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. Veraz IPO – What Went Wrong

For followers of the VoIP equipment market, the much-anticipated IPO of Veraz Networks was certainly disappointing. The company has slowly and steadily been building a good story for several years, and when their S-1 was filed in October 2006, this appeared to be a logical step for their growth plans.

Veraz is the product of a 2003 merger between ECI Telecom’s subsidiary, NGTS and NexVerse, the predecessor to Veraz. ECI is a publicly-traded Israeli company, and NexVerse was venture-backed, based in California. Both companies had a global footprint and catered largely to Tier 2/3 carriers in emerging markets. The combination made sense, as Veraz was one of the few nextgen vendors at the time who were focused on softswitch-based platforms outside of North America.

With current revenues tracking close to $100 million, and an IPO that was initially expected to raise $115 million, Veraz had all the appearances of becoming a substantial mid-market player. A successful IPO would give them a base to build a solid global brand, with the means to become a consolidator along the lines of AudioCodes or Cantata.

As we have cited in previous newsletter issues, IPOs in this market have been an uncertain proposition, and Veraz’s filing came just a few months after Vonage’s disastrous IPO, and a few months ahead of Acme Packets’ highly successful IPO. On the surface, as a casual observer it would have been difficult to accurately predict how Veraz’s IPO would be received. Veraz had expected the stock to be priced initially in the $10 - $12 range, but demand proved soft, and the IPO was priced at $8 per share, which yielded roughly $72 million. After the stock opened on April 11, it closed at $7, and has remained around that level so far, giving it a market capitalization of around $280 million.

A closer look at the company provides some clues as to why the IPO fared poorly. For starters, Veraz is not profitable, and for some, this alone is reason to stay away. They lost roughly $14 million in 2006, as well as the year before, and have a cumulative deficit of $60 million. Sales have been growing nicely, up from $76 million in 2005 to $100 million in 2006. On this basis, they are bigger than Acme, but Acme is profitable and has stellar margins in the 80% range. We also see cause for concern in Veraz’s cost structure. R&D expenses have been rising, and at $27 million, they account for over a quarter of revenues. While R&D is the lifeblood of innovative companies, we do not see where or how this level of spend is translating into competitive advantage for them.

Another important factor is their product mix. Unlike Acme, which is 100% IP from the ground up, Veraz has a challenging mix of TDM and IP in their portfolio. Until last year, the majority of revenues came from their legacy DCME business – Digital Circuit Multiplication Equipment. Not only had this been driving revenues, but DCME accounts for the majority of its customers – about 400, compared to only 45 who are using their IP platform. Understandably, there is concern about having so much business tied up in a declining market, and going forward, uncertainty about their ability to replace it with new business for IP solutions.

And then there is the VoIP market itself. While Acme is the dominant vendor in its segment, Veraz is a second tier player that typically competes against bigger and more established vendors. It is clear to us – and investors – that these are very different situations. Acme appears very capable of defending its market dominance for the foreseeable future, whereas Veraz is up against competitors who are only getting bigger and stronger as the softswitch market matures. Household names like Cisco, Nortel, Alcatel-Lucent, Sonus and even Huawei and MetaSwitch all figure to be competing for the same customers, and things will only get harder for Veraz, especially as there will growing pressure to become profitable as a public company.

The IPO market itself also needs to be considered in this equation. Aside from the success of Acme Packet’s IPO, this sector also saw two promising IPOs around the time of Veraz, namely Aruba Networks and Big Band Networks. Aruba went public March 27 and was initially well received, but is currently off about 5% from its offering price; meanwhile Big Band is up 50% since it priced on March 16. As a final comparison, we point to three companies in the WAN optimization sector who went public during the fall of 2006 – Riverbed Technologies, which is up over 200% from its offering price (trading with a $2 billion+ market cap; over ten times forecasted 2007 revenues), Sandvine, which is up over 100% from its IPO on the Toronto exchange last fall, and Allot Communications, another Israeli company which is down around 40% from its IPO in November.

Taking all this into consideration, it is understandable why the Veraz IPO fell short of expectations, as well as the sober view that investors are taking for companies in the IP communications sector. At this point in time, the big winner is ECI Telecom, who owned more than a 40% stake in Veraz and invested $10 million when the company was formed. Despite the mediocre IPO, their investment has grown to $30 - $35 million, which is still a healthy return for a four year investment.

Finally, we wonder if this deal has implications on other companies who have expressed interest in pursuing IPOs in 2007, such as Broadsoft and Nextone. Only time will tell.

2. Spotlight on IPTV Middleware

IPTV is an area we have been following with interest, and we see middleware being a leading indicator of the market’s readiness for larger deployments. Middleware is the interface between the subscriber and the content provider, and it manages the overall IPTV experience. From a growth perspective, it enables IP-based features that take IPTV beyond replicating the traditional viewing experience provided by legacy broadcast technologies. Examples include enabling Youtube-type Internet channels, integrating telephony features with TV watching, and interactive viewing, which enables service providers to better understand subscriber viewing habits and more effectively target advertising.

