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 regular analysis and commentary on the major business stories impacting the convergence of voice, video, data, and wireless communications.

1. 2007 Review

Looking back over the course of 2007, we saw very healthy deal activity, both large and small. Some deals made obvious sense, where others appeared to be defensive maneuvers to outflank competitors. Aside from the deals, there were some notable developments that we think will have implications for 2008. Overall, we see three key themes and story lines that best summarize 2007.

2007 Highlight 1 – Big Deals

We saw a large number of big deals in 2007, supported by industry giants with deep pockets, and a sense of urgency to acquire companies with established businesses that provide a quick entry to rapidly emerging markets. The first of these that we covered was Cisco’s acquisition of WebEx in April. At $3.2 billion cash, this was a large deal for telecom, and set the stage for a series of billion dollar deals that would soon follow. Microsoft countered quickly with Tellme, and in April, Google stepped up to acquire DoubleClick.

Microsoft kept pace taking out aQuantive, and to make things more interesting, and confusing, Cisco and Microsoft made some public pronouncements in August about working more closely together. Other large deals of note include Bain Capital taking 3Com private, Yahoo’s acquisition of Zimbra, and Cisco’s move into WiMax via Navini.

While this may have translated into a banner year for bankers and lawyers, we do not expect as many big deals in 2008. On a practical level, with so many good companies being acquired so quickly, not only are there fewer targets available, but the majors now have fewer holes to fill. Perhaps more importantly, the economic outlook for 2008 is cautious at best, and we expect spending of all types will be restrained.

2007 Highlight 2 – Industry Consolidation

Aside from all the large scale M&A activity, industry consolidation was a major ongoing theme throughout 2007. The drivers for consolidation are sometimes different from strategic acquisitions, and in this market, the main factor was the need to build mass and maintain competitive position. The stage was set from the top at the very end of 2006 with AT&T and SBC. This created the largest U.S. telco and from there, a wave of consolidation followed among vendors who wanted to keep pace. The incumbent telecom vendors responded accordingly, most notably Alcatel/Lucent, the Nortel/Microsoft alliance and earlier, Nokia/Siemens.

Several other forms of vendor consolidation continued all year long, with some acquisitions and some mergers. Most of these were analyzed in previous issues, including Mitel/Inter-Tel, NEC/Sphere Communications, GenBand/Tekelec’s switching business, Dialogic/Cantata, and most recently, NexTone/Reef Point. VeriSign should be noted as well, although their deal was really a divestiture, and no deal has yet been consummated. Privatization is another variation on this theme, and was seen by many as the best option for self-preservation. We saw four good examples of this in 2007, with three being carriers – Bell Canada, Alltel and Covad, as well as incumbent vendor Avaya.

2007 Highlight 3 – The iPhone

There was no single technology development to rival the iPhone in 2007, despite the fact that it was only in the market for the second half of the year. This is truly a testament to Apple’s brand, and in our view underscores a more important reality for everyone in the communications market. The most important innovation continues to come from outside the industry, and Apple is not alone in this regard. Not only does this open the door for others to find a way in, but it keeps the incumbents on the defensive. There is a lot at stake, especially for global companies like Apple, and we see the iPhone as a watershed product launch that sets the stage for continued disruption, opportunity and displacement in 2008.

2. Precognitions For 2008

There was no shortage of interesting activity from companies both large and small in 2007, and we saw many notable developments and initiatives that may have important implications for 2008. Many of these had the potential to create attractive growth and investment opportunities but for a variety of reasons fell short. We have identified seven such areas that would be driving growth had things gone to plan in 2007.

Expectations are still high for all these areas, and despite the stumbles, they all have several positive underlying attributes that make them important topics to follow for 2008. It may be easy to dismiss these as missed opportunities, but we think they are still worth watching.

Many people make predictions, some of which come true, but most of which do not. We don’t want to make the same mistake here, but instead will make “precognitions”, which is our attempt to perceive cautionary information about future trends in 2008, based on the results we observed in 2007.

Precognition 1 – Microsoft

Aside from their major acquisitions and strategic alliance with Nortel, 2007 saw two significant communications-related launches from Microsoft – Office Communications Server and Vista. Both had the potential to move the software market a quantum step forward and make definitive statements about how Microsoft will compete in a Web 2.0 world. In our view, this did not happen, and raises some concerns about whether Microsoft is leading or following. Their market dominance remains intact, but we are less certain about how well they are positioned for the next generation of growth.

By most accounts, despite a very expensive launch, Vista was late coming to market and did not offer enough must-haves to make this an automatic replacement for XP. Many existing PCs cannot power Vista, and for those who can, the high price for the top end Ultimate edition has kept many just using the basic package. Microsoft still retains most of its installed base for PC operating systems, but not in the manner they would like to see. In this regard, Vista is a small step backward, and with the recent launch of Apple’s Leopard OS, the continued uptrend for MacBooks may be a growing concern for Microsoft.

