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. Apple’s iPhone – Why Launch Now?

The New Year has already started with a number of notable deals and developments, but perhaps none as big as Apple’s iPhone launch on January 9. Despite the massive scale of the 2007 Consumer Electronics Show – their 40th – the biggest tech story of that week took place elsewhere at Apple’s own event, MacWorld. Marketing savvy has long been part of the Apple mystique, and the iPhone is no exception, especially considering that the product will not be available until June at the earliest.

In our December issue, we examined the smartphone market in the context of Motorola’s acquisition of Good Technology. The recent changes in the smartphone sector may explain Apple’s rush to announce the iPhone so soon, but we suspect other factors are also in play. We believe that the opportunity to upstage CES was too good to pass up, and that the FCC’s approval of the AT&T/BellSouth merger was also involved here.

One of the by-products of the AT&T/BellSouth merger is single owner for Cingular, whose wireless services will be re-branded under the AT&T umbrella. Apple’s entrée into telephony comes via an exclusive agreement with Cingular, so this Apple deal could lead to a longer term relationship with AT&T. Such a deal obviously could have future implications for competitors such as Motorola, RIM, Nokia, and Palm and their respective smartphone offerings.

The Cingular relationship is a mixed bag, and we cannot explore all the angles here. The easy explanation is that they are clearly the best carrier partner for a GSM launch in the U.S. – despite their too-slow EDGE network – but they likely were also the most pliable partner. Apple is very shrewd and seeks to control all aspects of its business. It has recently come to light that Verizon was approached early on, but the terms were too one-sided, so they passed on the iPhone exclusivity. Apple needs a partner to be in the mobile phone business, and have likely come to realize they cannot have it all their way. The Cingular relationship is not ideal for Apple, but we see it as being the most expedient for purposes of getting to market in 2007.

Despite the product announcement and the Cingular deal, there is no guarantee of success for Apple in telecom. While they did not invent the MP3 player, they reinvented the category and have since dominated with the iPod. The same cannot be said of wireless telecom, which is a new business for Apple, and the leaders are well established and very deep pocketed. To varying degrees, the iPhone may be viewed as a revolutionary product, but there is no shortage of opinion lauding its many shortcomings.

The iPhone is an impressive piece of consumer technology on paper, and may very well reshape how we interface with a mobile phone, but will take some getting used to. At a very basic level, the iPhone is expensive, large in size, has no buttons, and has limited memory for such a sophisticated multimedia device. It remains to be seen if using your finger as a pointing device is really a better user interface than the tried-and-tested keypad. The offering seems more targeted at consumer users, and may attractive relatively few business users, which is the sweetspot for both the Blackberry and Treo. We expect that these factors will prevent it from having mass-market success early on, but the early adopters and Mac crowd will no doubt be first in line.

Despite these concerns, there is good cause to get excited about the iPhone. Apple has an unrivaled cachet of cool, and the relatively high price of the iPod never got in the way of its success. The iPhone may not be at the leading edge of features, but its WiFi capability, and full screen Internet browser via Safari are the kind of things that redefine what a smartphone can be. Furthermore, by adopting GSM, Apple has created a global product that will be ready for rapid adoption once rolled out to the mobile-savvy markets in Asia and Europe.

Perhaps most important of all is the OS X platform inside. One could argue that the iPhone is really a mini computer with a softphone, and in that context, Apple could really become a game-changer. In reviewing Apple’s trademark filings, one can see that gaming is another application this device could potentially support. With an embedded OS X, it would not be a big leap to add gaming, which would put the iPhone squarely in competition with Sony and Nintendo. At this point, the phone almost becomes an afterthought. Looking even further ahead, Apple is undoubtedly using iPhone as a test product for their scaled-down OS X. If they have success here, you can be sure there will be other cool Apple consumer devices and appliances in the pipeline that will be of great concern to the likes of Sony.

Of course, you could argue that the iPhone is trying to be too many things, and will end up being the Swiss Army Knife of mobile telephony – something everybody loves, but nobody needs. Furthermore, there will certainly be some degree of cannibalization among consumers postponing iPod purchases as they wait for the iPhone. However, we feel that Apple can use this timing to their advantage – in effect gauging consumer reaction to the product before it hits the streets. They have six months to take in all this attention and free advice to fine-tune the product. So why not announce the product now, even if it is not yet available for prime time?

And then there is Cisco. The issue about ownership of the iPhone trademark is contentious, and brings into focus just how much is at stake. At face value, Cisco owns the trademark, but there is a stronger case to be made that they have not defended it until recently, and their sudden move to brand a line of Linksys phones under the iPhone name in late December now looks contrived. Cisco has argued that they want their phones to interoperate with the iPhone, as it is in the spirit of open systems. This is a noble sentiment, but rings a bit hollow when one considers how closed most of their IP telephony offerings really are. Perhaps this explains why Apple has boldly come to market using the iPhone trademark without legal title to the name.

