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. Skype Moving In (Too?) Many Directions

The past few weeks have seen the most public activity from Skype since being acquired by eBay. Both the number and variety of announcements, launches, partnerships, and investments beg the question as to where Skype is going and what this means for the IP communications sector.

As with most companies looking to make an impact in the consumer market, Skype came strong out of the gate at the trend-setting Consumer Electronics Show, held the first week of January in Las Vegas. Seven new products were launched there, most being end-user devices such as WiFi phones, cordless phones, USB phones, USB adapters and speakerphones. On the multimedia side, Skype also introduced an online photo sharing service with Kodak, where users can host talking slideshows with friends and family.

There are two fundamental reasons why Skype has been so successful in a market that is quickly moving from the early adopter stage to mainstream – it works, and it’s easy to use. These are deceptively simple ideas, but in the long run, are far more important than what’s under the hood. Skype profoundly understands this, and continues to focus on creating a great user experience that is now accessible to a far larger audience than its roots in PC-to-PC communications.

Strategically, Skype has chosen to partner with major brands to accelerate their adoption in the consumer marketplace – Kodak, Panasonic, Netgear, D-Link, Vtech, and at the channel level, Radio Shack. On a business level, Skype needs to prove its value to eBay, and this means monetizing their brand. They have had limited success doing so with SkypeOut/SkypeIn, and these moves are a clear signal that Skype needs to move off the PC and into the hands of consumers to generate appreciable revenues.

Another driver behind the company’s recent moves is the fact that Skype is no longer the runaway leader in VoIP traffic. Their early market dominance has eroded as retail VoIP offerings are gaining rapid traction, especially as part of a bundle offered by cable MSOs. Skype may be a very attractive free service, but that is not stopping millions of households from signing up as paid subscribers with the likes of Time Warner or Vonage. Millions will continue downloading and using Skype, but with so many broadband voice alternatives now, the value proposition for paid Skype services needs to evolve substantially to capture the kind of dollars eBay will soon be looking for.

Where does this leave Skype? For starters, the tables have turned. They are now competing for dollars instead of being the only game in town. This may be problematic since their service is based on a proprietary protocol, and does not support SIP. Most of the VoIP world is SIP-based, and embraces open standards. Skype may have created the first mass market, high-quality peer-to-peer voice service, but several others have innovated around them. SIP can be the driving factor that translates into widespread adoption of VoIP, and once the rest of the market reaches critical mass, Skype’s market power and brand will be diminished. Further complicating the issue is that Skype has been largely shut out of the enterprise market, where attractive revenue opportunities are waiting to be exploited.

One alternative is for Skype to completely open its API and become a platform that allows others to build on top of it. Some argue that in theory, Skype has opened up its APIs, but the reality has been somewhat different, with most of the best applications remaining homegrown and in-house. The danger, of course, in following an open API strategy is that Skype’s “secret sauce” becomes less of a differentiator, and revenues will largely flow outward to the developer community rather than filtering up to eBay.

Another alternative is to ramp up the spending from eBay to create new services and make investments that will accelerate the acquisition of revenue generating customers. In the weeks following CES, Skype has in fact been on this path, and we expect to see more of the same in the weeks to come. One of these moves was a partnership with Vapps, a New Jersey-based audio conferencing vendor. They have launched a service called High Speed, which allows Skype users to scale well beyond the existing conferencing limit of 5 per call to as many as 500 concurrent callers. This may well be a breakthrough offering, but it is hard to envision how popular it will really be. Bigger may not necessarily be better.

More recently, Skype announced a very curious investment in the Spanish WiFi startup, FON. Not only have they backed a new venture with an unproven – and for many, illegal – business model, but their co-investors include Google, their archrival in some regards. On the surface, Skype no doubt sees parallels in the iconoclastic zeal of FON’s founder, and their own early roots. Although WiFi will be a key technology for Skype’s future, it is not clear why they put their money on this horse, when other alternatives exist.

The FON investment may be a case of rushing to market to stay ahead of the competition, rather than making a strategic bet on broadband access. In this regard, Skype appears to be out of its element. Of course, their brand is still strong, and their subscriber numbers continue to grow at an incredible rate. However, it remains to be seen if these recent moves will translate into significant revenues and offer eBay a return on its substantial investment.

2. Google Speaks – And Everybody Listens

Following the Skype acquisition, Google’s rapid ascent onto the VoIP stage was perhaps the biggest story of 2005. Unlike Skype, Google has made most of its moves on its own. They have adopted an attitude similar to Microsoft in terms of resources, drive and market dominance. More than anyone in the Internet space, they have figured out a business model that makes money and offers something that virtually all broadband users have a need for – Internet search. Like Microsoft, they seem determined to do things very well, in whatever they choose to do.

GoogleTalk is the company’s initial foray into voice, and like Skype, it is a VoIP application that integrates with their instant messaging platform. They have recently taken things a step further with Google Click-to-Call, which is currently in test mode. The offering is still a bit of a mystery, but the underlying idea is quite powerful. Users who want to contact an advertiser would “click-to-call” via the search results, and a call (either VoIP or PSTN) would be initiated from their phone to the advertiser.

