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. Session Border Controllers – State of the Market

Given the consolidation trend occurring among both telcos and vendors, we felt it timely to focus on the session border controller space (SBC), as in many ways it typifies the dynamic nature of the overall IP communications market.

The SBC space came together rather quickly in 2004, largely in response to carriers ramping up the scale of their IP deployments. They quickly discovered that voice behaves differently than data in an IP network, and the exchange of VoIP traffic from one network to another posed a new set of risks and vulnerabilities that data-centric solutions could not address.

No two IP networks are alike, and not surprisingly, a variety of distinct SBC solutions have emerged, and each has a niche that so far seems viable. Each SBC vendor seems to have its own twist, usually built around the needs of particular type of carrier or application. Regardless, all SBCs address a common set of issues that carriers face with VoIP:

• NAT traversal – firewalls are designed to protect the network, and SBCs solve the problem of getting VoIP past the firewall and performing the network address translation function
• Call control – SBCs manage the flow of calls, or sessions, going in and out of the network
• Topology hiding – this is a form of security in the sense that SBCs prevent outside parties from having access to a carrier’s network architecture and routing configurations
• Network protection – by functioning at the network edge, all the signaling and media stays away from the core, and reduces the risk of network attacks

Most industry observers, including Mercator, have suggested that the SBC functionality would likely get subsumed by other network elements over time, and that the window of opportunity for stand-alone SBC companies would eventually close. It was a little over a year ago that the first notable SBC acquisition occurred, and seemed to signal the beginning of consolidation among these nascent companies. In March 2005, Kagoor Networks was acquired by router vendor Juniper Networks for $67.5 million. Kagoor was one of the stronger SBC vendors, and their product line lives on within Juniper, though branded now as the VF Series of SBCs. At the time of the acquisition, Juniper stated its intention to move the SBC function into its Netscreen edge router platform.

Not long after, in June, Jasomi Networks was acquired by Ditech Communications for $20 million. Comparisons were quickly made as to which deal was better for investors, and the modest valuation of Jasomi sparked concern that the bar was set too low for future SBC exits. On one level, it brought home the point that software-based businesses usually have lower valuations than hardware-based companies.

Secondly, Jasomi was privately funded, whereas Kagoor was venture-backed (including $10 million from Siemens). Expectations for an exit valuation are typically higher in a venture-backed deal, and since most SBC vendors are venture-backed, the fears about a low bar may be largely unfounded.

Since the time of these two deals, the SBC market has been quiet on the M&A front. In fact, the number of entries continues to grow, as the demand for SBC functionality is becoming more mainstream. As such, the question of “who’s next?” is a valid one as vendor consolidation picks up in other areas of IP.

A key reason why there has been little such activity is the fact that no dominant architecture or business model has emerged to define leadership in the SBC space. Some vendors believe a fully integrated hardware-based platform is the way to go, while others advocate a modular architecture whereby the signaling and media functions are decoupled. Purpose-built SBC vendors believe this space is complex enough to warrant a standalone solution, while other vendors feel that SBC functionality can be built into other network elements such as routers, media gateways, or security solutions.

In terms of the competitive landscape, here is a quick snapshot of the leading SBC vendors:

• Integrated platforms – Acme Packet, Netrake, Newport Networks
• Decoupled solutions – NexTone, Mera Systems, Sansay
• Integrated softswitch/media gateway solutions – MetaSwitch/Data Connection, Sonus, Tekelec
• Media gateway vendors – Versatel, Quintum
• Router/firewall vendors – Cisco, Juniper, Ingate
• Security vendors – Kayote, Borderware, VoIPShield

Some of these solutions are commercially available, and others have SBC functionality that is integral to their overall platform, but not offered as a standalone product. The latter is also the case for the legacy vendors – Nortel, Alcatel/Lucent, Siemens, Ericsson. These vendors have the largest installed base of carriers who would use SBCs, but none has truly developed a standalone solution of their own.

