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. VoIP IPOs – Is There Life After Vonage?

Vonage’s much-anticipated IPO on May 24 was disappointing, and underscores the difficulty of convincing investors that there is money to be made in VoIP. The IPO was not only important – crucial, actually – for Vonage, but for the entire sector connected to the IP revolution. With IPOs becoming a rarity in this space, Vonage was by far the best opportunity for Main Street to buy into VoIP, and a strong reception would certainly set the stage for others to follow.

Prior to Vonage, the blue chip vendors – Lucent, Nortel, Siemens, Cisco, etc. – would have been the only name-brand companies for investors to latch on to for VoIP. However, VoIP is really just a small part of their focus, so the ability to benefit from VoIP’s potential upside is limited. There are several quality public companies built around IP technologies, such as Sonus, Radvision, AudioCodes, Tekelec, iBasis and Packet8, but many of them lack Vonage’s mainstream consumer brand recognition.

The aftermath of Vonage’s IPO does not bear recounting here, and things have simply gone from bad to worse. Some factors are beyond Vonage’s control, but the problems continue to compound, and now, almost three weeks later, the end is nowhere in sight.

There is a vocal camp of cynics who contend the IPO was doomed from the start, and would simply say that the market is right – this is a $10 stock, and the risks around a money-losing business do not warrant a $17 share price. They would argue that Vonage’s real strength is the brand they created rather than the fundamentals of their business. What else could possibly explain the demand for the stock among retail investors?

In their view, professional money managers had the right read on Vonage, and have stayed away. By and large, Mercator Capital concurs, and despite the exciting growth opportunities ahead for VoIP, Vonage appears to be paddling upstream, with Niagara Falls in their rear view mirror. They were very successful establishing themselves as the market leader for residential VoIP before the Tier 1 operators arrived, but in short order, the MSOs have become dominant, and Vonage will probably never see a 50% market share again.

The market will only become more competitive once the RBOCs ramp up and IM-based offerings siphon even more minutes away from subscription-based VoIP plans. Vonage is basically cornered into going head-to-head with the incumbents, and will have a hard time changing their marketing techniques that requires extensive spending on advertising to attract subscribers.

This is a battle they cannot win, and as good as their offering may be, Vonage has a broken business model, and we doubt that they can ever become profitable. For this to happen, and inordinate number of things have to go right for them, and there is very little margin for error. Based on how they have managed the fallout from their IPO, we do not see any evidence of management savvy to navigate through these very dangerous waters.

So, what does this mean for future VoIP IPOs? Our view is that Vonage is a reality check for VoIP, and that the market is not prepared to repeat the tech bubble, even for a company with close to 2 million paying customers and annualized revenues approaching $400 million – something nobody was remotely close to having in 1999.

No one will doubt there is an appetite for VoIP investing, and the good news is that Vonage may be an anomaly among companies focused on this market. There is certainly a valid concern that a poor showing by Vonage would scare investors away from a sector that is poised for both growth and success. We believe the market understands that Vonage has a particular business model, but others exist, and Vonage’s lack of IPO success should not taint the entire sector. The market is rational and will recognize fair value where they see it as other IPOs come along.

Along those lines, we believe that VoIP IPOs-in-waiting may not be deterred by the Vonage experience. There are several pure plays in this sector that have been slowly building small, but solid businesses over the past five years, and are primed for IPO. Most are infrastructure plays, which are less glamorous than Vonage, and much smaller revenue-wise, but may have sustainable business models and market niches.

Leading candidates include Acme Packet, BroadSoft, Veraz Networks and possibly NexTone. We know that Acme has already filed, Broadsoft has selected its bankers and is planning to file within the next few months, and Veraz hopes to file by the end of the year. Common success factors for this group include the following – strong market position, a large customer base, a proven ability to land Tier 1 customers, a relatively small amount of venture funding, strong management, rapidly growing revenues, and relatively small accumulated losses.

These fundamentals paint a different picture from Vonage, and present scenarios to which we believe the market may be more attracted. This has in fact already been borne out by Acme Packet, who announced their IPO filing on June 2, to raise up to $85 million on a valuation of several hundred million. Given that more VoIP players resemble Acme Packet than Vonage in terms of their fundamentals and business models, we believe that Acme’s IPO may be a far better harbinger for future VoIP IPOs than Vonage was. However, although Acme’s recent growth numbers have been impressive, we wonder if any company with $50 million in revenues should really attempt to be a stand-alone public company in a post Sarbanes-Oxley environment. Only time will tell.

2. Telio – a Different Kind of VoIP IPO

While Vonage’s IPO may have been the biggest telephony story in May, there was another important VoIP IPO that garnered minimal attention in North America. Telio is a broadband telephony provider, just like Vonage, and their IPO in Norway was launched on June 2. Telio is a small, Norwegian startup, but in a short period of time, have done something Vonage may never do – build a profitable company with a sustainable business model.

