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. Spotlight on the Ottawa Technology Market

Mercator Capital participated in the 2007 Ottawa Venture and Technology Summit, which just ran from September 25-27. Ottawa prides itself as Canada’s “innovation capital”, and with the summit being in its 11th year, there is a strong track record to back that claim up. Toronto and Montreal may be bigger and more important economic markets within Canada, but Ottawa has an enviable combination of R&D excellence (both public and private sector), entrepreneurial leadership and quality of life.

Drawing from a pedigree of world class companies like Nortel and Newbridge Networks, the region has spawned hundreds of successful startups and is home to over 1,800 high tech and telecom companies. This in turn has attracted many multinationals to establish R&D centers there, such as Alcatel, Avaya and IBM. All told, the ecosystem of talent in Ottawa is on par with any other technology hub in the world.

The summit was a typical VC event, and we saw a number of interesting companies pitching their business plans. We focused mainly on technology and telecom start-ups, but there were also good stories in the areas of healthcare/life sciences and eco-friendly solutions. The latter was in fact a strong theme throughout the summit, with a particular focus on clean technologies, which has certainly become a magnet for funding everywhere these days.

Of relevance to our readers, we would like to cite the technology start-ups that appear most promising. First would be Kleer, not just for what we saw, but because they also won best-in-show. This is a semiconductor play and are distinct in their focus on portable and home audio markets, with the ability to transmit audio wirelessly. Along with Ottawa, Kleer has also won Best of CES 2007 and made the Forbes.com Top 10 Technologies To Watch list for 2007.

Other presenting companies of note included Embotics, Protecode and VoIPshield. Embotics develops server virtualization software to improve the management of IT resources, which we see as a rapidly growing space. Protecode is built around another area that has exciting growth potential – intellectual property protection tools for developers of digital content. VoIPshield, as the name implies, is targeting VoIP security, which is starting to come into its own, but is a longer term play than these other companies. With so many companies focusing on security now, VoIPshield faces a crowded market where standalone solutions will be competing with integrated platforms. However, the company has strong technical depth in security and purports to have the most comprehensive suite of security solutions on the market.

Overall, we found that most of the presentations and panel sessions were focused on early stage financing and IPO as the desired exit strategy. The recent success of Waterloo-based Sandvine was often cited as the model for other start-ups to follow, but we are highly sceptical that only a select few will replicate this scenario. Being a U.S.-based investment bank, our perspective was different from most of the audience, who were primarily Canadian VCs.

It is often heard from Canadian startups that raising capital in Canada is more difficult than the U.S., especially beyond early stage financing. We concur with this view, and believe that many of these startups will be better served long-term by seeking later stage funding to expand their business rather than attempt an IPO too early. Whether they take this funding to grow organically or via M&A, we believe this path will give them a better foundation for reaching critical mass, at which point they will have more options.

Mercator presented as part of a panel discussion on exits, and demonstrated that while the IPO bar has dropped over the past couple of years, the median tech IPO still requires a company to have $77 million in revenue and should be breakeven or profitable. In turn, 2007 tech IPOs are raising a median of $100 million at valuations of $567 million, a healthy premium over valuations achieved between 2002-2006. By contrast, data over the past five years have shown that a company is nine times more likely to exit via M&A than through an IPO.

Startups only go public once, and it has been our experience that early stage companies often go IPO for the wrong reasons, and many attempt to go out too early. Depending on market conditions, we believe a company’s long term prospects may be stronger going at a later stage once their business model and profitability are proven. We’d love to hear from Canadian companies who are potentially thinking about the IPO market and may be willing to explore the M&A market as a strategic alternative.

2. 3Com Goes Private to Bain and Huawei

On September 28, 3Com announced it was following Avaya’s footsteps by going down the privatization path, and marks yet another M&A move among enterprise networking vendors in 2007. This deal is quite interesting because the players involved have some history, and it raises trade issues not normally associated with the telecom or technology markets.

