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. Top Deals of 2006

As 2006 comes to a close, we thought it may be timely to look back at some of the most interesting deals of the year. Clearly there was a lot of vitality in the IP communications market in 2006, and we expect more of the same in 2007. When considering the scope of activity during the past 12 months, we are struck by the diversity of sectors being shaped by IP communications.

Not long ago, VoIP was the driver of this market, but today it is one of several branches on a rapidly growing tree. Alongside VoIP, 2006 saw several other sectors attract significant attention from the financial community, namely IPTV, WiFi/WiMAX, instant messaging, peer-to-peer, mobile applications, social networking, videoconferencing, IP broadcasting, FMC and IMS. For this year-end review, we feel that five deals in particular stand out, not just on their own merit, but for the broader implications in the IP communications world.

#1 Deal – AT&T/BellSouth Merger

It is interesting that our top deal of 2006 is a deal that was in danger of not happening, but was finally approved by the FCC on December 29. The deal, when announced on March 5, was valued at $67 billion – by far the largest in telecom – and had shades of putting Humpty Dumpty back together again. This merger placed AT&T back at the top of the U.S. telecom food chain, and in our view, created a ripple effect that has been the driving force for many of 2006’s important telecom deals. The merger touched off a wave of consolidation among carriers, which in turn led to combinations among vendors, reinforcing the need to build size and scale in order to be competitive in the telecom market.

Among carriers, the deal quickly reduced the U.S. wireline market to a duopoly with Verizon, and pushed Qwest aside as a regional provider. On the wireless side, Cingular became an integrated giant, leaving Sprint Nextel to carefully consider its options. There were many other implications for AT&T's market power in areas such as consumer VoIP, business customers, DSL service, IPTV, and on the regulatory front, especially for the pivotal issue of Net Neutrality.

The irony here is that this deal was expected to close in the fall, but the FCC approval process dragged on, and all of this regulatory activity has transpired with AT&T/BellSouth still on the table. As 2006 raced to a close, and following the ascendancy of the Democrats since the mid-term elections, the odds of the deal getting approved began to look longer, not shorter. Consumer and industry opposition to the merger had time to gain more momentum in a political climate that is now less receptive to this type of industry concentration, especially since the value of deal has now grown to $86 billion.

Opponents to the deal were looking for concessions on Net Neutrality, and likely came away disappointed. AT&T has agreed only to uphold the basic principles, but the deal approval does not represent a definitive FCC ruling on Net Neutrality. And at that, the terms only apply to residential voice and data services (not IPTV), leaving AT&T free to set terms of service for their business customers. It is too early to assess the implications and wisdom of the FCC’s decision, but the deal is done, which will be especially welcome news for all the vendors whose bids with either BellSouth or AT&T have been in limbo for a long time.

#2 Deal – Alcatel/Lucent Merger

As a result of the AT&T/BellSouth deal, incumbent telecom vendors had no choice but to move in lockstep, as their pool of prime customers continued to shrink. The first mega-deal among equipment vendors was announced on April 4, when Alcatel announced that it was acquiring Lucent for a reported $13.4 billion. The deal was later termed a merger, dubbed “Lucatel”, as Pat Russo was appointed CEO even though the headquarters were to remain in Paris. The deal finally closed on November 30 as the combined entity was renamed Alcatel-Lucent, with a new logo representing the limitless possibilities of the future, and $25 billion in legacy revenues.

As a result of this deal, other equipment vendors also decided to pair up. Siemens merged its networks division with Nokia, and Nortel allied itself with Microsoft. This in turn led second tier vendors to do the same, and ensure their primacy with the legacy vendors who often bring them into Tier 1 deals. Tekelec had already gone down this road, but they were soon followed by AudioCodes and Cantata, who each chose different paths to bring various nextgen elements together under one roof. Finally, vendors such as Radisys and Comverse made themselves more relevant to this market by making best-of-breed acquisitions.

#3 Deal – Vonage IPO

There is no doubt that Vonage was the most newsworthy communications IPO of 2006, both in its anticipation and its reception. The chronology of events following Vonage’s May 24 listing was widely reported as one of the biggest debacles of the year. Leading up the IPO, Vonage was considered the poster child of VoIP, but with a questionable business model and intensifying competition, market sentiment quickly shifted from underdog to doghouse status. Their share price quickly dropped from around $17, and has now settled in the $7 range, giving the company about a $1 billion valuation.