So, who is Telio, and what is their secret? Think of them as a cross between Vonage and Skype, taking the best from both, but with none of the bad. They offer residential VoIP just like Vonage, but with more features and more free calling areas. Despite offering more, Telio purports to have a higher ARPU, which is critical given how price competitive this market has become.

Aside from being based in Scandinavia, Telio also resembles Skype in the sense that the majority of their subscribers – over 75% – have come via viral marketing and organic growth. This is a major difference from Vonage, and Telio is not saddled with out-of-control marketing costs, and largely explains why they are profitable with less than 100,000 subscribers.

Unlike the ILECs and PTTs, with their enormous sunk costs in network infrastructure, broadband voice providers do not benefit from economies of scale. Vonage’s losses will not subside simply by adding a few million more subscribers. Growth will help make this happen, but more importantly, ARPU needs to increase, and churn needs to decrease.

Telio does not have these problems, and their management made a conscious decision to avoid the costly formula of acquiring customers by cycling revenues through to mass-market advertising. They are experimenting with retail channels, but this has been secondary to referrals that come so readily as subscribers share Telio with their family and friends. Not only does this yield healthy gross margins, but happy customers are loyal customers, which translates to churn rates reportedly under 1%.

This is a great recipe for success, and stands in stark contrast to Vonage’s American-style assault on the mass market. Bottom line: Vonage is just one – but not the only – business model for residential VoIP. We can only hope that others come to see that small can be beautiful, especially in this era of silicon and Internet economics.

Telio is far from being a household name, but the smart money will find them in due time. In absolute terms, Telio is tiny, and Norway is a tiny market. However, if you look at them in relative terms, their market power becomes more evident. On a per capita basis, Telio would have over 6 million subscribers in the U.S., which would make them the clear market leader, and over 3 times of what Vonage has. Hypothetically, if their profits scaled accordingly, Telio would be vastly more attractive to investors than Vonage, and would certainly command a Skype-like valuation as an acquisition target.

This is an exciting scenario, but today, Telio is really a regional story. Their stated growth plans, however, are ambitious, and we believe they have the capability to achieve them. Aside from geographic expansion across Europe, Telio has a clear roadmap for FMC and MVNO services. They understand the value of mobility for subscribers, especially in Europe, where cell phone penetration exceeds 100% in some countries.

Similar to Vonage in the U.S., Telio has first-mover-advantage in Norway, and is the dominant broadband VoIP provider. The PTTs – primarily Telenor – have been slow to market with VoIP, just like their North American counterparts. A key part of Telio’s success is the absence of any strong cablecos in Norway, which goes a long way to explaining how they have become the overall market leader for residential VoIP there. Broadband penetration in Norway is over 50%, but this is essentially a DSL market. As such, Telio operates in a less competitive market than Vonage, and one cannot assume a steady trajectory of growth once the other providers ramp up their VoIP offerings.

Telio has demonstrated success while the going is easy. So much so that they have enough accumulated capital to fund their growth plans internally. Unlike Vonage, their IPO is not essential for either immediate survival, or longer-term sustainability. It will probably have more value in terms of building a following for Telio, which will become important as the company graduates from its startup status, and needs to operate on a larger scale.

If Telio can hold its own as their market becomes more competitive, and if their business scales into millions of subscribers, we believe they have the potential to truly become a significant global VoIP operator. This is a big if, but should it come to fruition, Telio may bypass Vonage along the way, and a number of Internet advertising agencies may have to find another large client who can fill the void left by Vonage.

3. IP Communications and Social Networking

The terms “social networking” and “Web 2.0” are being used with increased frequency, and as with most things that suddenly become hot, the terms get muddled quickly. From an investment perspective, ever since News Corp’s $580 million acquisition of Intermix Media (parent of Myspace.com) last summer, there has been a rush of activity in the sector, including new funding and other early players seeking large valuations through M&A. Increasingly, there is also more of a communications angle related to social networking sites, so we felt it would be interesting to look more closely at the sector.

Social networking is really an umbrella under which a lot of things fall, and the common thread is the notion of creating and accessing communities via the Internet. This is a classic case of a “market” – for lack of a better word – reaching critical mass, and thereby gaining attention, momentum, and credibility as broadband adoption grows. A more noble rationale for ubiquitous broadband is to improve our quality of life by providing better access to things like health care, education and government services. While few would dispute these virtues as a matter of good social policy, the reality is that people want to be entertained, and consumers primarily use the Internet to have fun.

As such, when a service is offered that the Internet generation understands, finds easy to use, and does not cost much money, there is certain to be an audience. Despite our busy lives, people always have time for things that are of value to them, and that is why social networking is so popular.