While this market is still emerging, we see three distinct categories of middleware offerings. Early middleware was home-grown and proprietary, as there were no adequate third party offerings to meet their needs. These solutions were either developed by the service provider or custom-built for them. Like most home-grown systems, these were proprietary, and built from off-the-shelf components, with limited application outside their intended use. Leading examples would be FastWeb’s IPTV deployment in Italy or PCCW in Hong Kong.

These may have served their initial purpose, but middleware has matured, and the trend is towards open, standards-based architectures, such as the CableLabs spec used in the U.S for MSOs. We see home-grown middleware as being first generation technology that will have challenges integrating with third party IPTV network elements, and scaling as subscriber bases grow into the millions with mainstream adoption.

The other two categories of IPTV middleware are from third party vendors, and are more in line with what service providers are going to need to differentiate themselves from cable triple play bundles. One category is end-to-end platform systems where the same vendor integrates middleware with other IPTV ecosystem components and set-top boxes, and are somewhat monolithic, closed architectures. Examples include Microsoft, Minerva Networks, Kasenna, and Tandberg Television. The other category is a more modular and open middleware solution that integrates with IPTV ecosystem components from other vendors. Leading vendors here wou ld be Espial, Orca Interactive, and Siemens/Myrio.

Within this modular/open category, there is another break-down between browser-based solutions, such as Orca and Myrio, and data-driven architectures such as Espial. Browser-based solutions use HTML and javascript for service creation and electronic program guide customization and use standards-based development tools, but suffer from performance and scalability challenges. Data-driven architectures combine open development tools with a faster user experience and more scalable head-end server architecture. We are strong believers in an open, data-driven architecture that can maximize performance, and are therefore a strong believer in Espial’s approach.

Microsoft has been the dominant name in middleware solutions, but they have been slow getting to market and proving themselves for large scale deployments. Concerns on system scalability, total cost of ownership, and set-top box compatibility have dogged Microsoft and caused delays at leading Tier 1’s who committed to the system two or three years ago before viable alternatives on the market existed. These delays have given smaller vendors time to catch up and make the competitive environment more interesting. We see some parallels here with the session border controller market in that IPTV middleware is coming into its own now as service providers recognize its key role in enabling new services and applications. Furthermore, there are multiple types of vendor solutions, all of which have a place since no uniform approach to middleware has emerged.

In this environment, we see the fate of the middleware vendors largely tied up with how the Tier 1 equipment vendors are faring in their efforts to deploy IPTV with their service provider customers. Overall, Alcatel-Lucent appears best positioned, especially if Microsoft can succeed in this market. Aside from Alcatel’s tight relationship and extensive base of IPTV trials with Microsoft, Lucent is also partnered with Orca. This gives them a fallback position should Microsoft disappoint, as well as a viable route to market for non-Microsoft opportunities. Nokia Siemens Networks would be next best off by virtue of Siemens previous acquisition of Myrio. Nortel is less certain, as their Microsoft alliance for unified communications does not appear to extend to IPTV, and they are just one of several partners for Minerva.

The two dark horses we see in this market are Cisco and Motorola. Both are agnostic for middleware, and for now, appear more flexible than their competitors in this regard. This will serve them well where customers want best-of-breed, which at this stage of the market is a very viable option. With Cisco, Scientific-Atlanta’s set-top boxes support Microsoft, Myrio and Espial, so on the subscriber side, they have multiple routes to market. Motorola also partners with Microsoft, but given their extensive footprint in the set-top box market, they have other partners, including Espial and Orca, and in January 2006, they acquired Linux-based Kreatel. As the IPTV market matures, we expect one, if not both of these dark horses to acquire a middleware pure play, and at this time the most attractive candidates wou ld be Espial, Minerva and possibly Orca.

Not to be ignored is Ericsson, who is in the process of acquiring Tandberg Television, and has already acquired Redback Networks, in part to expand its IPTV infrastructure capabilities. Tandberg TV’s middleware solution is relatively limited, and we therefore see the need to acquire a more capable, open-standards platform to compete with the bigger players.

For now, Microsoft has an advantage by virtue of being in most of the Tier 1 trials, where conditions are ideal for large scale testing. The other IPTV middleware vendors do not have this luxury as a matter of course, making it difficult for them to convince service providers – and vendor partners – that they can scale too. That is about to change, as in April, Kasenna announced the setup of an IPTV test network in Hewlett-Packard’s lab in France. This is the next best option to testing in a live carrier network, and if Kasenna can demonstrate scalability here, their prospects for Tier 1 business will undoubtedly improve. We think this could be a watershed event that changes the balance of power among the middleware vendors, and will be following the progress closely.