There will be no cost to the caller, since it is an advertiser driven model. However, there may be fundamental security and privacy concerns about Google having access to their telephone number, even if only for the amount of time it takes to place the call. There is certainly a convenience factor for using the PSTN to place these calls, but it remains to be seen if consumers will accept the idea, and if it is even economically viable for Google. Regardless, it is another example of Google pushing the boundaries for integrating voice with Internet applications.

That being said, Google’s Click-to-Call service is neither new nor radical. Companies such as eStara and GlobalPhone, among others, have been offering this functionality for over five years, though they have never been applied to a mass market model or Internet search environment. Though their business models are quite different, these companies have proven that a PSTN-based approach can work, especially since it is far more ubiquitous than VoIP. Other large companies have also made click-to-call investments recently, namely Microsoft acquiring Teleo, and IBM partnering with Avaya.

Another interesting twist on click-to-call is a more recent announcement with Florida-based VoIP Inc. Details are not clear, but Google has struck a relationship to peer IP traffic with one of VoIP Inc.’s subsidiaries, VoiceOne. Time will tell, but it appears that Google will be able to offer both flavors of click-to-call – IP and PSTN. Perhaps they are just hedging their bets here, and want to be sure that all their advertisers will be reachable by all of Google’s users.

Google continues to remain focused on where the mass market is headed. At CES last month, they demonstrated the “Google Button” as part of their alliance with Motorola. By bringing search to mobility, Google can address the fastest growing area of personal communications – wireless. Unlike earlier versions of mobile search, which are text-based, the “Google Button” is GPS-based, and will allow for more localized one-touch search queries. Motorola’s handsets are GPS-enabled, hence the partnership.

On the PC-based front, Google has been equally active as of late. In early February, they launched Gmail Chat, which basically integrates IM with their email platform. Google’s Gmail has already become the fourth most popular email program for web users, and adding chat is a logical brand-building extension. Google Talk completes the trifecta here, which is essential for them to stay competitive with Yahoo and AOL, both of whom offer voice and IM integration with their email platforms.

We are barely into the first quarter of 2006, and Google has clearly been very busy. Like Skype, they are aggressively exploring new avenues in this Wild West market of IP. There is certainly much at stake, and Google seems determined to be a major force in the voice market. They cannot do it alone, which has partners trying to cash in on the Google halo effect. Investors should follow their moves closely, as we expect to see an IP arms race unfolding this year where the IM giants bulk up to take on the RBOCs and MSOs for their share of the broadband home.

3. Net Neutrality – High Stakes Poker for the Internet

“Net neutrality”, which basically pits carriers against content providers, has become a raging issue recently. This may prove to be a decisive battle as IP goes mainstream, and the market makers draw their lines in the sand. The argument has become more vocal recently since carriers have claimed that content providers have been getting a free ride.

In network parlance, “a bit is a bit”; they are all the same, and are treated equally. However, facilities-based carriers, namely the ILECs and MSOs, are increasingly seeing things differently than their competitors. Since they control the last mile and have the ability to control the flow of packets, they also have the ability to ensure that their bits get priority over those coming from competitors who are riding for free over their networks.

SBC’s (now AT&T's) CEO, Ed Whitacre, threw down the proverbial gauntlet in the now infamous BusinessWeek interview, brashly proclaiming that content providers like Google or broadband operators like Vonage will have to pay the freight to traverse their network, in a two-tiered architecture that charges for quality of service. Diametrically opposed are leaders like Vint Cerf, one of the creators of the Internet, and now Chief Internet Evangelist at Google, who hold the view that the spirit of the Internet is rooted in the notion of free access to all information over broadband. This environment has spawned tremendous and rapid innovation, all of which would be threatened by the imposition of an “Internet toll” and discriminatory access policies.

Both positions have merit, but it is difficult to see how they could co-exist. Facilities-based carriers face painful declines in their traditional lines of business, and with mounting competition, they are under pressure to find new revenues and to monetize their assets any way possible. The RBOCs are simply not willing to tolerate free riders who will eat their lunch along the way.

The RBOC solution, however, does not sit well with the free riders. A two-tiered Internet, where RBOC services flow unimpeded, but others do not, raises a host of concerns. Most would argue that the telcos are getting their fair share of revenues from subscribers – that’s always been the way the networks have been paid for. Charging content providers a toll on top of this is “double-dipping”, though the RBOCs feel this is justified since they bear the burden of investing in the infrastructure necessary to carry these wonderful IP services.

A more ominous issue is QoS, where subscribers pay a premium to receive telco-grade quality. This is where the notion of a two-tiered Internet becomes troublesome. In effect, the “free riders” are penalized, since their services suffer sub-par quality unless the subscriber pays a premium. Technically, there is no justification for this, since subscribers today receive carrier-grade quality from most of these content providers. Since the RBOCs manage QoS, and they decide which services get priority, no longer will the Internet be free and democratic, which does not bode well for consumer-friendly innovation.

