see enough positive indicators that with the right guidance, Platinum can restore Covad to health and derive full value from all their assets. There will be some difficult decisions, especially around the retail/wholesale mix, but we think once a clear direction is set, they will show that the decision to go private was the right choice.

5. Financial Highlights