To a lesser extent, we have concerns about the October launch of OCS 2007. This was another expensive undertaking, and serves to position Microsoft as the hub of communications for enterprises. This is part of the larger industry trend towards Unified Communications, where most major vendors are now trying to bring solutions to market and box out their competitors.

Microsoft has many of the pieces in place already for UC, but voice has been the most important missing element. This was a key aspect of OCS, but it is too early to tell if they now have a complete package. Our view is that the market is not yet ready to entrust voice, telephony and call control over to an unproven software platform. If that is true, then Microsoft may have a difficult time fulfilling their UC aspirations, and voice will largely remain in the domain of the IP PBX vendors. 2008 should go a long way to answering this question.

Precognition 2 – The iPhone

Apple thrives on love-hate relationships, and the iPhone is no exception. For all of its strengths, the iPhone raises a host of concerns that go well beyond Apple. The choice of AT&T as a network partner is a good starting point if only because 2.5G may be too slow to support the kinds of applications that make the iPhone so appealing, as well as what will make money for AT&T. Their $200 price cut early on may have kept demand moving along, but did not sit well with the first wave of buyers who simply padded Apple’s fat margins.

The follow up was no less comforting – a $100 rebate that could only be used to buy other Apple products (but not iTunes). Apple has proven no less friendly to the hacker community, as a thriving cottage industry quickly sprung up to unlock iPhones so they would work on other networks and support third party applications. This has become a popular short term solution, but now these unlocked phones will not work with future firmware upgrades.

In effect, Apple is trying to exert its customary control tactics, but they are not working to plan in this market. This is the first time a handset vendor has been in a position to change the status quo in terms of who controls the subscriber relationship, and being a telecom outsider, Apple is not getting its way. In time, we believe that Apple, and perhaps others, will reshape the balance of power in the wireless market – but this has not happened yet. Apple has made some early missteps entering telecom, but if they learn from this and become more open, they will have a second chance in 2008 to make their brand a true game-changer in this market.

Precognition 3 – Municipal WiFi

Early last year we noted how the U.S. market was getting encouraging support from major WiFi players – Sprint/Nextel, Clearwire, Motorola and Intel. It appeared that the pieces were falling into place, and if the core investments were made to bring municipal WiFi networks to life, the end-user market would follow and create a viable alternative to cellular networks. A vibrant WiFi market would open up several avenues for investment, and help accelerate the adoption of mobile broadband, the true Holy Grail for service providers.

Despite all this enthusiasm and seed capital, it did not take long for the economic and political realities to sink in, and from there, the domino effect has been quite profound. As we concluded in our earlier coverage, it made sense for Sprint/Nextel and Clearwire to join forces in July and build a national WiMAX network, which in turn would support municipal WiFi ventures. Similar to Cometa several years earlier, this plan is now off and there is nothing on the horizon of this nature for the U.S. This is a major setback for companies like Sprint/Nextel and EarthLink, both of whom have banked heavily on WiFi for their futures.

What would have been a boom for WiFi equipment vendors and operators eager to offer muni WiFi services is now a market on hold. This could well change with the upcoming FCC wireless auction, but coming into 2008, muni WiFi is a far cry from where most people thought it would be.

Precognition 4 – Google’s Dominance

Google seems to be a never-ending growth story, and to keep this going, they have spared little expense in moving beyond search and online advertising. Microsoft and Yahoo are their traditional rivals, and despite intense efforts to attack Google’s core businesses, have not made much progress. Both were heavy buyers of online advertising businesses in 2007, and both have tried new things. Microsoft is taking on AdSense with adCenter, and Yahoo has brought back Jerry Yang to refocus the company. Our concern is that if these companies cannot become a countervailing force, then nobody will be able compete with Google in these markets.

Google’s forays into other areas are widely followed, but the one we are watching most closely is wireless telecom. We think they will be aggressive bidders at the wireless spectrum auction, and they have been accumulating dark fiber for years. With the recent launch of their Android wireless operating system, Google is set to become a major force in mobile communications, perhaps as early as this year. Unlike Apple, they embrace the Web 2.0 mantra of open systems, and will have an easier time inserting themselves into this market. Validation for this comes from Verizon, who, in anticipation of Google’s entry, announced in late November they would be opening up their network in 2008 to support other devices. Having spurned iPhone early on, they are well aware of the threat posed by Google to their wireless business, and appear determined to be ready this time around. Never before have so many disparate entities shared a common enemy in the communications sector.

