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. Hosted VoIP Market Begging For Consolidation And Transition To "HoIP"

In our October 2006 issue, we looked at how quickly the small and medium business (SMB) VoIP market was growing, if not on the subscriber side, then certainly on the provider side. With barriers to entry being low, and viable solutions emerging for this underserved market, a lot of attention has been focused on bringing hosted VoIP to SMBs. Our article concluded that this space will continue to attract new entries, but will reach saturation, and that consolidation will likely follow.

While a number of the larger providers, including Verizon, BellSouth and AT&T, are offering business VoIP solutions, for the most part they are not targeting these solutions toward small and medium-sized businesses. Even the larger CLECs, such as XO Communications, Broadwing (now Level 3), and McLeod are focused on larger enterprise customers. And for the most part, these providers have started with IP trunk replacement solutions, rather than true hosted VoIP services all the way to the desktop.

However, the general consensus is that hosted VoIP makes sense for most small businesses – perhaps up to 200-300 employees, with a sweet spot of between 20-60 users per site – as a more economical and flexible solution. This is especially true for distributed offices with multiple locations, remote workers, or highly mobile staff. Historically, incumbents have not supported this segment very well since SMB customers are not necessarily highly profitable customers, they are cost conscious by nature, and they are not necessarily leading edge when it comes to adopting new technology.

The potential market opportunity in the U.S. alone is huge, with over 10 million SMBs employing over half of the country’s workforce. According to industry analysts such as In-Stat and Yankee Group, the hosted VoIP subset of this market is small but growing rapidly; it measured roughly $300 million in 2006 but is estimated to be growing at 50% - 80% CAGR and will be a $2B - $3B market by 2010. At an ARPU of $50-60 per month, this translates into roughly 400,000 hosted “seats” in service by the end of 2006. There is huge opportunity outside of the US as well, as many companies are deploying hosted VoIP services today to tie together international offices with extension dialing and free calls over the public Internet.

This market opportunity has attracted a large number of competitors. We believe there are over 200 such operators in the U.S. which are offering some form of hosted VoIP. The hosted VoIP market is extremely fragmented, with operators servicing a few customers and hundreds of seats on the low end, to hundreds of customers and 60,000+ seats on the high end. Most of the players have started in individual markets, and some have grown to a more regional presence. Although companies like Covad and New Global Telecom have leadership positions here, there is no clear market leader with a ubiquitous national brand name like Vonage established in the consumer VoIP sector.

The challenge we see shaping up is getting these operators to profitability, and finding ways to grow beyond organic methods. To survive, we believe that organic growth alone will take too long, as this market will begin to shake out over the course of 2007. We see this happening in a few different ways:

• New operators – similar to the ones already doing this - will continue to enter the market, simply because the cost of entry is low, and nobody is dominant.
• Operators already offering hosted SMB services will be looking for ways to grow into new markets or regions.
• Residential operators will look to enter SMB for growth as their existing markets plateau.
• Incumbent telcos will ramp up their SMB efforts as they become more committed to this market, and start to feel the pain of business lost to the competitors.
• Incumbent competitors, namely cablecos and ISPs, will enter the SMB market with their own hosted services. This has already happened in Canada, with Rogerslaunching their service last month in Ontario, and Cox and Comcast planning similar service in the U.S.
• Wireless operators, using FMC platforms, will also be in a position to compete in this market. We do not see this coming imminently, but this is certainly another class of carrier who will soon be able to offer SMB services.

In our view, the market opportunity for the SMB is more about hosted IP services – what we like to call “HoIP” – than it is simply about VoIP. As in the consumer VoIP market, it is less about voice, and more about bundled services. For the SMB market, we do not believe it will be the best VoIP offering that will win; rather, we believe it will be the best bundled offering of Internet access, fax services, web and email hosting, remote storage and backup, managed firewall and VPN, and mobility in addition to hosted VoIP that will ultimately prevail. These are all the services that SMBs need, and are currently purchasing through multiple suppliers, but would prefer to source from a single provider. Such a bundled service will dramatically increase ARPU for the service provider, and also improve customer retention.

CBeyond is a good example of having a good SMB bundle and strong sales execution, and they have been handsomely rewarded in the public markets. CBeyond offers their “BeyondVoice” packages that include Internet access, local and long distance, web and email hosting, and VPN services, all at an attractive price for the SMB customer. They also offer additional services including managed firewall, secure backup and sharing, remote access, and mobile services. The misconception with CBeyond, however, is that they are a pure play VoIP company; in reality they are simply offering a key system replacement that uses an IP trunking solution with no hosted VoIP offering. Clearly this bundled offering is working with SMB customers, as CBeyond has been able to attract over 25,000 business customers in the seven markets they serve. As a result of their success, CBeyond is trading at a 4X revenue multiple, which positions them at the top of the valuation range among service providers.

