Monthly news by Mercator

IP Communications Newsletter
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. iPhone – Redefining Telecom?

The June 29 iPhone launch was perhaps the most hyped telecom launch ever, and we find it interesting mostly because it was led by a company making its first foray into telecom. This story has been covered endlessly from many perspectives, but we will take a stab at commenting on the more pertinent strategic issues.

No other product launch in recent memory seems to have impacted so many companies and people, and for this reason alone, warrants coverage. The June 29 launch went largely as expected – Apple captured the hearts and wallets of the gadgerati, and the shortcomings of AT&T’s EDGE network quickly became apparent. If the product and service are successful, both companies stand to gain considerably from the iPhone.

Since Steve Jobs unveiled the iPhone at MacWorld back in January (discussed in our February issue), the build-up has done wonders for Apple’s valuation, driving the company’s market cap from $70 billion to over $115 billion in six months, and it looks now like they have a worthy successor to the iPod for their next growth engine. AT&T, by association with one of the strongest consumer tech brands on earth, gains the cool factor with the most valuable demographic segment in the market.

Ultimately, the iPhone is a testament to the strength of the Apple brand more than the underlying technology. The iPhone is not perfect, and there is a real danger of it becoming a Swiss Army knife that meets a variety of needs but is not a game-changer. Much like the Motorola Razr, the iPhone raises the bar for mobility, but in a more radical way, they seek to redefine the entire smartphone experience. Never before has a single product or brand had this amount of power to shape the communications landscape. In time, we think Apple may succeed, but our view is that the June 29 launch is “iPhone 1.0”. There will be a lot of learning from this launch, and we believe Apple will build on it, and are focusing on the long-term global launch. It has already been reported that Apple is planning a nano version of the iPhone, perhaps by the end of this year.

AT&T also has a lot to gain from leveraging the power of Apple’s brand. In the wireless market, AT&T is going through their own re-branding process now that they own 100% of Cingular, and are shifting back to the AT&T name. During this transition, however, Verizon has been capturing more growth among new cellular subscribers. Verizon’s churn rate is considerably lower, with the most recent numbers being 1.1% compared to 1.7% for AT&T. As a result, Verizon has caught up to AT&T, with each now having roughly 62 million subscribers. For this reason alone, AT&T may have felt compelled to partner with Apple, especially since Verizon earlier passed on the iPhone. Verizon may claim to have a superior network, and have attractive smartphone partners, but for the time being iPhone will make AT&T the hot brand.

AT&T has invested heavily to upgrade their EDGE network, including $50 million just before the iPhone launch. However, the limitations of EDGE to support this phone are well known, and it is not clear why the phone was not designed to use the faster 3G HSDPA network, which is closer in performance to the 3G EVDO network used by both Verizon and Sprint Nextel.

We see one of two scenarios unfolding. The good news scenario would see AT&T remedy its network issues to properly support the full range of features that make the iPhone so compelling. That said, it remains to be seen how much subscribers will use battery-draining features such as music and video at the risk of depleting their power for phone usage. If the iPhone can somehow work to its potential on the EDGE network, AT&T can leverage their exclusive deal with Apple to great success. In this scenario, the iPhone’s relatively high price will not impede sales, enabling Apple’s brand power to command healthy margins. This will also deliver strong margins for AT&T as they will not need to subsidize subscribers to drive sales.

Conversely, if the EDGE network does not meet users’ performance expectations, the bad news scenario would see the iPhone plod along, but with some bumps in the road, such as the brief service outage subscribers experienced during the launch. In this scenario, perceptions of the iPhone could shift to being an expensive gadget, having a touch screen that only a geek could love, being an oversized iPod that happens to be a phone, and having a battery that is inconvenient and expensive to replace. Such an outcome would play nicely into Verizon’s hands, vindicating their view that the network trumps the device, and their wisdom in not succumbing to Apple’s initial demands. Verizon would also have more time to upgrade their handset line-up and get closer to feature parity with the iPhone, which would mitigate much of AT&T’s first mover advantage with Apple.