Despite its problems, the company has grown to over 2 million subscribers, achieved fairly high gross margins, is on course for $600 million in revenues and established a well known name brand. Conversely, they are spending over $1 million a day in advertising, and at current churn rates, they are basically losing one customer for every two that sign up.

With the IPO behind them, Vonage may face problems raising additional capital, especially with an accumulated deficit of over $600 million. By most accounts, the IPO buys them a year or so to make the business work, and we would expect that by Q3 of 2007, their end game will have become clear. If they can fix the business model – and/or find a path to new markets (such as mobility or WiFi), they could become self-supporting, and from there, grow into profitability. Otherwise they may become an acquisition target for someone badly in need of a national VoIP subscriber base.

#4 Deal – Acme Packet IPO

The antithesis of Vonage was Acme Packet's IPO, which we discussed in the November newsletter. We hope the Acme IPO sets the tone for future communications IPOs-in-waiting for 2007. Whereas Vonage’s stock is down over 60% from opening day, Acme has done nothing but trend upward, and at roughly $21, is up 50% from the October 13 IPO. Incredibly, with sales that are a fraction of Vonage’s, Acme’s current market capitalization is slightly higher at $1.2 billion. The difference is Acme's 79% gross margins, positive cash flow, and tier 1 customer base.

Acme was the first VoIP vendor to IPO in over five years. As such, a lot was riding on this, and Acme’s good news story gives hope to companies like BroadSoft, Sylantro, NexTone, Veraz Networks and Aruba Networks. If and when these companies and others in the IP communications space go public this year, Acme Packet will be the standard against which they will be judged.

#5 Deal(s) – Motorola’s Buying Spree

The final deal of 2006 that we feel is noteworthy is really a series of deals that Motorola pursued to further establish itself as a leader in the IP communications sector. As we reported last month with its acquisition of Good Technology, Motorola acquired over a dozen companies in 2006, including Broadband Innovations, Kreatel, Orthogon Systems, TTP Communications, NextNet Wireless, Broadbus Technologies, Symbol Technologies, Vertasent, Good, Netopia, and Tut Systems, not to mention a $300 million investment in Clearwire.

While Motorola has a long history of growth through M&A, we feel that 2006 was particularly interesting in that they seemed to go after companies spanning the areas of cellular, broadband wireless, enterprise wireless, fixed-line access, FMC, IPTV, and software. The deals also ranged in size from just a few million to over $4 billion for Symbol. Clearly the team at Motorola is looking to expand the company’s $40 billion in revenues and $50 billion market cap to a multiple more along the lines of Cisco’s $16 billion market cap on $30 billion in revenues, so we look for them to do more deals in 2007.

2. 2007 Outlook – Trends to Watch

There are several important trends behind the key deals of 2006 that will carry into the New Year, along with others that have not yet resonated as much with the investment community. Here are four emerging trends that we think will be particularly important to follow in 2007.

#1 Trend – Cisco Versus Microsoft

This may appear as an unlikely coupling of companies, but both are big enough to warrant a trend of their own. Each has ambitious plans around IP technologies, and we see them being on a collision course in 2007 in both the consumer and business markets. Microsoft has long owned the consumer market, and has been pro-IP ever since it built SIP support into Windows XP. Their VoIP plans have been made known at various times during the second half of 2006, and they clearly have strong designs for integrating voice into their various platforms.

While this has been a big story, it has not been Microsoft’s only story. Of greater relevance to Cisco in the consumer market is their relentless focus on IPTV, where they have become a dominant player, especially in partnership with Alcatel-Lucent. Cisco is another major player in IPTV, and 2007 will see the first large scale IPTV deployments, so both vendors are betting heavily on this market. We intend to follow this closely for a simple reason – video is not a core competency for either company, but both have made many investments and acquisitions to become market leaders, and we fully expect this trend will continue in 2007.

On the business front, there will be a different battle fought. Microsoft may own the desktop, but Cisco owns the network, and they both want it all. 2006 saw both companies announce their all-encompassing unified messaging/communications platforms. It is difficult to see how the two will co-exist. Microsoft further upped the stakes with its Nortel alliance, although it is too early to evaluate the results.

Cisco will not displace Microsoft’s operating system, but they will seek to challenge them for control of the applications and how Microsoft interfaces with other IT functions and business processes in the enterprise. This will have significant implications across the complete enterprise value chain, and we expect both will be active acquiring strategic pieces throughout 2007.