To resolve this, the carriers – both telcos and cable MSOs – have been lobbying for a rewrite of the 1996 Telecommunications Act. They would like to eliminate the “network neutrality” provision, which has so far been voluntary. Conversely, the content providers want to see it stay and be updated to ensure everyone can use the same lanes on the Internet information highway.

Given how FCC policy has become increasingly pro-carrier so far during the Kevin Martin administration, it is not surprising to see content providers taking matters into their own hands. The most direct response is to build or create alternate networks for content providers. To this end, it is well known that Google has been acquiring “dark fiber”, which is still plentiful due to the overbuilding that occurred during the tech bubble. They have also started building out WiFi coverage, which is far more economical than a wired infrastructure. Should this prove viable, Google could become a big winner in the net neutrality wars.

Wireless alternatives are emerging as well, most notably with municipal WiFi initiatives in cities such as Philadelphia and Long Beach. Earthlink is an early leader here, having won the bid for Philadelphia. Municipal WiFi is an unproven concept, but could well become the future for ISPs who will find increasingly fewer options for partnering with facilities-based carriers.

Finally, with QoS being at the heart of a dual-tiered Internet, investors need to follow the leaders in this space. This would include the major router/firewall vendors – Cisco and Juniper, but also specialist vendors such as Caspian Networks and Qovia.

The drama around this bedrock issue has begun playing itself out, with the initial Capitol Hill Senate hearings taking place on February 7. Both sides are lining up their best and brightest to convince the FCC that they know what’s best for the Internet. The outcome remains to be seen, but we expect it to be a defining moment for IP’s future – for better or for worse. We will certainly revisit this in future issues.

4. Art of the Deal:
XConnect Wins World’s First National MSO VoIP Peering Project

Our January issue included a feature on VoIP peering exchanges, and briefly noted two major RFIs, one in the Netherlands, and a much larger one from CableLabs for the major U.S. MSOs. The article also identified the leading peering exchanges that are vying for these groundbreaking initiatives.

This issue marks the debut of our “Art of the Deal” feature, and the focus is on the outcome of the Dutch RFI, which was just made public on January 25. The XConnect win is an important deal since it provides validity to large scale VoIP peering, and is an important building block in creating viable PSTN alternatives.

In absolute terms, Holland is a small market, but it represents a model that other EU markets could adopt, as well as Asia and Australia. More importantly, though, it serves as a precedent for the all-important U.S. market, where the MSOs present a much larger and more imminent threat to the ILECs. To date, individual MSOs have had little reason to peer, and in an atomized state, they only have localized clout.

The stakes become much higher, though, if the cablecos banded together – or federated as those in the peering community would say – and created a common platform to share traffic together. Imagine all the CableLabs members peering their traffic this way, which would create a national footprint larger than any RBOC, and a de facto end-to-end network that bypasses the PSTN altogether.

This sets the table for the XConnect win. The Dutch tender represents a working group of the country’s five cable operators, with a total of 7 million subscribers, and over 450,000 VoIP users. With a 97% penetration level, virtually all of Holland has cable, meaning that once the peering agreements are in place, the MSOs will be able to duplicate the footprint of Holland’s telcos with an interconnected IP network.

Consumers are among the winners because the MSOs are able to offer free on-net calling, much the way people use Skype to call anyone else on the Skype network for free. This capability will allow the MSOs to offer very compelling VoIP plans that the telcos will have difficulty matching. Furthermore, traffic that stays on-net from start to finish saves the cablecos on interconnect charges they would normally pay to telcos like KPN when routing calls over the PSTN.

Another important benefit is an improved ability to offer multimedia, IP-based services. These new offerings represent the true ROI for IP, and with end-to-end IP connectivity, cablecos will have more control over the provisioning and delivery of these services. In other words, IP services are compromised when they traverse the PSTN. Functionality is lost when transcoding a signal from IP to TDM, and then back to IP when it reaches the destination. For example, a videophone call works as advertised when it stays on-net. When the PSTN is involved, these calls tend to lose the video, and become reduced to ordinary phone calls.

XConnect emerges as a big winner as well, by virtue of this being the first deployment of its kind. Presuming the execution proceeds as planned, they will gain invaluable experience in managing the complexities of peering on this scale. Not only does it validate the value of VoIP peering, but it also validates XConnect’s solution, which was a joint effort with Kayote Networks, who specialize in critical peering areas such as interoperability, security, identity, routing, addressing, and URI directory management (ENUM).

On the flip side, the Dutch PTTs are the most at risk, followed by the international carriers they pass traffic along to. Not only are they more vulnerable now to falling prices and shrinking subscriber bases, but if they do not respond effectively, they stand to become disintermediated altogether.

Looking ahead, all eyes in the peering space will be on the CableLabs RFI, which received 30 bids. A decision timeline has not been announced, but it would appear that XConnect is now well positioned by virtue of the Dutch cable win. Should the outcome go their way, both XConnect and Kayote Networks would have to be viewed as early frontrunners in a market that many analysts feel is poised for rapid growth in 2006 .

5. Financial Highlights