3. Cisco’s Ambitious SMB Strategy

During Cisco’s Global Partner Summit in early April, a lot of attention was focused on their plans to bring unified communications to the SMB market. At various points during the summit, Cisco made it clear to channel partners how important the SMB market was to their roadmap, and the opportunity it represents for both of them. They stressed how Cisco’s current penetration is quite low – only $1.5 billion in sales – but their view is that they are ready now to transform SMB the way they have done for the enterprise. Cisco has stated that they believe that ultimately the SMB market may be a bigger opportunity than enterprise.

To address this market opportunity, Cisco announced a comprehensive strategy at the summit. Their SBCS – “Smart Business Communications System” – is built around the UC 500 Series platform. This is Cisco’s SMB unified communications solution in-a-box, fully integrated with Cisco IP phones, a softphone, and all the tools to support voice and data applications for point-to-point as well collaborative communications.

As an SMB solution, the UC 500 is priced for this market – starting at $699 per seat, which is considerably less than enterprise-level pricing. Perhaps equally important, there is a strong emphasis on ease of use. Not just for the end user, but across all touch points, particularly implementation and maintenance. As explained by Rick Moran during one of the presentations, this is “plug and play, not plug and pray”. Cisco also claims that UC 500 can be up and running out of the box in as little as 15 minutes. This is a strong brand promise, but if it holds true, Cisco will have a winner on its hands.

Wrapped around the UC 500 are some compelling value-adds that we think will resonate strongly with SMBs. The Catalyst Express 520 is a Power over Ethernet (PoE) switch that is a nice upgrade for higher end SMBs, especially for LAN security. Their Mobility Express components provide WLAN connectivity and WiFi support. For system management, the Configuration Assistant helps users with setup, and Monitor Director allows channel partners to remotely monitor, manage and troubleshoot the customer’s network.

Cisco depends 100% on channel partners to sell into this market, and to support them, they announced the Select Certification Program, which supports partners who specialize in SMBs. Not only do they receive Cisco’s best SMB training and support, but they can also make use of Cisco Capital’s “Easy Lease” program to accelerate market adoption.

These are all important pieces of the SMB puzzle, but we see them largely as table stakes. The SMB market is by nature not very tech savvy, and for Cisco to become a force, they have to bring something new and show SMBs what is really possible with unified communications. In this regard, we want to cite two forward-thinking features.

The first is Cisco's support for third party applications, and integration with everyday business tools like Microsoft CRM, Outlook, Internet Explorer (click-to-call from the toolbar) and Salesforce.com. This makes UC 500 productive right from the start, and building on this is the second feature – the ability to support specialized applications for vertical markets. Cisco has partnered with software providers such as IPcelerate to develop customized solutions for distinct market segments, and we see this potentially adding value to resellers who focus on specific markets like education, retail, or professional services.

All told, there is a lot here to like for both SMBs and the channels. UC 500 may well be the most complete premise-based solution specifically developed for this market, and resellers now have a stronger offering to compete against Microsoft and IBM’s Lotus Sametime, along with greater upside for services revenues. With that said, Cisco seems to be willing their way into the SMB market, and the only thing that is missing is the customers. It very much remains to be seen how successful they will be, or how long it will take to achieve critical mass.

Another important piece of addressing the SMB market is providing non-premise-based hosted solutions, which may be more interesting to a large set of SMB customers. Cisco provides a couple of options here, including its hosted Linksys One solution (that includes a premise-based services router and phones), and its recent acquisition of WebEx, which is a pure Software-as-a-Service offering. We think that Cisco could also benefit from offering a fully hosted unified communications service to SMB customers, which would be an application that could tie these two strategies together.

We have little doubt that Cisco will win a significant piece of this market, but will by no means own it. Cisco’s enterprise brand equity may not carry over to SMBs, where success will depend more on the applications and ease of use, and most importantly price, than with how well the routers and switches perform. Similarly, they need to develop and support a new network of channel partners who are focused on SMB and believe in UC 500 enough to master it and sell it. And of course, there will be competition from many sources, as Cisco is hardly alone in recognizing the SMB market opportunity. This will be a difficult market for anyone to dominate, but regardless of how Cisco fares, they have certainly moved the bar higher with the UC 500.

4. Art of the Deal – Google Acquires DoubleClick

With each passing month in 2007, the deals seem to get bigger and bigger. On April 13, Google announced its $3.1 billion acquisition of DoubleClick, a move that has set off shock waves on a number of levels. Aside from this being one of the biggest deals of the year so far, it is Google’s largest, almost twice the size of the YouTube deal last year.