Alcatel had an early opportunity to lead the SBC sector when they acquired the intellectual property of Aravox, one of the earliest SBC entries. However, this has not translated into a carrier-grade platform for Alcatel. As such, most of the smaller vendors cited above target the legacy vendors with their SBC solutions as a partnership strategy to gain access to larger carrier networks.

We still feel that the SBC sector could continue to consolidate further. It remains to be seen how viable these companies will be, but we look to three indicators as gauges of market success to identify the best prospects for exits:

• Number of customers – this is probably the best metric as there is no substitute for having customers to prove your technology and build your reputation. With most vendors being private, there is little data available about revenues, so this is the next best thing.
• Caliber of customers – Tier 1 carriers trump all, as this is the best proof point of a vendor’s ability to sell at the highest level, and to validate their technology. The vendors cannot all sell into Tier 1s, but in lieu of quantity, the quality of customers is very important.
• Ability to raise capital – as this space becomes more crowded, vendors who can attract funding have demonstrated some staying power, and are in a better position themselves to become consolidators when the market reaches the next level. However, this is a double-edged sword since these companies will also require higher prices to translate into a successful exit for their investors.

There is still a lot of growth coming in this space, but if we had to pick some early winners based on these indicators, three stand out in our view:

• NexTone – by far, the greatest number of customers in this space (approaching 400), and they recently raised $35 million of additional funding, bringing the total to almost $70 million.
• Acme Packet – clearly the market leader for Tier 1 customers, and also a large customer base (over 200).
• Netrake – few announced customers, so it is difficult to gauge their true market penetration. However, they do claim 3.5 million SIP VoIP subscribers, and are at the forefront of supporting key network initiatives, namely IMS, FMC and UMA. Among all SBC vendors, they have raised the most capital to date (over $70 million) – but nothing since January 2004.

2. Lucent/Alcatel – What Comes Next?

Once again, things happen when AT&T gets busy. As noted in the April newsletter, the AT&T/BellSouth deal has led to much speculation as to how other carriers and equipment vendors will respond. Interestingly, little has happened on that front, at least in North America, but still waters run deep. On the vendor side, Lucent/Alcatel was the latest response to carrier consolidation, and it will certainly not be the last. Of course, Lucent and Alcatel almost made it to the altar a few years ago, but eventually egos got in the way. The market is very different today.

A couple of years ago, there were 4 RBOCs, 3 major IXCs, and the wireless space was still fairly fragmented. With the moves from SBC, Verizon, and Nextel, these IXCs are now gone, and the result leaves the U.S. with 2.5 RBOCs (Qwest representing a fraction of the other two). In mobility, Cingular has gone from shared ownership between two competing RBOCs to total ownership by AT&T, who is once again the largest telco in the U.S. Additionally, Sprint and Nextel have merged, leaving fewer but larger carriers in the wireless market.

Fewer carriers means fewer customers for vendors, and Lucent and Alcatel have taken this cue to combine forces. While it is too early to tell if this is good deal or not, attention invariably shifts to their largest peers, namely Nortel and Siemens. Putting these two together would make for a neat and tidy consolidation in the carrier equipment market, but the two companies are in very different places these days. Nortel has been through what seems like an eternal period of management turnover and accounting woes, and they are very much in a rebuilding mode under new CEO Mike Zafirovski. He has adopted the GE model of management, including their famed Six Sigma quality regime, and has publicly stated this will be a 3-5 year process.

Mr. Zafirovski appears determined to put his stamp on Nortel, and having plateaued at Motorola, turning Nortel around will likely be his career-defining personal challenge. As a result, it is unlikely he will be looking to merge with a competitor for the sake of bulking up. Conversely, it could be argued that his task is too daunting, and he will achieve glory more quickly by performing a short-term fix up and exiting by being acquired. In light of their recently reported 2005 results, Nortel is still a long way from financial health. Although 2005 revenues were $1 billion higher than 2004, the net loss was $2.6 billion, which more than 10 times the loss reported a year earlier.