#2 Trend – Voice 2.0 Applications

We see this as the broadest reaching trend in this group, as it means different things to different people. The underlying notion is that in a broadband world, applications drive value for subscribers, not access. Legacy-style applications simply replicate the past, which has limited financial upside. The future belongs to Voice 2.0-style applications, which essentially covers features or services that leverage the power and flexibility of IP. The end result is high personalized, customizable applications that are user-defined and user-controlled.

We began seeing signs of this in 2006 with companies like Iotum and iSkoot, which work with web-based capabilities like presence, peer-to-peer, and open source to enable a richer communications experience. More importantly, we see them being the basis for value-added services that carriers can easily deploy and generate new revenues from. We expect to see a plethora of such applications in 2007, many of which will address a specific need or market segment, such as social networking, dating, or listening to your emails.

#3 Trend – Emergence of the Prosumer

We recently referenced this term in an analysis of Brightcove, and how they are focused on professional developers of Internet video content. Whether producing user-generated content for fun and the buzz of being on YouTube, or broadcast quality content for a viewing audience, the prosumer class of commercially driven professionals seeking a market is rapidly evolving. For the Internet generation, this is not a large leap, and IP gives them the platform and the tools to generate an endless variety of content. Brightcove is very much at the vanguard in creating business models around this phenomenon, and we expect others will develop in 2007.

One need look no further than Second Life for evidence as to how quickly these changes are being adopted, and how sophisticated prosumers can be when given a forum to create and interact with others of like mind. As video messaging applications like SightSpeed gain adoption, as the interactive nature of IPTV becomes understood, as web-based communities like MySpace find new ways to engage users, and as mobile devices like iPods add video support, the prosumer will become a market force. This ties into the bigger picture of how IP is disrupting the entire broadcasting sector, and forever changing the interrelationships between content viewers, content providers, and the media that links them together.

#4 Trend – Game Changing Technologies Finally Arrive

We can barely touch on this topic in the newsletter, but we recognize that a number of industry defining technologies will gain serious commercial momentum in 2007. All of these have been evolving for a few years, and are ready for market now. Topping this list for us is IPTV, municipal WiFi and WiMAX, and to a lesser extent, FMC.

At this point, all we can say is that these technologies have received substantial investment, and once they move into the mainstream, each will spawn their own ecosystem of investment opportunities, for both carriers and vendors alike. Collectively, they provide validation that IP is far more than just voice. VoIP has really served as the alpha IP application, and the technology has now moved well beyond that to where the integration of voice, data and video is the Holy Grail for IP. Video promises to be a better moneymaker than VoIP, and mobility is the way people want to use services and consume content. In that context, it is no surprise that the technologies cited above are at the top of our 2007 watch list.

3. IMS Forum Plugfest

The IMS Forum is a non-profit association focused on advancing the progress and adoption of IMS – IP Multimedia Subsystems – services and applications in service provider networks. A key way they facilitate this is through various interoperability initiatives and activities to develop industry standards throughout the vendor ecosystem.

We have touched on IMS in the past, and it remains one of the dominant trends in telecom, despite the fact that commercial deployments remain very limited. We would like to draw attention to an upcoming initiative that we believe is important, not just in advancing IMS, but also for investors following the players involved.

From January 15-19, the IMS Forum will host its first Plugfest event, and is being hosted at the University of New Hampshire Interoperability Lab, located in Durham, NH. One of the notable aspects of this initiative is that it is not a one-off. This Plugfest is the first of a series scheduled to take place through 2008, and will provide a comprehensive “test plan” for vendors to achieve IMS certification and demonstrate best practices across a wide variety of interoperability scenarios.

A key driver behind the Plugfest is the growing need for carriers to deploy next generation applications and services across multiple network environments. There are a few distinct themes embedded in this statement that need to be parsed out. First is the fact that the market for next generation services is now being driven by the demand side rather the supplier side. Initially, carriers did not buy into the IMS vision being touted by the vendors, especially those from the wireless world. They felt that the cost, complexity and disruptive nature of an immature reference architecture were not worth the new capabilities that IMS would bring. Today, however, subscriber demand from both consumers and businesses has grown to the point where IMS is needed to address these needs.

Secondly, there is now a wider range of IP-based services and applications to provide, and subscribers have come to expect to access them anywhere, any time. As such, not only do carriers need to provide a host of multimedia offerings, but they also need to do so across all types of networks, most notably wireline, wireless and cable.

