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. Mitel/Inter-Tel: Win-Win Combination

We were not able to include Mitel’s acquisition of Inter-Tel in the May issue, but it is still a current story, and worthy of discussion. We like this deal, not just because of the fit, but also how it differs from most of the other consolidation plays taking place in 2007. Telecom vendors have been making moves to stay in lockstep with service providers, who continue to scale up by acquiring their peers. Many of the recent deals have been strategic acquisitions by large vendors taking on smaller vendors to fill gaps in their portfolio as well as to keep these companies away from their competitors.

The Mitel/Inter-Tel deal is a little different, as it is really a merger of equals with related offerings and similar customers. Publicly-traded Inter-Tel is slightly larger with revenues of $458 million. Mitel has been Terry Matthews' baby, and the largest member of the Wesley Clover portfolio, with revenues estimated in the area of $350 million. The companies are comparable in headcount, with Inter-Tel reportedly at around 1,900, and Mitel around 1,500. Both are focused on the SMB sector, and each are typically cited by analyst firms as having roughly 10% share.

In terms of the deal itself, this is an acquisition by Mitel, valued at $723 million, consisting of a combination of debt and equity. We do not often see private companies acquiring public companies, especially with the intent of remaining private. It is more typical to see these deals done to for a private company to do a backdoor IPO. This deal reminds us of Excel Switching’s acquisition of publicly-traded Brooktrout, which ultimately led to the company we know as Cantata today.

To make things even more interesting, Mitel has been on-again then off-again about going public, so at first glance, the backdoor IPO would appear to have been their motivation. Not only could this deal have made Mitel public, but it would provide a Canadian company with a U.S. listing, giving them a higher profile and more access to capital for further expansion. The reality turns out to be quite different, with Mitel indicating that the process of integrating the two companies will be easier by going private, though ultimately we suspect the converged company will re-emerge as a public company to provide some liquidity to Terry Matthews and other investors.

We think it is a prudent move given the uneven success rate of telecom IPOs in this market, along with the ever-increasing scrutiny that public companies are subject to. Being private affords Mitel more latitude in making changes, and their chances of success going public will be better once they complete the integration and come to the market as a unified entity. Mitel is not alone in this regard when one considers the trend towards private equity that is gaining favour in the telecom sector. The recent privatization of Alltel is a large-scale example of this, and Bell Canada appears to be going down this path as well. And of course, another blockbuster deal took place just this week with Avaya being acquired by private equity groups Silver Lake Partners and TPG Capital.

On the business level, we think this deal is a win-win simply because it creates a market leader. Together, they will have roughly 20% of the SMB market, which would make the new Mitel #1, ahead of Cisco, Avaya and Nortel, as well as SMB focused vendors such as Shoretel and 3Com. Having said that, the deal does not make Mitel a Tier 1 vendor; they just become a larger Tier 2 vendor. This could be seen as a shortcoming, but Mitel will never be a Cisco, and with their strong SMB focus, they are in a position now to become a driving force in that space.

The combined companies have little overlap in the product lines and geographic footprint. Both have strong offerings in areas that have lots of upside for growth in the SMB market, namely unified communications, messaging, contact centers and collaboration. In addition, Inter-Tel’s hosted offerings will serve to broaden Mitel’s existing portfolio. Building on this is a common embrace these companies have for open systems and standards-based technologies. Combined with Mitel’s long-standing emphasis on R&D, these elements will serve them well for being nimble and innovative, which we see as critical to remain competitive as the Tier 1s ramp up their SMB offerings.

Perhaps the greatest challenge we see is in the channels. Each company has an established set of channel partners, so conflict will be inevitable, and Mitel may lose some strong Inter-Tel supporters. On the other hand, Inter-Tel also has a direct sales force, which is especially important for serving larger customers. While this represents a new route to market for Mitel, co-opting them to sell both product lines will need to be managed carefully, as these reps do not want to confuse or upset their installed base of loyal Inter-Tel customers. These issues are not unique for this deal, but likely represent the largest hurdles. We would expect to see some channel attrition and some rationalization across the product lines, but these can be managed, and in the end we think Mitel will come out a winner.

2. Cisco Goes Mobile

For some time now, Cisco has been upfront about their mobile ambitions, and on May 22, made their most public declaration to date regarding the business sector. In Cisco’s view, mobility is simply a logical extension of the enterprise network, and serves to make their “network is the platform” mantra even more compelling. This is relatively new territory for Cisco, but as with all the other vendors offering enterprise voice solutions, mobility is too important to leave to someone else.