Siemens, aside from being larger and more diversified, is also profitable. Their recent Q2 results show that sales are up 21% from last year, and net income was just under $900 million Euros, up 14% from a year ago. That said, their Communications Group, which includes telecom, is not performing well, and it is widely believed Siemens is looking to exit this market. This is due in large part to shrinking margins caused by intense competition in a global market, especially from low cost Asian vendors such as Huawei and ZTE. These realities lead us to conclude that a Nortel-Siemens union is highly unlikely.

Under this scenario, the largest consolidation plays will likely revolve around the data networking, home networking or wireless markets. As always, Cisco could extend its dominance in the data market, or strengthen their position in home networking. Merging with Motorola could create a giant force (Ciscorola?), and while compelling, will not likely occur. Cisco recently spent $7 billion to acquire Scientific-Atlanta, who competes directly with Motorola, which has soured a previous Wi-Fi partnership agreement. Companies like Ericsson, Nokia, and Motorola are looking at acquisition as a way to address fixed-mobile convergence, and all have the financial prowess to become consolidators.

With that said, it must be noted that Cisco has long kept the door open for Nortel, as they have not matched their data market success with the telcos, and acquiring them would be one way to do this. Given Nortel’s current state, and the global competitiveness of the telco market, Cisco has probably changed their thinking on this, and decided to concentrate on where they are strong, where they can dominate the channels, and where they can make better margins.

Since Alcatel and Lucent will be distracted for the time being, it appears that the next wave of vendor consolidation may be led by other large players such as Cisco, Juniper, Ericsson, Nokia, and Motorola. Any of the vendors mentioned in this article could well make moves, but likely on a smaller scale, perhaps going after leading nextgen vendors such as Sonus Networks or AudioCodes. Moving down the food chain, it is also very possible that we will see more consolidation among the Tier 2 vendors along the lines of what companies like Cantata or Tekelec have done. Regardless of how these moves happen, consolidation will happen, as all vendors understand the need to get bigger to keep pace with a shrinking set of customers.

3. National Franchise Bill – Good News or Bad News?

The stakes continue to escalate as competition intensifies between the RBOCs and MSOs. While not yet passed into law, there is no middle ground with the National Franchise Bill – you are either on the telco side or the cable side.

On April 26, this bill passed its first test with a favorable vote of 42 to 12. The underlying objective behind this bill is to stimulate competition for cable TV, and to help drive the adoption of broadband in the U.S. These may be noble goals, but the real motivation is to make it easier for the telcos to jump into the lucrative video market.

A key obstacle facing the telcos is the long and costly process of negotiating state and local franchising agreements to gain the rights for national broadcasting. These have taken years for the cablecos to acquire, and the MSOs want to keep that barrier in place to ensure telcos have to work just as hard as they did to get into the business. Of course, this also buys them time, which is critical in allowing cablecos to bring strong Triple Play bundles to market that lock subscribers in before the telcos have a chance to take these customers away.

There are a few other layers to the story. First, taking the offensive position, consider what the RBOCs are trying to do. The MSOs have been quite successful with VoIP – largely at the RBOCs' expense – and they need to counter by going after the cable market with their own video offerings. They have had some success with satellite TV, but this is not IP-based, and is neither practical nor cost-effective in urban markets.

Fiber is the end game here, and the RBOCs have been investing billions to upgrade their infrastructure, but this process still has a way to go. Verizon has been trialing fiber-optic service with their Fios offering in Texas and Virginia. To illustrate why fiber is critical for the RBOCs and the Triple Play, Fios can operate at up to 30 Mbps (which is plenty for video), while their current DSL technology can deliver 3 Mbps at best. Texas appears to be the state where Verizon is the furthest along with fiber, and it is perhaps no surprise that the National Franchise Bill was tabled there, and the Committee Chairman, Joe Barton, is a Texas-based Congressman.