Finally, it must be noted that the IMS Forum’s focus is on applications and services. There are many aspects to IMS that are still works-in-progress, namely agreement on standards and protocols, and the architectural models that shape carrier networks. The IMS Forum, however, is addressing today’s most pressing needs facing carriers – how to remain competitive by bringing new, innovative IP-based services to market in a timely manner – rather than trying to adapt and extend the life of legacy services in an IP world. Most carriers have long viewed IP as the data network around which these services will be standardized, meaning that ATM and Frame Relay are not part of the IMS roadmap.

Another factor behind Plugfest is the notion that IP means open systems, and that carriers do not have to remain locked into a single vendor. Carriers need to be flexible so they can choose the vendors that enable them to offer the right services as dictated by subscriber demand. Vendors certified through Plugfest are IMS-compliant, meaning that carriers can integrate them right away, allowing them to be more responsive to changing market conditions. As the Plugfest program grows, it will become easier for carriers to select best of breed vendors for various applications to support their IMS networks.

In terms of the details, the Plugfest will test a wide range of applications and services across wireline, mobile, WiFi and cable networks. The addition of cable is important as it reflects the fact that now all major types of networks support IMS, and are prepared to work together to achieve common standards and vendor interoperability. We are also drawn to the diversity of applications being validated at Plugfest: VoIP, hosted IP PBX, FMC, presence, instant messaging, IPTV, interactive video and online gaming. These applications would rate highly on almost any carrier’s IP wish list, and the results should be a good indicator as to which applications will be the early IMS winners. Key vendors participating include Sonus, Tekelec, Empirix, Tektronix, Ditech and Trendium.

If this were a perfect world, the story would end here. IMS is far from perfect, though, and we will only touch on two related themes that provide context for Plugfest, and help explain why IMS is not yet here and now. The first is standards bodies, and the fact that the IMS Forum is not the only industry group focused on IMS. The MultiService Forum (MSF) is a bigger entity, but with a different focus. Whereas the IMS Forum is focused on applications and services, the MSF deals more with transport layer issues and network architectures. Complexity is a word commonly associated with IMS, and this a good example. It is easy to see these two groups as being competitive, but they are, in fact, complementary.

Furthermore, in late October, the MSF had its own testing event – Global MSF Interoperability (GMI) 2006. The scale was larger than Plugfest, but there are some differences of note. Plugfest is focused more on applications and services, especially among early adopters of IMS, and several Plugfests will be taking place over the next two years. GMI, on the other hand, occurs once every two years, and caters more to large, traditional carriers – primarily wireline incumbents. Plugfest addresses a wider range of networks, including WiFi and cable, and on that level, more broadly reflects the challenges of network convergence. As such, we see Plugfest as a better indicator of tomorrow’s IMS, whereas GMI speaks more about where IMS is today.

The second theme to briefly mention is Advanced IMS (A-IMS). Plugfest is very much about using new technology to enable new applications based on open standards such as SIP, but this is not a welcome message for everybody. Legacy vendors still wish retain their status with incumbents, and they have a vested interest in continuing to support legacy applications and single-vendor integrated platforms. To support this position, a coalition was launched in July 2006, led by Cisco, Lucent, Nortel, Motorola, Qualcomm and driven by Verizon Wireless. In essence, the A-IMS specifications developed by this group seek to extend the life of pre-SIP services, which would otherwise be left behind in the IP-based world advocated by the likes of the IMS Forum.

It is too early to tell how effective A-IMS will be, but our view is that this creates another layer of complexity on the IMS story, and only serves to satisfy the skeptics. Independent of this, one cannot ignore the fact many vendors offer “pre-IMS” solutions today that enable high degrees of service integration and creation across multiple legacy platforms, lessening the urgency for carriers to make this fundamental shift to a new reference architecture.

That said, we look forward to following the Plugfest event, and anticipate that good news will come from it. We also need to consider the bigger picture, though, and recognize that its impact will likely be incremental at best, at least the first time around. Regardless of impact level, we still feel the event will be a good indicator of companies to watch in IMS during 2007.

4. Art of the Deal - Ericsson Acquires Redback

On December 20, Ericsson AB announced its acquisition of Redback Networks, and with this, hopes to solidify itself as a major player in the IP routing, and in particular, the IPTV market, which is poised to break out in 2007. Redback was acquired in a cash deal for $2.1 billion, which translates to a $25 per share takeout. With Redback’s cash reserves being about $200 million, the net cost to Ericsson was closer to $1.9 billion, which is still a hefty multiple on Redback’s $250 million in trailing revenues.