Precognition 5 – Cablecos under Pressure

In our December issue we addressed the various challenges that are hurting the major U.S. cable operators. While enjoying continued success with VoIP, their core video business is under siege from both satellite operators and telcos coming to market with IPTV. VoIP may be the deal-maker that leads customers to subscribe to their Triple Play bundles, but lacking a wireless offering, video is where they make their money. Cablecos have spent billions on network upgrades to support bi-directional, high bandwidth services, and until 2007 they held the speed edge over the telcos.

That began to change last year, and as the fiber buildouts gained critical mass – both FTTN and FTTH – the speed advantage began shifting back to the telcos. The ball is back in cable’s court to counter, and DOCSIS 3.0 would appear to be the solution. Standards-based network upgrades are not only expensive, but they take a long time to deploy. Things move much faster in the world of IP, and our concern is that cablecos will not be able to respond before losing too much business to the telcos.

Not only can the telcos offer faster speeds with fiber – which consumers cannot seem to get enough of – but they are much better positioned to offer the Quadruple Play (aka “Grand Slam”) by adding wireless. Compounding this is the basic fact that cable is essentially a regional business, and even the major operators will find this a difficult market to raise the capital required to accelerate their catch-up plans. In this environment, the VoIP business is an after-thought, even for cablecos who venture into the SMB market. Their future rests with video, and 2007 has left them more vulnerable than ever before.

Precognition 6 – Social Networking

No other aspect of the communications sector attracted more attention – and hype – than social networking in 2007. This is truly an Internet-based phenomenon, and much like the dot com boom, social networking was where everybody wanted to be. The ability to quickly and cheaply build and engage virtual communities is unprecedented, and provides an irresistible opportunity for investment – ergo Microsoft’s exuberant spend of $240 million for a fractional stake in Facebook in October.

For all this promise and excitement, however, nothing has materialized yet in terms of a business model or a viable way to monetize social networking. The market is quickly becoming saturated with variations on the theme, and it is difficult to see how more than a handful will get through 2008. Humans can only be in so many places at a time, and the utility of social networks quickly diminishes after being engaged with a few of them.

That said, with such a large following, social networks have many of the ingredients in place for business success, so the potential is there to capitalize. Unfortunately, the first major foray in this direction went very wrong and is cause for concern on more than just a business level. In November, Facebook launched Beacon, an advertising program that would seem to be a dream for online marketers. It is inevitable that social networking sites need to become ad-driven, but Beacon was quickly rejected due to its insidious nature. Its Big Brother aura was quickly seen as a threat to privacy and crossed a line with people who are otherwise not at all shy about sharing their lives online. Beacon will certainly not be the last attempt to monetize social networks, but missing the mark this badly the first time around raises serious doubts about how well any of us really understands this ‘market’.

Precognition 7 – VoIP’s Meltdown

The three strongest names in residential VoIP fell from grace in 2007, and with that, the threat posed by VoIP to incumbents has largely dissipated. Vonage was undoubtedly the flag bearer for VoIP, and regular readers of our newsletter will be familiar with our coverage. Initially, they were poised to be giant killers, and had they gone public or been acquired earlier, this promise may well have been fulfilled. They survived a disastrous IPO in 2006, but 2007 brought on a different set of problems.

Compounding the competitive pressures from the cablecos has been a relentless assault from the telcos with patent infringement litigation. Most recently, Nortel has jumped into the fray, but this has been settled amicably. These attacks have not put Vonage out of business – yet – but have achieved their primary purpose by effectively marginalizing the biggest name in VoIP. As in any market, once the number one threat is removed, the rest of the competitive field becomes a minor distraction.

This brings us to the second VoIP implosion, which was certainly more fatal. Vonage was the leading VoIP pure play by a factor of 10, and SunRocket was their closest peer. Residential VoIP is very much a price-driven market, and SunRocket chose to differentiate itself on price. They introduced an aggressive annual pricing scheme which quickly attracted a lot of subscribers. This allowed them to establish some critical mass, but still a far cry from Vonage. The downside of this model is the constant need to attract new subscribers to generate cash flow, and in July, SunRocket conceded defeat and abruptly closed shop. Not only did this remove the number two player from the market, but it left over 200,000 subscribers without service and a sour feeling about VoIP. All of this was good news for the telcos and cablecos, and bad news for everyone else trying to make a go of this business.

The third setback in this space was Skype. They are synonymous with PC-based VoIP, and we see them more as a complement to subscriber-based services like Vonage than a direct competitor. The associated revenues may be much smaller, but the user base is too large to ignore, and Skype is widely seen as a bellwether for free VoIP. Skype endured a number of challenges in 2007 – especially its corporate relationship with parent eBay. The one to focus on here would be their global service outage that occurred in August. Skype’s incredible appeal has been largely based on the quality and reliability of its service, and this incident has raised doubts in many circles for the first time. Their incompatibilities with eBay are another story altogether, and only serve to reinforce those doubts.