Whether using data services – especially email – or voice services, mobility is commanding a growing share of where and how the business market communicates. This growth is particularly important for Cisco in terms of supporting future sales of network gear. As all forms of communications migrate from landline systems – especially PBXs – to mobile devices, data networking vendors like Cisco are at risk of having less traffic flowing over their routers and switches. This could be bad for business, so Cisco has a vested interest in adding mobility to its portfolio.

Cisco’s latest entry into enterprise mobility can be traced back to their Orative acquisition in October 2006. This deal did not receive much attention, but was a key enabler for Cisco, who made its recent announcements about mobile capabilities in March 2007. Their initial offering – Unified Mobile Communicator – was designed to operate on smartphones supported by the major operating systems – Microsoft, RIM and Symbian. On a broader scale, mobility serves to strengthen Cisco’s Unified Communications thrust, which is becoming increasingly central to how they plan to compete, not just against the likes of Nortel and Siemens, but also Microsoft and even IBM.

To this end, at the Interop Las Vegas 2007 event, Cisco announced three mobility solutions, each targeted at a distinct vertical market. Cisco is not alone in understanding the importance of developing solutions tailored to the needs of a specific market – all vendors understand that in the world of IP, one-size-fits-all does not create competitive advantage. However, their rich technology partner ecosystem allows them to bring well-defined offerings to a number of vertical markets, and it is here where we feel Cisco is on the right track.

The three markets addressed by Cisco’s mobility solutions are retail, health care and energy. These markets have distinct needs, but also represent distinct opportunities for vendors who can provide viable solutions. For retailers, Cisco’s In-Store Mobility Solution utilizes WiFi to create better experiences for both customers and employees. The most interesting customer application involves WiFi-enabled shopping carts that can deliver real-time promotions while moving through the store. Shoppers can also utilize this capability to ask questions and interact with employees instead of searching to find someone who can help them. Employees can also benefit via push-to-talk service using Cisco’s new wireless IP phones.

In health care, Cisco’s Location Solution addresses an entirely different problem. This solution is built around WiFi, RFID tags and telemetry, and serves to intelligently monitor the location and state of high-value equipment within a facility. Aside from monitoring the condition of tagged equipment, this solution can alert administrators to events such as mishaps or movement outside of authorized areas. Whereas most asset-tracking technologies are focused on movements over wide geographic areas – such as trucking – Cisco’s is much more localized, and it is not difficult to see the potential for application in many other vertical markets.

The third solution is called First Mile, and by focusing on oil and gas, Cisco is demonstrating its capability for remote and physically demanding situations. Built around their 1500 series wireless mesh access points, Cisco has developed a wireless solution that can be delivered in challenging environments such as oil rigs. This is probably the furthest removed application from where Cisco is typically associated, but sends a message about Cisco’s breadth of vision for mobility and wireless solutions.

3. Intel Making Moves Into VoIP

On May 10, a relatively unknown start-up – Jajah – announced a $20 million funding round, with Intel Capital being the lead investor. Intel has maintained a strong but quiet focus on VoIP, and this item is notable as it is much more than a financial transaction. Jajah is less than two years old, and typical for many newer software companies, they are not easily categorized. Mobile VoIP would be the simplest way to describe them, but they are not a VoIP provider, and they do not build systems or solutions. Jajah is really an enabler, as their software simply enables people to make lower cost phone calls, mainly on their cell phones, but on their PCs as well.

This basic premise holds a strong appeal, especially for those who make a lot of international calls on their mobile phones. Jajah starting gaining attention in late 2006, and have since surpassed 2 million users, which was enough validation for Intel. While the attraction for consumers is mostly about mobile calling, it is the PC calling capability that has brought Intel to the table.

In the ever-evolving silicon chip market, Intel relies heavily on innovation to maintain its industry dominance. Adding communications capabilities has proven successful in this regard, as Intel has already done this twice. First was adding wireless networking to their Centrino chipsets, and they are doing the same now with WiMax, as they are a heavy backer of this technology. Embedding VoIP into their chipsets is a continuation of this strategy, and with the booming growth of Internet telephony, having this capability will make “Intel Inside” an even more powerful brand message.