Interestingly, $2.1 billion is roughly what Ericsson a paid a little over a year ago for its last major acquisition of Marconi. However, there seems to be little overlap with these two deals.

Redback’s forte is IP edge routing, which was a missing piece of the puzzle for Ericsson. With this acquisition, many things fall into place, not just for these companies, but also for their competitors. In short, Ericsson has come late to IPTV, but is determined to be a Tier 1 vendor, and Redback, with its troubled history earns a timely and attractive exit. Furthermore, Redback will operate as a wholly owned subsidiary, and the key management team will stay intact. While Redback could have been acquired for much less just a few months ago, the timing was not right then, but going forward, Ericsson has a more complete solution to compete head-on with the two majors, Cisco and Alcatel-Lucent.

The key driver for this deal is growing importance of edge routers, which serve to aggregate broadband content for operators, and then distribute it to subscribers. Video is the most bandwidth intensive form of content, and for IPTV to be successful, intelligent edge devices are needed for efficient and reliable delivery of traffic. Among the four major IP edge router vendors – Cisco, Alcatel-Lucent, Juniper and Redback – only two were realistic targets for Ericsson.

Juniper had long been viewed as a logical partner for Ericsson, especially given their existing reseller relationship for core IP routers, and gateways for mobile carriers. However, Juniper would have been far more expensive to acquire, and not as strong of a fit strategically for IPTV. Furthermore, Juniper has lagged Cisco and Alcatel-Lucent in product development, especially carrier Ethernet switching. For Ericsson to be viewed as a serious contender in this market, it would be difficult to justify Juniper’s price tag and not be getting a clear market leader. Conversely, as a much smaller company, Redback has a large, global base of carrier customers – including Tier 1s such as BellSouth, British Telecom, Deutsche Telecom, France Telecom, Telefonica, China Netcom and China Telecom, a strong R&D core, and is riding a current wave of success in a fast growing market.

In this light, a $1.9 billion investment takes Ericsson a long way to making IPTV a three vendor horse race, along with Cisco and Alcatel-Lucent. The latter is widely viewed as having the strongest position, especially by virtue of their close partnership with Microsoft and string of early IPTV trials with Tier 1 carriers. Cisco, like Juniper, is a data vendor, and has been steadily making acquisitions and forming alliances to earn its way into carrier networks for IPTV. Going back to last year’s Scientific Atlanta acquisition, Cisco’s strategic IPTV adds have included Arroyo Networks for VOD software and Widevine Technologies for digital rights management. On the partnership side, the key piece is their move with Siemens/Myrio for IPTV middleware, while others include Integra5 for client-side middleware, and BroadHop for subscriber management.

Even though Ericsson has been a late entry to IPTV, we believe the Redback deal positions them strongly against these competitors. First, it is still early days for IPTV. While many trials are in the works globally, large-scale deployments have yet to occur, and no platform has truly proven itself yet with Tier 1 carriers. Like Alcatel-Lucent, Ericsson is a major incumbent voice vendor, with an extensive global customer base from which to sell into for IPTV. Finally, there is FMC, which we feel may be Ericsson’s key differentiator. Wireless has long been a strength for them, and mobile TV is a key part of their IPTV vision. In fact, they state that 16 of their wireless customers are providing mobile TV to subscribers today.

Redback does not create a complete IPTV solution for Ericsson, but edge routing is a critical element, and we expect the remaining pieces will be easier and less costly to acquire along the way. Like Ericsson, Redback has a global customer base, which only adds to their appeal for IPTV deployments. The company has also performed very well as of late, with revenues reported to be 87% higher from last year over the first nine months of this year. They are on track for 2006 revenues of about $280 million, and with an exit price of $25 per share, things have come a long way from the $14 level the stock was trading at as recently as September, and as low as $5 around 18 months ago.

While their September stock decline was tied largely to concerns over not getting a contract with Verizon, Redback has since announced wins with Thailand’s True Corporation, China Netcom and China Telecom (now deployed in 22 of China’s 32 provinces), and expanded business with BellSouth. Considering the company came out of bankruptcy two years ago, this has to be viewed as a great success for both Redback’s management team and investors.

5. Financial Highlights