On paper, the deal is worth $2.2 billion – all cash – with Bain Capital being the primary acquirer. China’s largest networking company, Huawei Technologies, will gain a minority stake. Their share has not yet been disclosed, but it is believed to be upwards of 20%. 3Com shareholders gain immediately from the deal, as the offer values their common shares at over $5.30, which is a 44% premium over their value prior to the deal.

3Com has a long and uneven history, both as a market leader and on Wall Street, where their share price had been north of $100 in 2000, but has been well under $10 in recent years. Before Cisco became so dominant in enterprise networking and telephony, 3Com was a top tier vendor, but their handling of transactions such as U.S. Robotics and Palm Computing contributed to their downfall, and in recent years they have been a minor player struggling to define its niche. For these reasons, it is difficult to determine if $2.2 billion was a fair price to pay. However, we think 3Com’s relationships with Bain and Huawei will provide some clues.

It should also be noted that this deal comes in the midst of a credit crisis that started in the U.S. subprime real estate market, but has spread to private equity markets as well. This is not a great climate for making large deals, especially for a market laggard who hasn’t been profitable since 2000. Interestingly, Avaya’s $8.2 billion privatization deal was approved the same week as this deal was announced, but Avaya has a much stronger pedigree, market share and balance sheet. It seems clear to us that Bain really wanted to do this deal despite all the red flags. Bain is making a big bet on 3Com, and it should not be forgotten that Bain Capital was the lead investor in Vonage’s last major capital raise of $200 million in May 2005 prior to their IPO.

So, what makes 3Com worth $2.2 billion to Bain? Huawei; and more specifically, H3C. As the name implies, H3C was a joint venture formed in 2003 between 3Com and Huawei. In March 2007, 3Com gained full control of H3C by acquiring Huawei’s 49% stake for $882 million. Bain was one of the unsuccessful bidders for H3C, so the current deal is their second chance, and this time around, 100% of H3C is valued at approximately $1.8 billion. That leaves a $400 million valuation for the rest of 3Com, and given that the majority of their 2006 revenues of $1.3 billion were from direct 3Com business, the primary target for Bain is H3C.

H3C is of interest to Bain for two reasons – access to Asian markets, and a chance to leverage their assets along with 3Com’s to compete with the market leader, Cisco. With these motives in mind, the synergies make more sense. H3C makes 3Com’s Gigabit and Ethernet switches, where they rank third globally behind Cisco and Hewlett Packard. However, in emerging markets, H3C is at or near the top, primarily because of their lower cost of production, which gives them an edge in these price-sensitive markets. Furthermore, Huawei accounts for 30% of H3C’s revenue, giving 3Com a solid foothold in China. This deal has multiple facets in China, and we believe it could set a precedent for future China deals as the vendor landscape continues to globalize.

Bain actually benefits on two geographic fronts with these entities. 3Com is more established in North America, and H3C is strongest in emerging markets, particularly China. Huawei and 3Com have a non-compete agreement that holds through 2008. This means that each side of H3C can focus on its sweet spot without any conflict, and greatly increases Bain’s chances of integrating these companies under one roof. This would not have been the case had H3C been acquired by another vendor, such as Siemens or Nortel.

There may also be a side story behind Bain’s interest in bringing Huawei into the deal. Back in January 2003, Cisco filed a major lawsuit against Huawei for patent infringement and unlawfully copying software code. This had all the appearances of an Asian vendor pirating intellectual property from a market leader to become a low cost competitor. The suit was quietly dropped in 2004, but did not enhance Huawei’s image in the West. This closure, however, eliminates a potential risk factor for Bain, and regardless of what actually occurred, Huawei undoubtedly gained valuable insights about Cisco’s technology.

On the downside, the most notable risk factor lies outside the realm of technology. Concerns have been raised in Washington about national security, and the idea of Chinese companies gaining stakes in American technology companies does not sit well with some. This is especially pertinent for Huawei, not just for their Cisco history, but their connections to China’s military.