It is in this context that an investment in Jajah makes sense. Both companies share the vision that PCs and telephony should be more closely coupled, and of all companies, Intel arguably has the most leverage to make this a reality. Their dual core microprocessors are designed to support real time communications applications such as VoIP and conferencing, and to keep them running even if the PC’s operating system crashes. This will be a very attractive feature for business users who require 100% uptime, especially those using Microsoft Vista, which is still prone to crashing.

While we do not expect the PC to replace the desktop phone anytime soon, Intel’s view is that the PC holds great promise as a communications device, and not just to replicate everyday telephony. This would largely explain Intel’s partnership last year with Skype, which could potentially be supplanted now by Jajah. Intel’s chips integrate well with Skype, but their application is proprietary, and the user experience for PSTN calling remains uneven.

Jajah is not built around a proprietary standard, and they have proven to be successful in connecting low cost calls across both wireline and wireless networks. We see this Skype-Jajah dynamic as an interesting sidebar, and will be watching for any signs that Intel is moving closer to Jajah. Intel has a good track record of setting the pace for PC innovation, and should Skype lose ground to Jajah, this will not be good news for eBay.

Aside from the financial infusion, the Intel relationship brings several other tangible benefits to Jajah, not the least of which is the validation that comes when an industry giant invests in a fledgling start-up that started out with no customers. Perhaps most important of all is the intent to collaborate on R&D, and being able to participate in Intel Capital’s IP Access Program.

Not only does this provide Jajah with access to Intel’s VoIP patent portfolio – which includes licensing rights to 16 Web-based calling patents – but also to Intel’s global ecosystem of dealers and developers. This appears to be a much deeper relationship than what Intel has with Skype, and the ingredients are there for Jajah to be embedded as the default voice application for Intel-powered PCs.

We should also note that the Web-based calling patents are particularly important in light of the fact that Intel was recently granted a patent on the softphone. It remains to be seen how effectively this can be enforced, especially with all the uncertainty around the Vonage/Verizon patent issue. However, if it can be upheld, Jajah will have an even stronger position given the softphone’s ability to enable PC-based calling, and the fact that the majority of Jajah’s users make their calls via PC. Even without this, Jajah will enjoy the umbrella protection of Intel’s broad patent base, and it is difficult to see how they will be exposed to the risks that could potentially be the undoing of Vonage.

There is another dimension to this story that we think bodes well for Jajah. Intel Capital was the lead investor in this funding, and it was recently announced that Deutsche Telekom was also a participant. The backing of a major telco like DT is further validation for Jajah, especially since they are a competitive threat to any telco with wireless operations. That said, we see this as a forward thinking move by DT, as they recognize the potential for VoIP, and are in fact set to launch a WiFi/cellular service in the U.S. Also, with most of Jajah’s calls being international, they should benefit from lower termination costs with DT. This will make it easier to ramp up sales, especially in emerging markets that rely heavily on mobile phones to meet the rapidly growing demand to make calls.

All of these factors add up to a promising situation for Jajah, and it is rare to see a company like this receive investment from both a major vendor and a major service provider. If Jajah executes well, they could emerge as a compelling alternative to Skype, but one that is more strategically positioned at the crossroads of the PC and telecom. Even without trying to displace Skype, Jajah has a lot going in their favour, and we suspect it will not take long for Intel and DT to earn a handsome return on their investment.

4. Art of the Deal: Microsoft Acquires aQuantive

And the trend continues. As we indicated in May, with each passing month in 2007, the deals continue to get bigger, and at $6 billion, this one is almost twice the mega-deal we reviewed last month between Google and Doubleclick. As we higlighted last month, aQuantive Inc. was a logical candidate to do a deal. And on May 18, Microsoft’s announced the acquisition of aQuantive, which is simply the largest acquisition by a vendor we have seen to date in the IP communications space. This was an all-cash transaction, and aQuantive will now become part of Microsoft’s Online Services business. Microsoft competes on many fronts with the likes of Google, Cisco, Apple and IBM, and this deal certainly makes a strong statement to them that Microsoft is playing for keeps.

At face value, one may question whether aQuantive is worth $6 billion, but they have a lot of what Microsoft needs to keep pace with Google in the online advertising business. Microsoft rationalized the price by saying that the competitive M&A process forced them to increase their bid, which resulted in an 85% premium over an already-inflated stock price. It just goes to show you what a well run M&A process with serious competition can do for an exit value. Kudos to aQuantive's bankers.

