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. Municipal WiFi – If You Build It, Will They Come?

This is the big question anyone following municipal WiFi is asking, and the world is about to find out, based on several high profile U.S. deployments. On June 29, the city of Anaheim, California launched the largest such deployment to date in the U.S. Anaheim is certainly not the first muni WiFi project; several smaller American cities have being doing this for some time, and with mixed results. Larger scale deployments are another matter, as WiFi is typically used in localized settings or over a small geographic area.

Aside from being the first large scale muni WiFi deployment in the U.S., there is another important first for Anaheim. This project is the first commercial WiFi launch for EarthLink, branded as “Feather”; the company has quickly emerged as the leading network partner in this market. In addition to Anaheim, EarthLink has won bids for seven other muni WiFi projects, including Philadelphia, San Francisco and New Orleans. EarthLink has long been an innovative ISP, and to a great extent is betting its future on muni WiFi. Given EarthLink’s nationwide footprint, their activities are drawing more attention than smaller WiFi projects, and their success could have far-reaching implications. At minimum, if EarthLink is successful with these projects, that will be good news for Tropos Networks and Motorola, two of their key network infrastructure partners (wireless mesh routers and backhaul solutions, respectively).

Before addressing these implications, the motivations for muni WiFi need to be examined. There are three distinct interest groups, and each has its own agenda. First are the municipalities themselves. Their rationale for muni WiFi tends to vary on a case-by-case basis, but a common theme is the perceived need to make broadband more accessible and more affordable. Some cities have a grander vision that muni WiFi will be an economic driver, and therefore become a strategic imperative. Others simply feel that some segments of their population are not being well served by private operators, and a more affordable option needs to be provided.

All these intentions are well founded, but it seems that in these early days of muni WiFi, the desire to invest is not grounded in a strong business case or tied to a clearly articulated strategy. It is easy to see the attraction – WiFi is unlicensed spectrum, which is available and inexpensive. While not yet proven on a large scale, it will support broadband service for the masses, and most PCs now have WiFi cards or chips. WiFi networks can be built quickly and cheaply, especially if riding on the rights-of-way of the electrical utilities. However, just because you can do this, does not necessarily mean that you should.

That is certainly the view of the second key stakeholder group, the existing network operators. The telcos and cablecos have made substantial investments to upgrade their networks for broadband services, and are clearly threatened by WiFi, especially when provided by a public sector entity. Municipalities can afford to subsidize broadband service if it suits their agenda, and are not beholden to shareholders for hitting profit or revenue targets. Understandably, they would argue that municipalities are not in the business of providing or supporting communications services, and the consumer is simply not well served this way, especially when problems arise. If municipalities end up deciding that WiFi is not working out, they can exit the business without consequences.

To ensure this does not happen, the municipalities must engage the right partners to build these networks. This is where the third stakeholder group comes in, since cablecos and telcos will almost certainly never be willing partners here. EarthLink is not the only player in this group, but they are arguably the most important. Their motivation for building WiFi networks for municipalities goes well beyond being just a business opportunity.

EarthLink is one of the largest independent ISPs in the U.S., and are facing serious growth issues of their own. All ISPs face the challenge of a dwindling base of dial-up customers, and seem to be fighting a losing battle against the Triple Play bundles being offered by the incumbent telcos and cablecos, who own their network infrastructure.

The cost of building their own terrestrial network is prohibitive to say the least, and EarthLink realizes it must find another route to market. In many ways, they face the same challenge as Vonage, and other virtual operators who are dependent on access to incumbent networks. To further complicate matters, the regulatory climate favors network operators, who are now under no obligation to provide access to ISPs, or to provide wholesale pricing that competitive providers need to be in the game.

As such, muni WiFi presents what looks to be an ideal solution for EarthLink. These deployments would lessen their dependence on incumbent networks for access to subscribers, and offer a broadband solution for their dial-up customers. Additionally, WiFi networks can be deployed quickly, and at a cost that EarthLink can afford. In isolation, muni WiFi deployments are not substantial. However, as a growth strategy, muni WiFi provides a path for EarthLink to transition away from incumbent networks and still maintain a national footprint.