3. Vonage Is Winning... The Race To The Bottom!

Since SunRocket’s sudden, but not surprising demise in July, the consumer VoIP market has imploded. In that period of time, the three biggest names have had major setbacks, and it is difficult to see how this “market” will ever recover. We analyzed SunRocket in the August issue, Skype’s service outage last month, and now it is Vonage’s turn – again.

We have commented on Vonage in previous issues, and this probably won’t be the last time. There are few parallels to Vonage in terms of their upward trajectory and where they are today. On September 26, the courts ruled in favour of Sprint Nextel’s patent infringement claims, and the penalties were even more onerous than what came from the Verizon litigation.

Sprint Nextel’s charges pre-date Verizon’s and it is not clear why they have taken so long to adjudicate. However, in the wake of a pro-Verizon verdict, it became much easier for the Sprint Nextel case to reach a second guilty verdict. Verizon’s March ruling levied a 5.5% royalty on all new revenues, plus Vonage has to settle for $58 million in damages. Vonage did score a partial victory, however, as Verizon was unsuccessful in its attempt to prevent them from trying to sign up new subscribers. This would have been a decisive blow, as Vonage must continually add customers just to offset turnover, which is a simple fact of life in this business.

Prior to these litigation issues, Vonage was basically losing one customer for every two it signed up, so had Verizon been able to make that charge stick, it would have been akin to cutting of their oxygen. The current market is actually much shakier for Vonage, as their rate of add-ons has dropped significantly, and churn is no doubt rising as subscribers lose confidence in their stability.

Since then, there has been some hope for reprieve from Verizon, as one of the three patent claims – related to wireless VoIP – was rescinded. As a result, Vonage is seeking to have the case re-tried with the hope that all charges could be overturned. We are not optimistic for such a reversal, but Vonage must operate business-as-usual so long as there still is hope for better news.

Regardless of this outcome, the Sprint Nextel ruling stands, and to settle that, Vonage must pay $69.5 million plus a 5% royalty. Vonage may have a strong cash flow from subscribers, and a healthy cash reserve, but settling both cash penalties and absorbing a 10.5% total royalty would be crippling. With their stock now trading under $1 per share, they have no liquidity or ability to raise more capital.

At best, if they aggressively cut back their marketing spend, the remaining cash reserves could carry them a year or so. To date, they have not devised any “workarounds” that would neutralize the impact of these claims, so the status quo set by the courts is not likely to change.

Stepping back, the overall state of consumer VoIP is bleak and only makes matters worse. The cablecos dominate this space now, and will only get stronger as the VoIP pure plays fade from relevance and the telcos stay on the sidelines.

Vonage really only has two options to offset the financial impact of these verdicts – accelerate subscriber growth and increase ARPU. Neither is likely in this climate. Skype’s recent outage did nothing to instill confidence in the public’s mind about the reliability of VoIP, especially from an upstart provider. And neither did Niklas Zennstrom’s sudden resignation as CEO of Skype on October 2. To date, the only way Vonage has had success attracting subscribers was to spend exorbitantly on marketing, but that will have to change now. The fastest way to increase ARPU is raise prices, but consumer VoIP is a race to zero, and this plan will only backfire.

Regardless of your perspective, Vonage is clearly backed into a corner, and the market is becoming increasingly indifferent towards their fate. When you lose hope and nobody cares, there is little reason to carry on, and we feel that Vonage may choose to fall on its own sword as SunRocket did. That would be an ignoble end for the company that truly defined VoIP for the mass market.

Unfortunately, the disruptive energy they brought to telecom has dissipated, and its absence had led to their undoing. Despite urgings from many corners, Vonage stopped being disruptive and is now little more than a voice 1.0 provider. The market has moved on, and they have not been able to develop more cost effective forms of marketing or more diverse ways to increase ARPU – such as wireless or social networking.

If Sprint Nextel ever really had designs on acquiring Vonage, now would be the time. This was certainly looking likely before their litigation was settled, but now, with Vonage’s market capitalization radically reduced, the price will be much more attractive. If that comes to pass, Vonage may well get a second chance to be disruptive again and keep the competitive spirit alive in American telecom.