We can think of no parallel to the iPhone in terms of a product that has the potential to impact so many sectors of tech and telecom. This is especially noteworthy because the product has not yet come to market, and Apple is a telecom outsider. There are numerous other legs to this story, and we will revisit the iPhone shortly after it launches.

2. Consolidation Trend Continues

Only one month into 2007, the consolidation trend has already become well established. In addition to the Arris / Tandberg TV deal covered later in this issue, we have seen five other notable acquisitions during the month of January. In the last newsletter, we assessed the 11th hour approval of the AT&T/BellSouth merger just as 2006 closed out, and believe that this has set the stage nicely for 2007. With the U.S. service provider landscape largely settled now (but not entirely), it is not surprising to see such a healthy flow of deals as vendors either bulk up or acquire strategic pieces to keep pace with their key customers. Here is a brief snapshot of these five acquisitions.

#1 Cisco / IronPort Systems – Next to the Arris / Tandberg deal, this is the biggest acquisition so far in 2007. This deal was announced on January 4, and was valued at $830 million, for a mix of cash and stock. IronPort is a privately-held messaging and email security vendor, so this move seems like a way for Cisco to stay competitive in the enterprise messaging sector with others like Microsoft. The deal is valued at about 8X Ironport’s revenues, and a significant return on the $100 million invested in the company. The valuation will be welcome news to all the other security vendors, and we can expect to see further activity on this front as the role of security in IP solutions continues to grow.

#2 Avaya / Ubiquity – This deal was announced January 12, and is another cash deal, valued at $145 million. Ubiquity Software is a leader in SIP application servers, which are a key component for IMS, so Avaya is getting some valuable and proven technology. The fit, however, is not that evident, as Ubiquity has focused mainly on carriers, while Avaya is an enterprise play. That said, Ubiquity does have applications that are relevant for enterprises, such as SIP-based conferencing, and we suspect the real value lies in strengthening Avaya’s IMS story, and perhaps making it easier to provide solutions that carriers will roll out to their enterprise customers. One could also argue they bought it for defensive purposes, as in keeping Ubiquity away from Cisco. It is worth noting that Ubiquity’s revenues were small – around $20 million – and they were losing money, so this represents another successful exit for Terry Matthews and Wesley Clover.

#3 Polycom / Destiny – In another cash deal, Polycom acquired Destiny Conferencing for $48 million. The two have enjoyed a successful partnership, but as the stakes keep climbing in the telepresence market, Polycom has wisely moved to bring Destiny and their patents in-house. This sends a clear message to the competition that Polycom is in this game, and will defend their market, especially against the outsiders, namely Cisco and Hewlett Packard. For further reference, please see our telepresence analysis in the November issue, as well in the video roundup article that follows below.

#4 Amdocs / SigValue – Valued at $54 million, this deal represents consolidation in the OSS and billing space. Amdocs already holds a minority stake in SigValue Technologies, and on January 3, announced they were buying the rest in cash. Much like other consolidators such as Motorola and Cisco, SigValue is just the most recent in a string of acquisitions, as Amdocs seek to dominate this critical space. With FMC poised to become commercially deployed in 2007, OSS and billing will become a key enabler as fixed and mobile carriers seek to integrate their operations and offer revenue-generating services across multiple networks.

#5 eBay / StubHub – This deal announced on January 10, and was valued at $310 million – all cash – and represents a form of consolidation in the e-commerce space. StubHub is an online ticket reseller, mainly for sporting events, but they have recently branched out into other entertainment areas such as theater and music. Unlike the other deals, which are hardware/software vendors buying other vendors, this one is about online services, an area we expect to see substantial growth, especially as broadband penetration increases and electronic payment and settlement systems mature. This deal strengthens eBay’s position against more traditional competitors like Ticketmaster. We look to see a number of other large players become active in this market in 2007, including Google, Yahoo, Microsoft, Visa and MasterCard.

3. Current Developments in Video

Aside from the strong deal flow so far in 2007, we have seen an unprecedented level of activity in the video sector in January. We use the term “video” loosely here, as it includes several areas that are rapidly evolving, are having a significant impact on their target markets, and represent exciting potential for deals in the near term. Below is a short summary of four different video scenarios we are closely following.