As they continue to win bids, and build out across numerous municipal markets, EarthLink may be creating an entirely new business model for a broadband ISP. Collectively, these deployments could represent a sizeable base of subscribers, and EarthLink would be the common link among them. They should be able to leverage this to achieve some economies of scale. To reduce transport costs, they could peer these deployments. To attract business subscribers, they could offer free roaming when traveling to other cities in their WiFi network.

All of these scenarios are possible, but EarthLink – and all the stakeholders discussed herein – must face some basic realities. First and foremost, WiFi can provide basic broadband connectivity, but it cannot yet truly compete with the throughput – and QoS – that both cable and DSL (and in some cases, fiber) can provide today. Then there is the matter of pricing. EarthLink’s WiFi pricing is $21.95 per month, but the telcos are offering DSL for less, and if necessary, could undercut EarthLink even more to keep them from gaining traction.

Furthermore, muni WiFi is not ready to be a replacement for DSL or cable broadband. To date, most deployments have had uneven coverage across metropolitan areas, and this will only be amplified with larger scale build outs in big cities. On a more basic level, WiFi signals work best in open spaces, and a common problem has been a limited lack of access inside the home. To overcome this, subscribers need to get a device in their homes to boost the signal, which adds cost and complexity.

For all these reasons, muni WiFi’s strongest appeal may lie with business users, or those who want an adjunct service to use outside the home. This is still a fixed-line solution, and until mobility comes via WiMAX, muni WiFi will be hard pressed to differentiate itself from existing DSL and cable broadband offerings.

This combination of factors leads us to conclude that while muni WiFi is exciting and full of promise, there is a high degree of risk. Subscriber growth is more likely to come at the expense of the incumbents as opposed to finding new broadband users, and this will put muni WiFi providers on the same collision course that Vonage finds itself going up against the big incumbents. We do not think municipalities will have the stomach for this type of competition, and unless companies like EarthLink can quickly and convincingly demonstrate a winning value proposition, muni WiFi could be a doomed experiment. As such, there is a lot riding on this for EarthLink, and all WiFi providers who feel they have a viable alternate to DSL and cable. All eyes will be on Anaheim for now, and we will revisit this deployment in a future issue.

2. IPTV Launches – Let the Triple Play Battle Begin

All hats are in the ring now among the major operators offering the Triple Play bundle of voice, data and video. The cablecos have been offering telephony for some time, and Time Warner has already caught up to Vonage in terms of residential VoIP subscribers. Arguably, it is easier for a cablecos to add voice than it is for a telco to add video, and that would help explain why the telcos have been slower to respond with IPTV.

That being said, following AT&T’s recent consolidation of SBC and BellSouth, the U.S. is essentially left with two strong RBOCs – AT&T and Verizon. Qwest is very much alive, but is little more than a regional operator with limited growth options. In September 2005, Verizon debuted its FiOS TV service, which runs over their FiOS fiber optic network. Though Verizon’s service is not technically IPTV – it uses digital cable broadcast over an RF overlay, with IP-based VOD servers – it is well on the path to a full IPTV solution. AT&T has been trialing its IPTV offering since January, and on June 26, their U-verse IPTV service was launched over SBC’s previously announced “Lightspeed” network.

It is no coincidence that both services were launched in Texas. Following the merger, AT&T’s head office shifted to SBC’s traditional base in San Antonio, so that was a convenient location to launch from. More importantly, though, last year Texas passed legislation supporting statewide franchising for television service. Previously, franchising had to be granted on a city or town level, which is far more time-consuming. The telcos successfully lobbied to gain statewide approval in order to accelerate their market entry and provide competition to the cablecos. As such, AT&T launched in San Antonio, and Verizon launched in Keller, Texas. For further reference, this topic was covered in our May issue.

With AT&T’s entry, all the pieces are in place for true Triple Play competition. Their San Antonio launch to 5,000 homes will be followed by a roll out target of 20 markets by year-end. This is an ambitious plan, but at this point AT&T lags the cablecos and Verizon in that U-verse is not yet offered as part of a Triple Play bundle. The cablecos are betting heavily on the bundle, and Verizon’s version is called Verizon Freedom All. These bundles are all competitively priced, and it does not appear that IPTV is being used a lower priced alternative to cable, much the way that VoIP is marketed against POTS.