The market, as it stands today, is comprised of three basic types of providers. First are the recent entries, which are typically raising small amounts of capital, and are targeting niche markets and/or applications. A good example is Bebo, who recently raised $15 million, and is focused mainly on the European social networking market, and distinguishing themselves by integrating with Skype for both voice and video. Others in the growing category of new players include Tagworld.com, tagged, Visible Path, Buzznet.com, and Friendsorenemies.com. If you think there is a dot com/dot bomb aspect to this hyperactivity, rest assured you are not alone.

Moving up the food chain are the most established providers, who either have serious capital behind them, and/or have developed vibrant user communities on a large scale – tens of millions or even higher. Myspace, Facebook, Friendster, and Nexopia are the ones that come to mind here. Their stories are well known, although it is still not clear what the true value of their business really is, since their revenue models are early-stage.

Finally, there are IM-based platforms, which are simply extending social networking to create stronger online communities. Microsoft has MSN Spaces, Yahoo has Yahoo! 360, AOL has just launched AIM Pages, and even Google is in the mix with Orkut.

While all of these offerings provide compelling ways for people to connect and leverage the power of the Internet to truly create a global village, there is a sameness in terms of the user experience. They all center on Internet savvy people, and provide a similar mix of fun applications – blogs, RSS, photo sharing, file sharing, posting personal reviews, personal web sites, etc. As such, there is a risk of becoming a commodity very quickly, with the only form of bankable cachet being the ever-elusive “cool factor” that each of these providers dearly covet.

With so many social networking users being young and single, this can be a very fickle market with a strong herd mentality. Unfortunately, at least for investors, social networking plays lose their “cool” once they get large enough to create a base from which a viable business can be built. As with fashion, markets quickly shift to the next big thing, and no one can afford to stand still.

So, the question remains – is this a money making market or just a fad? There are two basic business models to consider in this regard – subscription-based or advertising-based. People will typically not pay just to have fun with the Internet, but they will where there is real utility such as dating, especially for specific demographic or lifestyle audiences. This leaves us with an advertising-driven market, and as new players keep coming, it is hard to see how they can all be supported.

There is national advertising coming from the likes of Microsoft, but this is still a new medium, and social networking is not yet viewed as a mainstream market. Furthermore, advertisers face a fundamental issue that is a roadblock for many – social networking content is largely user-generated, and they have no control over the context around which their advertising will be presented.

Another issue is the simple fact that these businesses are not capital-intensive, and do not meet the criteria of many potential investors. Compounding this is the lack of a proven business model and ability to generate an attractive payout upon exit. Barriers to entry will likely remain low, and this market will continue to attract new providers, making it that much more difficult to follow and evaluate all the players.

It is too early in the market cycle to identify the long term winners and losers, as we are really seeing the first generation of social networking. One indicator will be the extent to which Instant Messaging becomes a driver of social networking activity. The market basically falls into two camps – those based on IM platforms – AOL, MSN, etc., and those that are not – Myspace, Facebook, etc. This is a market that evolves quickly, and it is easier for someone like Myspace to add IM than it is for AOL to extend into the world of social networking, as they are essentially doing with AIM Pages. Arguably, the hard part is building up the user community, and adding IM should be akin to a feature upgrade. Voice over Instant Messaging (VoIM) is a further feature upgrade being included in many of these platforms as well.

More importantly, though, will be the ability of these providers to move beyond the everyday applications cited herein and make social networking more real than virtual. Examples would be a more extensive use of presence-based applications, advanced security for parental control and sharing of personal information, support for micropayment platforms to enable on-demand commercial transactions, and greater mobility for anywhere/anytime use. This is where we think the money will be made, and early stage investment in this space should look to the emerging leaders in these areas, who we believe will be the enablers of the second generation of social networking providers. Look for us to spotlight some of these companies in upcoming issues.

4. Art of the Deal:
AudioCodes Acquires Nuera

There is little doubt that the telecom market is going through a classic consolidation phase, especially at the top end, with the likes of AT&T and SBC on the carrier side, and Lucent/Alcatel among the incumbent vendors. This trend is filtering down to the second tier now, and the acquisition of Nuera by AudioCodes is a classic example in a few different ways.

Nuera was one of the few remaining independent vendors from the first generation of IP infrastructure providers. They have had their ups and downs, and similar to other vendors from this time period, Nuera has never developed enough Tier 1 business, or amassed a critical mass of customers to get beyond being a small vendor. Many of these vendors have long since been acquired or exited, and Nuera is to be admired for outlasting most of their peers. This is probably one of the qualities that attracted AudioCodes to Nuera, as their team has accumulated valuable experience in developing, marketing, supporting and evolving their platforms.