Another interesting issue has Net Neutrality overtones. To get their voice heard on the topic of national franchising, the RBOCs have prepared television advertising campaigns. They have recently filed complaints with the FCC about cable operators who refused to run the ads over their networks. The cablecos have argued that they have the right to not carry ads from direct competitors, and Comcast has added that AT&T’s ads were “false and unsubstantiated”. There may be some legitimacy to these arguments, and it is clear that both sides have dug their heels in.

The cable industry has gone so far as to have a report issued by the NCTA to discredit the telcos, and show how they have misled the public. Titled “Phone Companies and the Truth: A Bad Connection”, the report challenges claims by the telcos that cable prices are perpetually rising, that consumers have no choice for their cable service, and that many “independent” consumer groups that are pro-telco are, in fact, subsidized by the RBOCs.

Another angle the cablecos have been using to attack the telcos is the alternative to a national franchising model. If cablecos can pursue a statewide or municipal-level approach to acquiring broadcast licenses, the concern is that they will “cherry pick” only the most desirable markets, and not provide service to less affluent areas. This would give them an unfair advantage, allowing them to only offer service where they can make an attractive profit, while leaving other markets underserved for broadband.

Clearly, there are some fundamental conflicts here between economic interests and social policy issues. They also speak to the Net Neutrality debate, which itself will have a hand in shaping how the telcos come to market with video. There is no middle ground here, and the fate of the National Franchise bill may come down to which side has the stronger lobbying team.

If the telcos win, it will be because they make the case that their presence is needed to provide choice and pricing competition to cable subscribers. However, for them to deliver, they need a fast track to market, and this means no national franchise agreements. In their mind, they can build out a fiber network faster than it takes to get a franchise, and if they could work at a state level instead of a national level, they could bring competition to consumers in much less time.

Conversely, for the cablecos to win, they need to convince Congress and the FCC that they have been serving the consumer’s interest well, and that the telcos are not trustworthy. If they can discredit the telcos, it will be difficult for Congress to change the rules of game to suit the demands of the RBOCs.

Even if the MSOs succeed, they know they cannot keep the telcos out of their market, especially as they continue to take telephone subscribers away from them on a steadily increasing basis. Congress will not let a double standard like this stand, but perhaps more importantly, Kevin Martin’s FCC administration has been pro-RBOC for some time. They have not put up any red flags regarding the AT&T/BellSouth deal, and their position on Net Neutrality favors the broadband providers who advocate a two-tiered network. As such, the stronger the RBOCs get, it can be argued the harder it will be to fight them.

4. Art of the Deal:
Comverse Acquires NetCentrex

On April 10, Comverse Technology announced the acquisition of France-based NetCentrex S.A. for $164 million in cash, plus up to an additional $16 million in earnouts. Comverse is a public company, listed on NASDAQ, while NetCentrex is private, but had been considering an IPO later this year. The acquisition is targeted to close on July 1.

The mechanics are rather straightforward, but the deal is noteworthy for other reasons. Comverse is a large, profitable and cash-rich company. They are based in Israel, and have a global footprint with over 500 carrier customers in more than 120 countries. NetCentrex, on the other hand, is a spinout of France Telecom, and had $50 million in revenues in 2005.

It should be noted that in the wake of the AT&T/BellSouth deal, the inevitable wave of vendor consolidation has begun. The most visible has been Alcatel and Lucent mentioned previously, but clearly, the vendor community understands that the pool of carriers is getting smaller, and they will need to bulk up to keep pace.

Comverse has established itself as a global player in traditional areas such as messaging, voicemail, and billing. As their customers shift focus from traditional applications to IP, it becomes easy to see how Comverse needed to change course. They either needed to develop these applications in-house, or acquire them from existing vendors. With IMS platforms becoming a necessity, and many carriers moving to Triple Play bundles, Comverse looked to take advantage of the opportunity. They recognized that things move more quickly in the IP world, and they did not have the luxury of time to develop new applications internally. Being cash-rich, it became an easy decision to seek an acquisition.