Perhaps equally important, by paying such a high premium, Microsoft ensured that aQuantive would not end up elsewhere, and that they would not be left with a second-tier agency during a time when such agencies are quickly being acquired by the consolidators. Aside from Google’s deal, Yahoo recently acquired RightMedia, and advertising consortium WPP Group did the same with 24/7 Real Media. On a practical note, it should be added that aQuantive’s proximity in Seattle is certainly a plus for working with Microsoft.

aQuantive has three distinct lines of business, all of which will be of value to Microsoft. First is Atlas, which operates ad servers, and is akin to Doubleclick in terms of the solutions it can offer to both advertisers and publishers. DRIVEpm is the second business, which focuses on buying unsold blocks of advertising inventory and resells it to publishers who are better able to deliver a targeted audience to the advertiser. Finally, there is Avenue A/Razorfish, the world’s largest independent interactive ad agency, with many leading consumer brands as clients, including Coca Cola, Ford, Nike, Dell and Disney.

Aside from the need to remain competitive, Microsoft’s motivation for acquiring aQuantive is being driven by changing market forces. First and foremost, Microsoft understands that while the software business is large and still growing, the advertising business is far bigger and has substantial upside in the digital sphere. They have long been the dominant PC software vendor, but that position is becoming increasingly difficult to defend. Conversely, the online advertising business is still developing, and Microsoft has a window now to enter and become a leading force.

Another important trend is the emergence of the software-as-a-service model, where applications will be hosted in the network. These services can be offered on a subscription basis, but to accelerate adoption will more likely be offered free, and subsidized via online advertising. Microsoft is certainly able to provide such applications, and Windows Live is a step in that direction. However, to be successful on a free basis, the monetization must come from the advertising, and this is what aQuantive brings to Microsoft.

On a more granular level, aQuantive provides capabilities that should allow Microsoft to exploit some of their new technologies in ways they could not do before. One of these is Silverlight, a plug-in formally launched in April that is Microsoft’s answer to Adobe’s Flash and Apple’s QuickTime. Using the high-end VC-1 video codec, Silverlight can display video in HD quality, with minimal delay, which Microsoft hopes will make this the plug-in of choice for online advertisers to support.

Another technology of note is Seadragon, which was demonstrated in May at Microsoft’s Strategic Account Summit. Seadragon offers a new way to view images – or advertising – with what Microsoft describes as an “infinite zoom”. The basic idea is that for images that catch a viewer’s interest, they can scroll over that image and zoom in on it to see more images in greater detail. This opens up a host of opportunities for advertisers to innovate and create new experiences to engage online viewers, and we believe this is exactly what Microsoft has in mind for Avenue A/Razorfish.

There is one more aspect to this deal that could provide a significant hidden upside. While Microsoft’s video ambitions are most evident with IPTV and the telcos, they are also very focused on the cable sector. There are, in fact, two distinct opportunities that aQuantive is already addressing with cablecos that will provide Microsoft a point of entry they have not been able to achieve on their own. The first is video on demand advertising, where cablecos are looking for ways to tailor ads for specific viewer demographics. aQuantive is trialing this now with Charter Communications, and the ability to insert targeted ads on the fly for given VOD viewing can be an effective way to attract the advertising dollars that are going to IPTV for this same reason.

The second area is website advertising, which has more to do with brand building than watching video programming. Cablecos are increasingly using their websites as content portals to promote their programs, as well as serving as the home page for many of their broadband subscribers. Interactive advertising is a core competency of aQuantive, and for Microsoft, this will be particularly important for Comcast.

Aside from being the largest cableco in the U.S., Comcast had been Microsoft’s sole U.S. Interactive Program Guide customer. In May, Comcast switched out IPG as part of a larger move away from Microsoft TV’s Foundation Edition set top platform. This platform had been running in Microsoft’s home state – Washington – since late 2004, but has been Microsoft TV’s only U.S. deployment with a cableco.

Their lack of success in the U.S. cable market has been a disappointment for Microsoft, and aQuantive may give them another way in. Portal advertising is a different business, and aQuantive is very well positioned to work with CIM Labs, the interactive media division that runs Comcast’s portal site. Establishing a foothold there would take the edge off losing IPG, and could potentially open the door for business with other cableco portals.

5. Financial Highlights