Furthermore, over the past few years Nuera has established itself as a leading vendor in the fast-growing cable sector, and by most accounts, the company has finally become cash-flow positive. As such, Nuera has earned its stripes, so to speak, and the timing was right to exit via an acquisition.

The acquisition by AudioCodes was announced on May 16, and should close over the coming weeks. By the numbers, Nuera is to be acquired for $85 million in cash, plus an earn out of up to $5 million if specified revenue targets are hit within a 12 month period after the deal closes. Issues of branding and operations remain to be resolved, but Nuera is set to become a wholly owned subsidiary of AudioCodes. The deal is valued at about 5.3 times Nuera’s trailing twelve month revenues of $16 million, which is a slight premium to recent VoIP deals such as Comverse-Netcentrex, and also a premium to AudioCodes’ current 3.3 times multiple. But with over $200 million of cash on hand, this was a deal AudioCodes could afford to make.

At first glance, the fit may not be that apparent. AudioCodes is a public, Israeli vendor with a global footprint, and like Nuera, has a line of media gateway products. Nuera is based in California, is venture-backed, and is more of a regional vendor. AudioCodes, like Nuera, is among this group of first generation nextgen vendors (but with a longer history), out of which Sonus has achieved the most success in terms of growth and market presence. Following Sonus, AudioCodes is in the next highest tier from this set of vendors who are still around. They have long separated from the pack of smaller vendors, and have followed a few paths to success.

First and foremost, AudioCodes is the best example of a nextgen vendor who has moved up the value chain, evolving from producing components, to being an OEM, and now to providing integrated IP solutions to service providers. By shifting from the commodity mentality of low margin/high volume components to high value/mission critical systems, AudioCodes has been able to grow both its top and bottom lines.

A second growth strategy for AudioCodes has been acquisition. They have a proven track record of successful acquisitions, namely Ai Logix in 2004 and Nortel’s UAS Product Group in 2003. These were smaller acquisitions in dollar value, but have provided AudioCodes with the experience for larger deals like Nuera. Future acquisitions should not be ruled out, as all vendors are seeking ways to grow in order to keep up with the consolidation occurring among the carriers.

It is also worth noting that AudioCodes is yet another example of an Israeli company growing through acquisition, which often involves a U.S.-based target. The RAD Group is probably the best-known example, but others include Tdsoft acquiring VocalTec, ECI Telecom’s merger with NexVerse to create Veraz Networks, and more recently, Comverse acquiring NetCentrex (covered in the May issue).

For AudioCodes, Nuera offers them a ready-made entrée to the cable market, especially in North America. The deal allows them to broaden their geographic reach as well as expanding beyond wireline and wireless, which are their core markets. AudioCodes has a strong appreciation for the value of R&D, and they recognize Nuera’s strategic position in this regard. Not only does Nuera have access to all the major cable operators, but also their flagship BTX family of media gateways is PacketCable 1.1 certified. In addition, the acquisition also strengthens AudioCodes’ supplier relationship with Nortel, as both Nuera and AudioCodes have OEM agreements with Nortel. The deal also allows AudioCodes to focus on being the pure play media gateway leader in the VoIP industry.

With the cable market accelerating its adoption of IP, AudioCodes does not have the luxury of playing catch-up to reach this level of certification with their existing gateway offerings. Aside from Nuera’s solid customer base of cable operators, both Comcast and Cox are early investors. In this context, the synergies are more evident, and the combined resources of Nuera and AudioCodes will position them well for broader and deeper penetration of the cable market.

There is also a longer-term aspect to this strategy that needs to be considered in the rationale for acquiring Nuera. Cable telephony has essentially been a residential offering, and North American MSOs have had tremendous success there in the past year. We expect them to be the dominant VoIP providers by year end, as the RBOCs have been slow coming to market, and among the pure plays, only Vonage has had any appreciable degree of success. However, this market is very price competitive, and margins will likely only continue to compress.

The business market is largely untapped for cable operators, but not for long. All the majors are planning to enter this market, not only for growth, but for better returns as well. This market is less price competitive, and there is greater opportunity for value-added services, which can be highly profitable. AudioCodes has extensive experience selling into the business market, and can take VoIP much further there than Nuera would be able to do on its own.

When all these pieces are put together, the deal looks like a win-win all around. Nuera gets an attractive payout for moving the company forward to this point, and AudioCodes strengthens its position as one of the leading Tier 2 vendors. On this alone, the deal makes sense, as it enables them to stay in the game and even grow by extending their reach into cable. The sweetener, though, is that as a combined entity they can now compete for bigger deals, and perhaps give AudioCodes a chance to rival Sonus as a leading Tier 1 VoIP solution provider.

5. Financial Highlights