So, why NetCentrex? Some reasons are practical, and others are more circumstantial. On a practical level, NetCentrex has a proven Triple Play platform, and is well along the path for both FMC and IMS. Perhaps more importantly, NetCentrex has implemented large-scale deployments, which Comverse needs for its large roster of global Tier 1 carrier customers. Furthermore, NetCentrex is a market leader for video, which is arguably the key moneymaker for Triple Play. All told, this gives Comverse an attractive set of proven applications that can provide bottom and top line benefits right away.

A more subtle explanation is based on geography. Most of NetCentrex’s success has been in Europe, with carriers such as Italy’s FastWeb, and France’s Wanadoo and France Telecom. There has always been a concern about NetCentrex not being well understood in North America, and their lack of deployments here has only reinforced that perception. As such, one could argue that it would take a European-focused vendor like Comverse to recognize value in NetCentrex, as opposed to a North American based vendor who would be less likely to have familiarity with them.

This factor is important in the context of the alternatives available to Comverse. Although they also offer some softswitching capability, NetCentrex is essentially an application server vendor, and there are two strong competitors in that space, BroadSoft and Sylantro. Both vendors have larger customer bases, and stronger brand recognition. However, they lack the Triple Play focus, and video emphasis that has been the hallmark of NetCentrex. Furthermore, most of their customers are small, and mostly have deployed IP Centrex solutions instead of the residential VoIP services that NetCentrex has had success with. And finally, most of their customers are North American.

Comverse likely had a higher comfort level with a partner who had proven success selling globally, as well as on a large scale. This last point is relevant if one considers the fact that carriers outside of North America typically have less legacy infrastructure, and are more willing to deploy IP on a large scale. Clearly, this would be an important consideration for Comverse given its customer profile.

From a valuation perspective, at $164 million, the transaction represents a multiple of about 3.3X trailing revenues. This is perhaps a slight premium to the average publicly traded peer group, but a discount to other notable transactions in the VoIP sector in years past. Companies like Taqua, Telica, VocalData, Kagoor, and Cirpack all sold for multiples ranging from 6X - 15X revenues. The deal is more in line with recent transactions such as Brooktrout and Santera, which occurred at 2X - 3X trailing revenues. Regardless, the transaction still represents a successful exit for investors, who had invested about $37 million in Netcentrex.

In this context, the deal has implications for BroadSoft and Sylantro. As with NetCentrex, both are believed to be pursuing an IPO. On April 21, Sylantro quietly announced a new round of funding, valued at $11 million, bringing its total to over $100 million, and also bringing into question the company's profitability. BroadSoft has raised $60 million to date, but nothing since 2002, so they appear to be self-sustaining.

The Netcentrex deal provides yet another data point for relative valuations. Assuming that Broadsoft is slightly larger than Netcentrex, a 3.3X multiple would indicate that they are worth approximately $200 million, once again, assuming that they trade at a premium relative to their peers. In today's Sarbanes-Oxley regulatory environment, does it make sense to be an independent public company at this valuation? The implications for Sylantro could be even worse. At this point, both companies are holding their collective breaths to see how Vonage fares with its IPO, which seems to be just around the corner.

Finally, the Comverse/NetCentrex deal has taken a sudden twist which must be creating untold anxiety for Olivier Hersent, the NetCentrex founder and CTO. On May 1, three top Comverse executives resigned in the midst of a company review of stock option grants. Especially troubling is the fact that one of these executives was Kobi Alexander, the company’s founder, CEO and Chairman. It is not clear whether this jeopardizes the NetCentrex deal. We will update this story at the earliest opportunity.

5. Financial Highlights