4. Art of the Deal: Yahoo Acquires Zimbra

On September 17, Yahoo announced a $350 million cash deal to acquire San Mateo-based Zimbra. This is actually Yahoo’s second major deal in September, as they made a $300 million cash deal earlier in the month for BlueLithium. Both moves are coming roughly at the mid-point in Yahoo’s “100 day” quest to find its strategic path, and CEO Jerry Yang is clearly willing to spend freely to put the right pieces in place. Yahoo has been lagging Google and Microsoft for some time, and in light of their recent billion dollar deals, these moves are a visible way to keep pace.

It is too early to pass judgment on Yahoo’s deals, but both are consistent with their overarching need to acquire rapidly-growing, revenue-producing properties that are built around the Internet. BlueLithium is an online advertising network that utilizes advanced data analytics to target ads based on behavioral patterns and preferences. This deal builds on Yahoo’s earlier acquisition of Right Media to build up its online advertising capabilities, so the rationale here is clear.

The more recent acquisition of Zimbra takes Yahoo in a different direction, however, and warrants further analysis. Zimbra is a small but promising email platform built on open source, but Yahoo already has an email platform. To justify spending $350 million for another email platform, and an open source company with less than $20 million in revenues, Yahoo must have had a good reason. We see two possible explanations – the enterprise market and mashups.

Yahoo has always been consumer-oriented, but is currently a distant third to Microsoft and Google, and they need to find new growth markets. The enterprise focus addresses this in two ways – it is a new market for Yahoo, and there is better growth potential in terms of revenues and profits than consumers can currently provide.

Zimbra white labels its platform for several Fortune 500 companies, with Comcast being their flagship customer. With over 6 million paid mailbox subscribers, Zimbra has a solid base from which Yahoo can make inroads with the business market. Given Microsoft’s dominance in the enterprise market, we expect Yahoo will focus more on SMBs, where open source solutions will likely gain faster acceptance.

Complementing the focus on business markets is the open source nature of Zimbra. Yahoo understands that email is the core application for any business platform, and with open source, they have the capability to build on this for a host of services such as calendaring and conferencing. However, this is just the beginning for any business that sees value in Web 2.0-style applications. With open APIs, Zimbra can quickly become a development platform to support mashups, which would tie in nicely with many of Yahoo’s existing applications such a maps and search.

Zimbra comes at a critical point in Yahoo’s history, when exploring new technologies and directions is becoming a strategic imperative. On a business level, Yahoo paid a very rich premium for Zimbra, whose investors earned a terrific payout of over 10x on their collective stake of $30.5 million. More importantly, this gives Yahoo an instant entree into a new market, and a platform upon which they can leverage their widely used applications in new and more profitable ways.

On a competitive level, this is a savvy move in terms of keeping Zimbra out of Google’s hands. Had Zimbra been taken first by Google, Yahoo’s chances of entering the business market would have been considerably diminished, and therefore, price was not a key consideration. Not only does this give Yahoo the tools to compete with Google Apps, but it positions them more squarely in the Web 2.0 camp, providing further validation for open source and software as a service as business-class solutions.

In this regard, these two companies are beginning to develop a compelling alternative to Microsoft, especially in the SMB sector. Large enterprises will not be leaving Microsoft Office any time soon, but more adventurous SMBs will be more receptive to the lower cost of open source and the flexibility to create distinctive applications and mashups that engage their customers.

Going head-to-head with Google, we should also note a potential differentiator in that Zimbra recently added a downloadable version of their email platform. This means that Zimbra can run on any company’s server and does not face firewall issues where sensitive corporate data resides offsite. Such an architecture raises Sarbanes-Oxley compliance issues for Google Apps, which conversely represents opportunity for Yahoo to now pursue with Zimbra.

As with many other challenges facing Yahoo, success with Zimbra comes down to execution. Zimbra brings new capabilities and opportunities to Yahoo, and they have an immediate window to position themselves at the forefront of Web 2.0 for business. Their survival may depend on it, and for this reason alone, we believe they will make Zimbra a winner.

5. Financial Highlights