Elsewhere in the “HoIP” arena, few players are doing a good job putting together attractive bundled service offerings. Most players are focusing exclusively on VoIP services, while perhaps bundling in a T1 for Internet access. Among the private players doing a good job with a bundled package is Lightedge Solutions, an Iowa-based company that grew out of an ISP to provide a full suite of hosted IP services including a Broadsoft-based VoIP offering. There are a number of other regional players as well, such as Vantage Communications, CallTower, and Unity Business Networks, though none seemed to have mastered the art of the full service SMB bundle.

To a certain extent, the sector is somewhat a victim of its own success. Many companies have had early wins in launching and signing up new customers. However, most small providers are financially constrained and are seeking outside capital. Two recent success stories are M5 Networks and Whaleback Systems, who each raised just under $8 million last September. Both are using venture capital to expand their operations, most notably M5. In late February, M5 announced their expansion into Chicago, and other regional markets such as Boston are slated to follow.

There are literally dozens of other companies who are currently seeking capital, but each business plan is difficult to differentiate from the numerous providers already in the market. Certainly VoIP-only business plans will have difficulty in getting funded, and we feel a strong HoIP offering will be necessary to compete. As a result, many of the smaller companies who have had early successes will likely hit a wall in 2007, and begin exploring their own alternatives, such as consolidating with one another or being acquired by some of the larger players in the industry.

A consolidation strategy requires a different vision, and we see this more in the domain of larger operators, who have a critical mass of customers and better access to capital. Operating a national network can be a real asset in this case, as this allows the operator to deliver a consistent user experience across all regions. To support this, it would be best to have one application platform for all customers, likely either BroadSoft or Sylantro, who also could play a role in targeting which companies consolidate.

There are several examples of consolidation in the hosted VoIP market, though none has yet resulted in a clear market leader. Initially Level 3’s acquisition of Telverse created the first very visible market opportunity for hosted VoIP. This was subsequently followed by Covad’s acquisition of GoBeam, which provided the entrée point for Covad into the market. Both deals may have happened too early in the hosted VoIP market, and neither has resulted in additional consolidation. Interestingly, NGT ultimately benefited greatly from the Level 3 – Telverse deal, as they picked up many of Level 3’s resellers after Level 3 exited the business.

More recently, Level 3 has gotten back into the hosted VoIP business, albeit indirectly. In 2006, the company acquired TelCove, Progress Telecom, and Broadwing, all of which had some hosted VoIP or IP trunking solution. In February, Broadview Networks acquired InfoHighway Communications, in a move that brings together two large players in the SMB market, who are particularly strong in the New York area. PAETEC and US LEC also closed their $1.4B merger in February that brings together 45,000 medium and large business customers – though neither company was particularly strong in hosted VoIP.

We believe 2007 is the right time to assemble a clear leader in the “HoIP” SMB sector, and we think the first mover who can assemble a strong team with an attractive bundled offering will be the ultimate winner here.

2. Sonus Strengthens Its FMC Story

Sonus Networks made plenty of positive news this month on a number of fronts, from partnerships to financial results, which were released on February 28. Financial and business performance was very strong, and they have a record cash balance of $361 million, and a market cap around $1.7 billion. With 2006 sales of $279 million, Sonus is a long way from being a startup, and despite pending restatement of financial statements, they are holding their own quite well, and still trade at a relatively high multiple compared to other companies in the sector.

Sonus’ financial growth and market success has almost exclusively been achieved from internal product development, and they have yet to make an acquisition since the 2001 acquisition of telecom technologies. Certainly with the company's healthy cash balance and relatively strong stock as currency, we think that the company is in prime position to find and execute accretive deals.

The company’s most recent news, aside from the Q4 results, involved two announcements made at 3GSM on February 14. Both were partnerships rather than acquisitions, though we feel they are very significant. Sonus' strategy appears to revolve around making very selective, strategic partnerships, rather than pursuing M&A activity. This is a very different strategy than competitors like Tekelec, who made a number of VoIP acquisitions to build a relatively weak portfolio, and Audiocodes, who executed a number of deals in the past year to assemble a much broader product offering than what they previously had.

That said, we like both partnership announcments. They support the company’s fixed-mobile convergence (FMC) solutions, especially in Europe, which is further along this curve than North America. The new partnerships are with 3Way Networks and ip.access Limited, and interestingly, both companies are based in Cambridge, England. Both companies are focused on in-building wireless solutions to support 3G and GSM services.