Strategically, we see the iPhone launch being important on several fronts. First, the iPhone is a very advanced consumer device, and Verizon may have more success catering to this market by offering less expensive, unlocked phones that deliver sufficient value for mainstream subscribers. The second front is the business market, which Apple is trying to crack by touting the iPhone as a smartphone. In this market, price is secondary to functionality, but they would be up against very established brands, especially Nokia and RIM. We are sceptical that business users will embrace a touch screen, a lesson that Microsoft learned years ago with their Pocket PC. Furthermore, the Apple brand will carry less weight in the business market, and we feel that Verizon is less at risk with business users than with consumers.

We will continue to monitor the iPhone story, with particular focus on how the three principal players – Apple, AT&T and Verizon – behave. It will be interesting to see whether Apple can make the iPhone a game-changer like the iPod, or if in the end, it becomes just another over-hyped consumer device.



2. Espial IPO – Staking Their Claim in IPTV Middleware

On June 8, Espial Group Inc. became a public company, listing on Canada’s premier exchange, the Toronto Stock Exchange (TSX). Going public is usually viewed as an exit strategy, but in Espial’s case, it appears to be a way of raising growth capital, and we have mixed views on the path they have taken.

First, it must be noted that the initial reception has been very positive. Espial’s IPO opened at $7.00, and generated about $25 million on the sale of some 3.5 million shares. This was supplemented by an over-allotment option that was exercised on June 15, yielding an additional $3.5 million. After deducting underwriting fees and expenses, Espial’s net proceeds from the IPO came in at $26.9 million, which is more than what the company raised from VC investors in two previous rounds dating back to 2000. Not only was the IPO over-subscribed, but the price has steadily climbed and has been trading around $9.00 for some time, a healthy 29% above the opening. This values the company with a market cap around $80 million, and an enterprise value of around $55 million net of cash, on 2006 revenues of $10.6 million.

Before considering what Espial will do with this money and their strong valuation, some context is in order. Espial is one of the few remaining independent IPTV middleware vendors, with the closest being Orca Interactive and Minerva Networks. Myrio is another important middleware vendor, but they are now part of the Nokia Siemens Networks business. These vendors are all competing against Microsoft, who is well positioned to dominate the middleware market, especially via their partnership with Alcatel-Lucent. For more detail, please see our IPTV middleware coverage in the May 2007 issue.

A primary reason behind the IPO is that Espial has been able to hold its own in this environment, and they see a strong upside for their technology. IPTV middleware is a key enabler for scale, which service providers will need to do as their trials expand to full deployment. There are actually two components for a complete middleware solution – one at the head-end that resides on the network server. The other is client-based, and is housed in the set-top box. Together, they ensure a consistent end user experience that provides customizable viewing choices along with integrated support for back end systems such as billing and support.

Espial’s Evo IPTV Service Platform provides these capabilities, and a differentiator for them is the platform’s modular nature, as well as being based on open standards. This allows for flexibility across a range of deployment scenarios, making Espial more adaptable than the all-inclusive Microsoft offering. That said, we expect Microsoft will end up dominating the Tier 1 market, where the norm is a single vendor, single point of contact solution.

Espial, on the other hand, thrives in a best-of-breed environment, and at this stage of the market’s development, is in no immediate danger of fading away. This has, in fact, been borne out by their base of over 45 carrier customers, including Tier 1's such as NTT and Belgacom. Espial’s customer base is complemented by a diverse network of channel partners, including Sumitomo and NEC in Japan, Nokia Siemens and Motorola in Europe, Cisco/Scientific-Atlanta in the U.S. All told, this translates into a global presence, with particular strength in Asia and Europe, which are the leading IPTV markets. Espial began deploying in 2003, and by their estimate, has sold over one million licenses to date.

All of these pieces add up to a strong story, but for a company moving to the next level, their IPO strategy leads us to wonder if this was the best route to take. An IPO definitely makes a statement that Espial has the means to control their own destiny, not just to become a leading independent middleware vendor, but also attempt to compete with Microsoft in some markets. They have stated that the funding will allow them to build on their 2006 spend of $5 million on R&D. Espial currently has two pending patents and two issued patents, and continued investment in their intellectual property will be money well spent. This market is still emerging, and we feel that a strategy of building out the capabilities of their Evo platform will be the best way to create sustainable competitive advantage.