In isolation, these three developments are important, but together paint a much darker picture for VoIP’s place in the telephony landscape. Simply put, VoIP is not viable as a standalone business, and we do not see how it can compete in the residential market against the growing momentum of the cableco bundles. This does not mean VoIP has no future; in fact, we think the prospects are very bright, but more so an application to enhance other services as well as a cost-effective transport technology.

3. 2008 Areas of Opportunity

Against this backdrop of false starts, we see three areas that should have more hits than misses in 2008 and, as such, offer more promising opportunities. All three are in high growth sectors where the markets are far from saturated, the pace of innovation is robust, and consolidation has not yet taken hold to drive out startups and winnow out the playing field.

Opportunity 1 – Wireless

We think this will far and away be center stage for growth in 2008. In North America, both the U.S. and Canada will be holding wireless spectrum auctions this year, and this will invariably bring forth new competition and capital to support network buildouts and upgrades, as well as making strategic acquisitions along the way.

Despite the challenges discussed earlier about the WiFi market, meaningful wireless network advances will have a positive impact this year. Two of note would be HSDPA to deliver faster 3G data speeds, and the readiness of picocell and femtocell technologies, both of which greatly improve indoor cellular phone reception. These developments should help drive demand for new services, especially video, which will in turn drive demand for video-capable handsets. On the service provider side, we see all of this as good news to keep moving FMC – Fixed Mobile Convergence – forward, and making it more practical for wireline and wireless operators to integrate their networks.

Add to this the earlier references to Google’s Android, Apple’s iPhone and Verizon opening up its mobile network, and we have the makings for a very dynamic market opportunity in 2008.

Opportunity 2 – SMB IP Telephony Market

This sector began attracting significant attention last year, and is now being served by carriers and vendors of all stripes. The market is simply too big to ignore, and we are now seeing some stratification within it. Typically, SMBs are not PBX users, and a healthy variety of solutions now exist that cater to this market but also provide PBX-type functionality.

Within this sector, however, different offerings are being tailored for specific sub-segments. The micro SMB market is at the lowest end and represents SOHOs and single office businesses. Moving up is the small market, which typically uses key systems and has one or two locations. Finally there is the top end of the SMB market, which could be using a basic PBX or an expanded key system, often across multiple locations.

Historically these customers were served with premises-based telephony systems, but with the advent of IP telephony, SMBs are increasingly turning to hosted solutions. These are usually offered by CLECs and other providers focused on IP telephony such as M5 Networks, CBeyond, XO and Covad. We are also seeing a wide range of innovative alternatives, several of which were cited in our December feature on this market. Add to this the continued advances in both Open Source telephony and SaaS – software as a service – and the elements are in place for strong growth on many fronts.

We maintain our earlier position that this market is primed for consolidation on the service provider side, as many of the operators are small with limited network reach. On the vendor side, we expect to see the incumbent vendors make acquisitions of startups – such as Avaya did with Nimcat Networks – to accelerate their go-to-market plans in a bid to stake their claim in this market.

Opportunity 3 – Telepresence

We have followed this technology closely, and while Cisco may be what first comes to mind, there are several other strong players with equally interesting offerings. 2007 saw the arrival of telepresence in the enterprise market, and with it the concept of videoconferencing has been taken to a whole new level. While this remains very high end technology, Cisco is finding an eager market, as are its main competitors – Hewlett Packard, Tandberg, Polycom, Teliris and most recently, Nortel.

What makes telepresence different is the immersive experience that comes from life-size and life-like video imagery. Traditional videoconferencing is still very serviceable, but telepresence takes full advantage of IP and broadband technologies to create a virtual presence that is eerily real. The prevailing view is to dismiss telepresence as overly expensive videoconferencing that will only gain traction in the Fortune 500 club.

We think this view is not only short-sighted, but inaccurate. As with all new technologies, the price of telepresence will inevitably fall, and as adoption grows, lower-end variations will be offered, not just to reach a broader market, but also to gain deeper penetration within the installed base. This is a technology whose value and benefit increases the more often it is used. Once deployed, there is minimal incremental cost per session, and by most accounts, telepresence customers are fully utilizing their systems. Furthermore, we are only scratching the surface for how telepresence can be used, and once it filters down to the mainstream, we think the market opportunity will be substantially bigger than what it is today.

Another interesting development is a recent announcement by Cisco to interoperate with other standards-based telepresence systems. This will be another key to growth since you need these systems at both ends to use them. The green theme that is pervading all businesses will come into play here as well. Aside from the productivity angle of telepresence, another big selling point is the ability to reduce travel costs for in-person meetings. With oil now charting north of $100 per barrel, the justification for telepresence becomes easier with each passing day.