More specifically, there are two key technologies behind this – femtocell and picocell. These technologies improve in-building coverage for cellular service, which is becoming important to mobile carriers, as they stand lose this traffic to competing services, especially WiFi. Dual mode handsets are not widely deployed yet, but that day will come, and when it does, single mode handsets will be vulnerable if the problems related to in-building coverage are not addressed. This would not be good news for operators planning FMC services for subscribers using single mode phones.

In short, ip.access is focused more on picocell solutions, which are primarily used in business and office settings, and supports 2G devices. 3Way has a different focus, and is known more for femtocell technology. Their Home Base Station product is designed for residential and home office use with 3G phones. These two technologies represent different approaches to a common problem, and together address most of the challenging in-building scenarios facing GSM subscribers. Given the fact that the vast majority of handsets are single mode – and will remain the majority for the foreseeable future – there is a significant addressable market here for FMC.

Equally important is the emergence of Low Powered GSM (LP GSM), which is largely coming out of Europe. The U.K. is one market where regulators have begun issuing GSM spectrum licenses specifically for low power services. Femtocell and picocell technologies provide low powered solutions, and will be key enablers of FMC services for these in-building situations.

As such, Sonus appears to be hedging its bets by partnering with both companies. Again, this is not growth through acquisition, nor is it a bold move that changes things overnight. These are incremental, low risk moves, and for those who believe that slow and steady wins the race, Sonus is on the right track. They also clearly have their eye on the global opportunity for GSM-based FMC, and for an American-based company, it is a forward-thinking move, and 3GSM was the ideal place and time to do this. We like the basic direction, but are still waiting to see if the company becomes more active on the M&A front.

3. Cisco Gets Social

Ever since they dropped “Systems” from their name, Cisco has regularly been in the deal mix, and February was no exception. Two acquisitions were announced last month, and this article focuses on the first one. The deal was actually quite small by Cisco standards, but speaks quite loudly to their ambitions. On February 8, Cisco announced its acquisition of Five Across, a small company focused on social networking. Financial details or terms have not been disclosed, and we suspect the value would be under $50 million.

The initial reaction would be “why?”, especially when Cisco's focus is the enterprise equipment market, and not on consumer-based web services. Perhaps Cisco is of the view that social networking has valuable applications in the workplace, and they see Five Across as an enabler. Cisco is viewed by some as the hub of all enterprise communication, so this could be a proactive move toward an intersection of enterprise applications and social networking. To be fair, though, they are not the first company to move in this direction.

Just two weeks earlier, IBM announced Lotus Connections at their Lotusphere conference. By most accounts, this is the first Web 2.0 solution that combines enterprise productivity applications with social networking. It is a powerful combination, and while yet to be commercially proven, the fervent adoption of social networking at home gives indication that these tools may also take root in the workplace.

It appears that Cisco agrees with this premise. Cisco has actually made a substantial commitment to new media, and last December, unveiled its Media Solutions Group, which is totally dedicated to this sector. The group is run by Dan Scheinman, who led Cisco’s much larger acquisitions of Linksys and Scientific-Atlanta. These are the deals that put Cisco on the map in the consumer world. Five Across appears to be the first acquisition for this group, and there may be subsequent deals that strengthen Cisco’s social media position.

Five Across primarily serves the consumer market, but it is the underlying capabilities and applications that Cisco sees fitting into their vision for the enterprise. The Five Across Connect platform is designed to build online communities and use social media tools to create closer bonds between organizations and the audience they serve. Being web-based, this includes all the familiar applications such as blogging, file sharing, photo sharing and messaging, but in the context of everyday business.

The most convincing example of this is NHL Connect, Five Across’s premier customer. Although consumer-based, the applications are relevant, and more importantly, it demonstrates how well their platform works on a large scale. This will be crucial for the customers Cisco has in mind, especially if they are going to compete with Lotus Connections. And of course, both must contend with Microsoft Office, who recently updated its collaboration software, SharePoint.

Aside from being able to meet the needs of large customers, we believe there is another fundamental reason why Cisco may want to provide large-scale social networking solutions. Being web-based, the solutions will create more Internet traffic that will run on Cisco’s networks, especially video applications and sharing of large files for collaboration. This can only be good for their hardware business, where the ROI is easier to measure and quicker to realize.