One reason why AT&T is not yet bundling is their network build out strategy, which differs from Verizon. Both have been investing aggressively in fiber as a solution to gain the edge over cablecos for bandwidth capacity, especially for video services. Verizon has adopted the fiber to the home strategy (FTTH), which is more expensive as it provides an end-to-end fiber connection that delivers more bandwidth than any other commercially deployed solution.

AT&T has gone with the less costly fiber to the node approach (FTTN), where fiber terminates at network nodes, and from there, services are delivered over the existing copper infrastructure. The trade-off for AT&T is a lower investment for their network upgrade, but less bandwidth, and hence less ability to bundle video with other services. The short-term impact should be minimal, as AT&T and Verizon do not compete directly. However, as Triple Play becomes more ubiquitous, and as all carriers look to expand outside their native footprints, AT&T will be at a competitive disadvantage unless their network is upgraded to keep pace with Verizon.

It is still early days for Triple Play bundles, and so far, most offerings have done little more than offer subscribers some savings for the convenience having a single provider and a single bill. IPTV offerings are very comparable to cable or satellite TV, with just a handful of new features, such as picture in a picture viewing, or faster channel changing that with digital TV. There is not enough differentiation yet to separate the winners from the losers, and we feel that the sheer novelty of IPTV needs to wear off before this can occur.

Today, the stage is simply being set. As service providers become proficient in delivering Triple Play, their networks will need to evolve to transition from a silo approach to an integrated architecture where all modes of service are provisioned and managed under one roof. Microsoft is already a winner in this environment, with middleware wins at both Verizon and AT&T. Moving forward, other vendors like Comverse, Personeta and Leapstone, among others, also hope to garner market share with middleware platforms that facilitate the service creation and service brokering capabilities needed to enable IPTV networks.

Triple Play has many complex challenges, and the winners will be distinguished by providing an end user experience that is intuitive, easy to use, and customizable. The bundling packages we see today will look very rudimentary compared to how these integrated offerings will evolve once subscribers learn how to harness the power of IP. Our view is that the market will quickly move beyond Triple Play, and that no two bundles will be exactly alike. Subscribers will be able to mix and match services and applications into a highly personalized plan, and this plan will change on a regular basis.

3. Microsoft’s Unified Communications Strategy – Going Forward or Backwards?

As this current issue has shown, June was a busy month on many fronts, and Microsoft was certainly part of the mix. On June 26, Microsoft held their Unified Communications Group Strategy Day, and with a long-winded title like this, one would be expecting big news. The news was not really that big, but is significant in terms of articulating Microsoft’s plans for integrating voice within their software platform. Building from that, there are notable implications for a variety of other players serving the enterprise communications market.

Microsoft has been behind the curve with voice, and given how quickly things move today, one has to be somewhat concerned that this missing link will not be available until Q2 2007. Branded as Microsoft Exchange 2007, this updated platform will have productivity features that are new, but not revolutionary. One example is being able to have email converted to speech so you can review email over the phone. Definitely attractive, but not radical, especially for those in the open source world, for which applications like this are second nature.

In essence, we are talking about adding intelligence, presence and voice to the Microsoft environment, something that companies like Iotum have been working on for some time. Iotum was noted in the March issue, and is a great example of where Microsoft needs to be. They have in fact, gone beyond this, recently adding integration with Asterisk and PhoneGnome, where their application can be offered to the consumer market. The latter is particularly interesting because their application is both network agnostic and carrier agnostic. Plus, it reaches a huge market that Microsoft does not appear to be addressing with this announcement.

These capabilities are a far cry from where Microsoft is today, and you can be certain that by the time Exchange 2007 is launched, applications like Iotum will be have advanced even further. We draw attention to this as an example of the velocity of innovation in the Web 2.0 world, and how Microsoft may be in danger of having the software model becoming increasingly less relevant as new models arrive and thrive.

In short, server-based software platforms have competition now from web-based solutions and open source telephony, and this approach does not look leading edge any more. Microsoft may still dominate the desktop, and may be the gold standard for reliability and feature richness – much like legacy PBXs or the PSTN – but these lower cost and more flexible alternatives are clearly getting traction. Linux continues to gain credence in the enterprise world, and along with it, industry leader Asterisk takes root as an open source PBX replacement solution, with well over 500,000 deployments.