#1 Telepresence – A lot has happened since we analyzed the Cisco Telepresence launch in the November issue. We would like to focus on two developments here, both of which occurred in January. The biggest story is the alignment of Tandberg with Hewlett Packard, which we see as a strong move for two reasons. First, it stands in direct contrast with Cisco’s closed approach, and offers a more flexible, standards-based solution that can immediately address a much broader market. Second, there is mutual benefit for both partners. Tandberg, who just launched their own High Definition (HD) telepresence solution – Experia – can now offer the even higher end Halo Collaboration Studio, and now boasts the most complete telepresence product family in the market.

Hewlett Packard, on the other hand, now has a partner in Tandberg, which gives them much easier access to an installed base who may consider upgrading to Halo. Perhaps more importantly, Tandberg is an ideal partner to utilize their dedicated HVEN – Halo Video Exchange Network – which really is a win-win for both companies.

The second development in January is Polycom’s move to upgrade its RPX telepresence solution to HD. This builds on the Destiny acquisition cited in the previous story, and ensures that Polycom keeps pace with Tandberg and Cisco in terms of offering state of the art video quality. The strategy is right, but we are not so sure about the execution. RPX HD will only be offered outside North America, while the home market will have to live with Standard Definition. With pricing being north of $200,000, we cannot see how Polycom will be competitive in North America without HD, especially now that Tandberg has raised the bar with its wide range of telepresence solutions.

#2 Brightcove Gets Funding – We featured Brightcove in the December newsletter, and on January 17, they announced their third funding round, an impressive $59.5 million. This level of commitment further validates our view that a distribution platform for professionally produced content is the basis for a new business model. The New York Times and Warner Music Group are early believers in this model, and we expect to see explosive growth here in 2007, especially as the major network and cable television channels expand their online programming initiatives.

As we noted in the December article, this is a very different approach to video than Google/YouTube, and one we believe will be far more lucrative. Brightcove is not the only player in this rapidly evolving space, and others we are following include iTunes, Tivo, Orb and Cozmo.tv. These are very disruptive times for broadcasters, and as the market matures from time shifting to place shifting, the economics change, creating opportunities for new players all along the value chain. In this context, it is not difficult to see why Brightcove received so much funding, and in our view, the time is now for them to claim their stake.

#3 Joost – If you thought Skype was a strange name, how about Joost? Previously known as the Venice Project, the founders of Skype launched their attack on the video space in January. Joost is not alone in the belief that there is a market ready to watch television and movies online, but they have taken a different path. Whereas most models are based on storing content on servers, which is then downloaded by viewers, Joost has adapted Skype’s peer-to-peer approach for video. In short, they view this as a more cost effective way to manage and deliver video-based content, which normally requires far more bandwidth than most people have.

Joost has developed video compression technologies to mitigate this problem, and as content deals fall into place, they will represent a powerful alternative for consumers. Having learned their lessons from Kazaa, Joost will only offer 100% legit content, and building on the success of Skype, they want the service to be free, which dictates that an advertising-based model will be needed. We will be following Joost closely, as we believe their vision of online television will be successful, and if so, will spawn numerous investment opportunities along the way.

#4 Netflix – Streaming VOD – We wanted to mention this briefly as an example of how established companies are responding to the shifting sands beneath them. Netflix is the world’s largest online rental service for movies, and they have done well using a physical distribution system of sending DVDs by mail for rental customers. On January 16, they launched a new online service, where customers can instantly download streaming video on a rental basis. Being new, they can only offer about 1,000 titles of movies and TV shows, but their online catalog will no doubt expand quickly. Essentially, they have tapped into changing consumer habits, especially the desire for anywhere, anytime viewing, and the ability to download content with minimal delay.

Netflix has taken an innovative approach to pricing, with tiered plans, based on blocks of time, and works out to a rate of $1 per hour. By using blocks of time, subscribers can view content any way they like – they can watch one movie multiple times, they may only watch portions of a movie, or they can mix and match across any number of titles. This is a very different pricing model, but fits well in the world of IP, and we think is a harbinger of things to come, as video companies scramble to adjust to a changing market. The four streams of video we have covered in this article are just part of the story, but are a good indicator of what the year ahead holds in store.

4. Art of the Deal - Arris Acquires Tandberg TV

On January 15, Arris Group announced its offer to acquire Tandberg Television, a move that vaults the combined company into the top tier of video networking vendors, alongside Motorola and Cisco. The deal, valued at approximately $1.2 billion, is a mix of cash and newly issued Arris stock, and is expected to close during Q2 2007. (Tandberg TV is a sister company to Tandberg ASA, the videoconferencing leader mentioned in the previous article).

Arris has long been a leader in selling voice and data technologies to cablecos, and with Tandberg, they can now expand into video, with the ability to serve both the cable TV and IPTV markets. This deal is typical of the continuing telecom vendor consolidation trend, and as technologies mature into viable business opportunities, the larger vendors make strategic acquisitions to establish themselves as market leaders. With the pool of large service providers shrinking, suppliers must scale up as well, and within any given segment, two or three vendors will emerge as dominant and in the best position to serve the biggest buyers. This is exactly what we see in this deal, and feel it is a good move for both companies.