Aside from the sheer size of the deal, we find it interesting to note that it was all cash. Google has both stock and cash to use as currency, and using cash indicates they still feel there is potential upside in the company's stock. They may have paid a healthy premium to acquire DoubleClick, but it can be justified for at least two reasons. First, they can afford it, especially considering the potential upside for integrating the two businesses. Second, purely for defensive reasons, Google may have felt that it needed to make this deal. Acquiring DoubleClick puts them in a much better position to compete against Yahoo, the market leader for Internet display advertising. And, looking in the rear view mirror is Microsoft, who could have quickly become a market force had they made this deal, which we believe had been in play earlier.

In essence, market conditions dictated this move rather than business fundamentals. It is moot to consider that DoubleClick could have been acquired for much less not so long ago. Microsoft may have felt the premium was not worth it, and time will tell if this will prove costly. On the other hand, private equity firms Hellman & Friedman and JMI Equity have no complaints, since they took DoubleClick private in 2005 for $1.1 billion in cash and debt.

Acquiring DoubleClick is part of a bigger picture where Google is aggressively making moves across the full spectrum of the advertising business, both online and offline. They clearly are determined to leverage their strengths in other arenas, as they have come to dominate the search business in a way that is akin to how Microsoft dominated the desktop software market in the mind-nineties. That dominance will be difficult to sustain over time, and Google is now to trying to learn which other facets of advertising their business model can best be applied to. Recent moves include a deal with EchoStar for television, a pending deal with DirecTV, Clear Channel for radio, and a cash acquisition last January for DMarc Broadcasting, also for radio.

It remains to be seen how successful Google will be in these endeavours, especially since traditional media companies may not be receptive to Google’s entry. If Google can build up knowledge of end user patterns and preferences via profiling, they will gain leverage in attracting advertisers. From there, Google could be in a position to dictate terms and pricing, which could hurt the revenues and profits of these media companies.

From Google’s “do no evil” point of view, they are simply bringing the advertising world into the Internet age, and will in fact enlarge the pie rather than compete for the existing market. Traditional advertising is not optimized for efficiency, and there is always an overhang, or “inventory” of unsold space or time. With DoubleClick, Google believes it can leverage the Internet model to more efficiently sell that inventory to a pool of advertisers who otherwise cannot find their way to traditional media buyers. In short, Google has an audience that traditional media cannot serve very well – primarily SMBs – and they can now bring these advertisers economical access to offline media to enable them to reach new markets.

Aside from the high price paid to acquire DoubleClick, we see two issues that bring risk to the deal. The first is DoubleClick’s ability to prevent erosion of its business now that it is in the Google fold. Yahoo and others are DoubleClick partners, and inevitably, these competitors may take their business elsewhere.

Perhaps more importantly, companies like Microsoft and AT&T are expressing concern about industry concentration and privacy. This may not resonate with the regulators, but is a sign of a growing wave of concern about Google’s influence. Having search and advertising under the same roof raises the possibility of advertisers having access to personal profile information, which would allow them to target specific messages to unwitting Web users.

These are uncharted waters, but clearly there is discomfort about Google’s moves beyond becoming a market share leader. It is undeniable they are riding a wave of unprecedented success, with booming earnings, recently being cited as the number one global brand, and earlier this year being named by Forbes as the best U.S. company to work for. There is a lot here for their competitors to be concerned about.

Going forward, we will be watching how Microsoft responds. They have not had much success so far competing against Google’s strengths. They are a distant third in search, and their Live platform, which serves to counter Google’s web-based applications, has been slow to gain acceptance. Microsoft’s priorities have been focused on the launches of Vista and Office 2007, which are necessary to protect their core installed base. Interestingly – perhaps to keep Microsoft off balance, Google is now offering free hosted business applications.

Given the size of the Google deal, one cannot rule out a large scale move by Microsoft to counter them, such as acquiring Yahoo, or even AOL. They could just as likely make a smaller move, if only to keep pace, and acquire another advertising property. Yahoo, in fact, did just that on April 30 by acquiring the 80% of Right Media Inc. it did not already own for $680 million. This may not be their last deal, and other potential targets for them or Microsoft would be aQuantive, 24/7 Real Media, and ValueClick. DoubleClick is not likely the last major deal we will see in this space, and we would not be at all surprised if either Microsoft of Yahoo makes other moves before Q2 is out.

As a final note about Google’s M&A activity in April, they also acquired a small Swedish web and videoconferencing company called Marratech, for $15 million. On the heels of the DoubleClick deal a week earlier, this acquisition barely received any coverage. But we think it is a noteworthy addition to Google’s communications and collaboration offerings, as it strives to compete with Microsoft and Cisco/WebEx in the hosted applications sector. Slowly but surely, Google continues to build a presence outside of pure advertising, and we think they will make other moves to further strengthen this positioning.

5. Financial Highlights