Another concern is that Microsoft is still a proprietary operating system. While they were early to embrace SIP (and arguably the ones who truly put SIP on the map), Microsoft will only support applications integrated with their Office Communications Server platform. For those not using Microsoft – such as the Asterisk IP PBX – you will not be able to share in this new environment. This may suit Microsoft well for protecting their franchise, but it is out of step with the industry-wide move towards open standards.

The same week as their news came out, IBM announced an upgrade of their Sametime instant messaging software, which integrates with Windows. Sametime 7.5 will be available this summer, pre-empting Microsoft by at least two quarters in terms of integrating voice with Office applications. Being open source-based, IBM has been able to get this upgrade to market faster than Microsoft, and the timing of their news sends a message that there is more than one way to bring voice into the Microsoft world. IBM is well ahead of Microsoft in embracing open source, and in fact, the development platform for Sametime – Eclipse – was spun out from IBM in 2004 as an independent open source foundation.

If anyone is pleased with Microsoft’s slow pace to market, it would be the PBX vendors. They stand to lose the most should Microsoft fully realize their vision of a totally integrated, server-based communications environment. Once the voice piece is added, the PBX may become redundant. On the other hand, do corporate IT managers and executives trust Microsoft enough to put their mission critical voice systems on MS Office software? We do not expect a rush to Microsoft voice services, and PBX vendors at least have a window now to shore up their value propositions before Exchange 2007 comes to market, and ultimately is mature and stable enough to garner a significant share of enterprise voice communications.

All told, there is a lot at stake here, and our conclusion is that Microsoft is taking one step forward and two steps back. Given their market dominance, these various alternatives will only chip away at the edges, but ultimately, the best technology will win out. Microsoft still holds most of the cards in this game, but we are not sure if they still hold the aces.

4. Art of the Deal:
Nokia and Siemens

On June 19, Nokia and Siemens announced a new joint venture, which will be equally owned and focused on the service provider infrastructure market. In the wake of the “Lucatel” merger between Lucent and Alcatel, this is another consolidation play, but one that seems more strategic. This is not a wholesale merger of two Tier 1 vendors; rather, each company is combining specific operational units in an effort to create synergy and size to compete more effectively in the carrier market.

The entity will be called Nokia Siemens Networks, and brings together Nokia’s Networks Business Group and the Siemens Communications Group. As with all large-scale deals, each party has its own motivation and agenda, out of which enough common ground has been found to move ahead. First, we will examine Nokia.

This venture only involves the network side of Nokia’s business, which is quite small relative to their industry leading mobile handset business. So, for Nokia, there was a strong motivation to partner with Siemens and create a stronger entity to pursue the wireline carrier market. The success of their handset business has given Nokia the means to pursue acquisitions and partnerships, and they have been in this growth mode for some time.

In fact, earlier this year, Nokia formed a partnership with Sanyo to make CDMA handsets. Interestingly, despite having substantial cash on hand - over 9 billion Euros – from which acquisitions could easily be made, the joint venture with Siemens required no cash investment. Finally, there likely was also some satisfaction in that the other Scandinavian telecom giant – Ericsson – had long been considered the frontrunner to acquire the Siemens carrier operations. In essence, then, this deal allows Nokia to be a more meaningful competitor to Ericsson.

For Siemens, there were a number of factors at work here. Perhaps most importantly, the Communications Group has been underperforming, and despite being profitable, was viewed as a drag on Siemens’s overall corporate and share price performance. Although Nokia is primarily a wireless company, they were still viewed as the right partner to make this group a better performer, especially in light of carriers’ desires to converge their fixed and mobile networks.

Last year, Siemens sold off its wireless handset division to BenQ, a Taiwanese GSM handset producer. Perhaps Siemens has more faith in the management style of a wireless partner as opposed to trying to run a wireless business of their own. No doubt the consumer electronics business is highly competitive, and Siemens recognized the difficulty of competing head on with the Asian vendors. As such, their deal with BenQ – which was not actually an outright sale - makes sense.