4. Art of the Deal - Polycom Acquires SpectraLink

On February 7, Polycom Inc. announced its deal for acquiring SpectraLink. The deal is a cash offer, valued at roughly $220 million, which we would consider mid-sized in the current telecom M&A climate. We see this deal as another case of a large vendor consolidating the market, and making strategic acquisitions to keep pace with their rivals. There have been several deals like this in 2007 already, and we think this move positions Polycom nicely as it squares up against the likes of Cisco and Avaya in the fast moving enterprise telephony market. Polycom also picks another $145 million to add to its revenues, and does so at a relatively low multiple compared to its current 3.5X revenue trading multiple.

At a basic level, the deal makes sense. Polycom has an extensive wireline communications portfolio, and SpectraLink is a pioneer in wireless enterprise telephony. We hesitate to label Polycom a telephony vendor, as their offerings go well beyond the IP phones that are the domain of Cisco and all the PBX vendors. Their SoundPoint IP phone product family is but one offering among a broader suite of telephony and voice conferencing solutions.

This, of course complements their videoconferencing systems, which run the gamut from traditional through to High Definition and telepresence solutions. In that regard, their scope of offerings to enterprises is unique, and in our view, they truly live up their name – poly communications. Adding wireless only strengthens this moniker, and Polycom now has a compelling and complete solution set, not just for IP telephony, but also for all enterprise voice and video communications.

Two factors stand out in the motivation for this acquisition. First is the simple fact that mobility within the enterprise is rapidly growing, and most vendors are rushing to address this emerging market opportunity. Related to this is the growing consensus that 2007 will see the first major deployments of WiFi, and in the enterprise market, SpectraLink is one of the true leaders. Their proprietary QoS solution – SpectraLink Voice Priority – is the de facto standard for managing LAN-based wireless enterprise voice quality. In terms of handsets, SpectraLink’s portfolio includes the NetLink line of WiFi phones. They operate on the major WLAN enterprise standards – 802.11a/b/g – and interoperate with all the leading PBX vendors, both legacy and IP.

The second factor is SpectraLink’s strong focus on vertical markets. Polycom has traditionally had a horizontal focus, selling across all markets – which is another dimension of being “poly”. SpectraLink has been more strategic, and built its business around vertical markets that have a demonstrated need for wireless telephony, namely healthcare, hospitality, schools/campuses, manufacturing and retail. Vertical markets have been a key part of the value proposition from both vendors and service providers in their efforts to sell IP services and solutions to enterprises.

This market presence brings added depth to Polycom, and makes them a viable choice now for enterprises seeking a complete voice solution for both wireline and wireless. Furthermore, it creates synergies both ways to cross-sell each other’s offerings. With SpectraLink, Polycom gains access to established customers in these vertical markets, and the opportunity to sell them audio and video conferencing as well as wireline IP telephony. Taking this one step further, Polycom can now create fully integrated fixed and mobile solutions that are customized specifically for the needs of a vertical market. Going the other way, SpectraLink benefits from Polycom’s more extensive market reach and global channels, which can only be good for sales.

Another aspect we like about this deal is the minimal overlap in their lines of business. Acquisitions of companies with like products come with many challenges, such as branding, customer ownership, channel programs, partnerships and intellectual property, to name a few. This is not the case here, and Polycom can go to market now with a proven and known product family. No R&D is required, and there should be few issues around integrating the product lines.

Perhaps the most pressing item will be making sure that everything is SIP-based. Polycom has been a leading adopter of SIP, which we see as key factor for their success in the transition to IP. SpectraLink, on the other hand, is on the road to SIP, but not as far along. No doubt, Polycom’s expertise will be brought to bear to accelerate this process, so we do not expect this to remain a problem for long.

Aside from creating a complete voice solution for enterprises, Polycom can now address another hot area that is potentially lucrative – collaboration. Multimedia solutions are becoming a reality now for enterprises, and collaboration is emerging as an important capability to demonstrate the value of IP technology. In this regard, Polycom would compete directly against Cisco, the only other vendor who can offer so many collaboration tools – IP telephony, WiFi, audio conferencing, video conferencing and telepresence.

This leads us to our last point, which is this – to get something, you have to give something. Both companies owe a fair degree of their success to the reseller and partner relationships they have with the major IP PBX vendors, namely Cisco, Avaya and Nortel. Their paths are more likely to cross now as competitors, especially with Cisco, and it remains to be seen if the principle of “co-optition” will hold up here. For every fixed/mobile account they win from Cisco, Polycom may well lose out on handset or video conferencing orders they would normally get with a Cisco deal. Long term, however, we think they have a strong enough book of business of their own to make this deal a winner.

5. Financial Highlights