Arris continues to be a leader in the cable market, especially with cable modems and cable modem termination systems (CMTS), and there is little overlap with Tandberg here. However, Tandberg does bring Arris into the video arena, particularly video processing and encoding, where they are a top tier supplier to over 170 service providers globally. Not only does this bring Arris into the burgeoning IPTV market, but also it broadens their product portfolio for cable operators beyond modems and CMTS to video applications such as encoding, transcoding, multiplexing and system management.

Tandberg, on the other hand, gains some stability, as the IPTV market has been slow to develop. Their sales were below expectations in 2006, partly due to lighter than expected demand – especially for HD chipsets – as well as the loss of two major contract bids in Q3. Tandberg is not alone in this regard, as all IPTV vendors have struggled, waiting for the telcos to make their long-awaited deployments. In the U.S., AT&T’s U-verse service is the most significant IPTV deployment, and the results so far are good, but not perfect.

Aside from IPTV, Tandberg also benefits via Arris’s strong market position in the U.S. cable market. Tandberg is largely a European company, with a Norwegian parent and U.K.-based headquarters. The two companies also share Atlanta as a U.S.-based headquarters, and will have combined revenues of about $1.3 billion in 2006, which is slightly more than the value of the deal. Arris expects year-end revenues in excess of $900 million, while Tandberg expects to be at about $350 million.

Arris had been looking at acquisition targets for quite some time, and has openly discussed M&A as a component of a broader strategy. In November, Arris closed a convertible debt offering to bring $276 million in cash into the company, largely to fuel M&A.

Consistent with how other markets are evolving, this deal by Arris was largely predicated by the competitive environment. Motorola and Cisco are their strongest rivals, especially in the traditional cable modem market, which itself is undergoing a fundamental transition. Motorola has the most history in this space, whereas Cisco has entered via its more recent acquisition of Scientific-Atlanta.

This market has two basic segments – data-only modems, and integrated voice and data modems. Traditional data-only modems follow the DOCSIS standard, and like the PSTN, represent the legacy-based solution. Data modems are very good at what they do, and account for most of the installed base. Motorola and Scientific-Atlanta (now Cisco) are the equivalents of Nortel and Lucent in this market, and are the clear leaders. Other key data modem vendors include Ambit and Thomson, and Arris is a minor player in this market.

The story is very different in the integrated modem market. These modems contain an embedded chip that supports VoIP, and conform to the PacketCable specification. Referred to as E-MTAs – Embedded Multimedia Terminal Adapters – these modems are driving the growth, much the way that telecom vendors are shifting from PBXs to IP PBXs. E-MTA growth is outpacing data modems, and should become the dominant product within two years. Arris is the clear market leader for E-MTAs, with Motorola and Scientific-Atlanta being the only serious competitors. The cable modem market continues to enjoy healthy growth, and as the momentum swings towards E-MTAs, Arris should remain well positioned for the foreseeable future.

To keep pace with Motorola and Cisco in the video market, however, Arris needed to combine with a company like Tandberg TV. With IPTV being slow to develop, there is still a window for them to become a player, so the timing was right for this deal. Motorola was on a major acquisition binge in 2006, including a number of video targets, namely Tut Systems, Broadbus and Vertasent. Cisco has been in a similar mode, and aside from the very expensive Scientific-Atlanta deal, their video acquisitions have included Arroyo, KiSS and Widevine. Most of these deals were relatively small, and with one large deal, Tandberg TV brings Arris up to par with Cisco and Motorola, at least for now. Furthermore, had Tandberg TV gone to either competitor, it would have been much more difficult for Arris to get into the game.

Going forward, the video market is now left with fewer players, with the lion’s share consolidating around these three vendors. In terms of who’s next, the two companies to watch are Terayon and Harmonic. It has been widely reported that Terayon is currently evaluating its strategic options, after completing its re-audited financial statements. One scenario would see them merge, especially since they have an existing reseller arrangement in place. Another scenario could have Harmonic acquiring Terayon, which would enable Harmonic to become a fourth video player, albeit a distant competitor to the top three.

Other suitors for Teryaon could include Motorola and Cisco, but with the Tandberg deal still to consummate, Arris is not likely to be an active participant. We expect to see other deals in this space, as the video market is still developing, and no vendor has all the pieces assembled. Regardless of Terayon’s fate, Arris has done the right thing by acquiring Tandberg TV, and we suspect that service providers are happy to know they will have more to choose from than just Motorola and Cisco.

5. Financial Highlights