In terms of their competitive standing in the carrier world, Siemens undoubtedly felt the need to make a move to keep pace with Alcatel and Lucent. Teaming up with either of the remaining legacy Tier 1s – Ericsson and Nortel – was not in the cards, and the same can be said for Cisco. With carriers consolidating and the Asia vendors becoming stronger, Siemens was not in a position to stand still. This is especially true considering the weak financial performance of their carrier operations, and comparing that to the financial strength all these other vendors, perhaps with the exception of Nortel.

The main question arising here is whether Nokia is the right partner for Siemens. Clearly, the choice is a good one for the wireless network infrastructure market. Ericsson is the global leader, and Nokia Siemens Networks figures that this joint venture makes them a solid number two, ahead of Lucent/Alcatel. In this regard, Siemens comes out a winner as they had limited traction previously in wireless. Also, with Nokia, they gain a strong focus on GSM and WCDMA, which is widely felt to have better global growth potential than the CDMA standard embraced by Lucent/Alcatel.

The only potential drawback here is that both Siemens and Nokia are European, and they lack the global wireless presence that both Ericsson and Lucent/Alcatel have. In the latter case, a key strength of their union is the mix of American and European legacies to create a truly global player. On that count, it could be argued that Motorola would have been a better strategic choice than Nokia, but it is hard to see what interest Motorola would have in a deal with Siemens.

On the wireline side, it is less clear what Nokia brings to the joint venture. This market is more fragmented, and the combined forces of Lucent and Alcatel have made for a market leader here. Presumably, Nokia will help make Siemens more competitive in this market, but that in itself should be sufficient. After all, Nokia is stronger in wireless than Siemens is in wireline. Conversely, of course, wireline is where Siemens is strong, so Nokia stands to benefit from their market power.

These comparisons, though, are secondary to the bigger picture, namely, how competitive this new will venture be. Overall, the best growth prospects are in wireless, not wireline, and that is where the bulk of their business is today. Nokia Siemens Networks reported that 78% of their aggregate revenue mix in 2005 was from wireless – 56% being network infrastructure and 22% being services.

Furthermore, it must be noted that this new venture is made up of entities that were secondary businesses for their parents. The network business of Nokia is relatively minor compared to their handset operations, and the carrier business within Siemens was secondary to their more lucrative enterprise operations. In the new joint venture, these two businesses now become primary, and the net result is a company with strong operations in both wireless and wireline, and collectively remaining very competitive among their peers. Both are clearly better off in this scenario, especially with so few options available for mergers or acquisitions.

Going forward, the deal is expected to close later this year. We believe the success of this venture will depend heavily on how well the companies integrate their operations. With both being European, there should be fewer cultural issues than Lucent/Alcatel, and the geographic proximity of Germany and Finland will be convenient for day-to-day business dealings.

The companies expect to generate 1.5 billion Euros in annual cost savings through the joint venture, largely via the inevitable staff reductions. We expect that Asian vendors will create constant pressure on pricing and margins, and this will present a significant challenge here, as European companies have traditionally had higher cost structures. On the revenue side, we are optimistic the new venture will successfully leverage the strength of both companies, and they will win their share of business. The real key will be on the expense side of the ledger, and how efficiently they operate. Time will only tell on that front, but on the whole, we see this deal as a win all around.

As a sidebar, the most immediate fallout is with Nortel, who is now left with two fewer dance partners. At this point, only three North American vendors remain independent among the relevant majors – Nortel, Cisco and Motorola. A Nortel deal with Motorola is not in the cards as long as Mike Zafirovski is CEO. Cisco has kept the door open for Nortel for years, but this does not seem to be the direction Nortel wants to go in. They seem committed to their own path, but market forces may dictate a change in thinking. As the pressure mounts to get bigger to remain a Tier 1 vendor, two scenarios seem likely. Either Nortel gets railroaded into a shotgun wedding with Cisco or Motorola, or they succumb to a deal with the likes of Huawei or ZTE.

Finally, what are the implications for the smaller players who see vendor consolidation a necessity and are seeking an exit? With Lucent, Alcatel, Nokia, and Siemens all distracted with their current deals for the foreseeable future, what type of reception are smaller, non-billion dollar mega-mergers likely to receive? We feel there is still room for these deals, but they have to be carefully positioned in order to maximize the value for both acquirer and the acquired. Feel free to contact us for specific insights here.

5. Financial Highlights