With that said, we must also ask why they chose to list in Canada. The TSX may be Canada’s leading exchange, but it is not where one would expect to find an IPTV middleware vendor. Perhaps they could have raised more money on NASDAQ; then again, most $10-20 million revenue companies do not fare very well on NASDAQ. Going forward, the TSX may limit their ability to attract additional investment that will be needed should they choose to become a consolidator, though it is worth noting that Espial has stated they have no immediate acquisition plans. London's AIM was also a plausible alternative, but track records for other early stage Canadian companies such as Newport Networks have not necessarily proven as positive case studies.

On the other hand, it may be that as a Canadian company, they chose to list on home soil as a show of support for the domestic tech community. If so, a TSX listing may make sense given that their current capital requirements are modest. Another contributing factor is that VenGrowth, one of Espial’s venture investors, is also publicly traded on TSX, and they have strong connections to the exchange, which likely enabled the listing and contributed to the positive reception to Espial's IPO.

But given Espial’s relatively small size and short history, why go public, and why go now? Recent telecom IPOs have had mixed results, and IPTV is not widely understood or truly proven as a mainstream technology that average investors can fully embrace. It is possible that the company’s Board and management team felt that an IPO was the best alternative to raising capital from private sources. Clearly the company was able to raise a substantial amount of capital – over $25 million – without the existing investors having to kick in any additional money. But at the same time, the event did not provide any liquidity to its investors, and now the company has to deal with the extra overhead of operating as a small public company, subject to the scrutiny and expectations of Wall Street (or Bay Street, as the case may be).

Finally, as investment bankers, we must pose the question if an IPO was the best alternative for a company of their stature. Clearly, Espial believes strongly in their future as an independent, but in terms of return on investment, it remains to be seen if they would have been better off exiting via acquisition. We are seeing very lucrative exits right now, and we think it may have been possible to achieve a higher valuation in a strategic sale, and provide more near-term liquidity to investors. But now that the valuation has been set by the public markets, the company’s exit possibilities via acquisition may be more limited, or at the very least its financials are more transparent. We wish them the best of luck, and congratulate Espial on the strong performance thus far.



3. ShoreTel IPO – PBX Vendor Consolidation Continues

Mercator has been closely following the enterprise communications market, and has been anticipating a consolidation trend among the vendors for some time. In our March issue, we focused on the opportunities we see in the hosted IP market, and in June, we evaluated the Mitel/Inter-Tel deal, which has yet to close. With Avaya also being bought out, and Cisco making a strong push in the SMB market (covered in the May issue), there is considerable consolidation taking place, especially among PBX and IP PBX vendors.

Not only are traditional PBX vendors struggling to transition their offerings to IP, but a growing number are trying to address the SMB market, which many view as an untapped growth opportunity. This remains to be seen, as it has a distinct set of challenges, and our view is that vendors with a history with SMB are better positioned for success than new entrants. One established vendor, ShoreTel, has focused on SMB customers from day one, and was hoping that a successful IPO would raise enough capital to allow them to keep pace with their competitors, and secure their standing as a leading Tier 2 player.

This sets the stage for our focus on ShoreTel’s rocky, yet ultimately successful, initial public offering. The company originally set the terms of their IPO on June 11, and indicated a pricing range of $8.50 to $10.50 per share. On June 27, the company priced at $10.50, the top end of the range, with the expectation to begin trading the next day on June 28. But that same night they locked in the terms of the IPO, the company was slapped with a patent infringement lawsuit by Mitel, an event that was not previously disclosed as a potential risk factor, which subsequently placed the IPO on hold. After a few more days of delay, the offering was re-priced at $9.50 per share, and the shares began trading on July 3.

ShoreTel’s shares opened at $9.80 on July 3, and closed at $12.15, for a 28% gain on Day 1. Since then the stock has traded between $12.00-$13.00, giving the company a market capitalization of over $500 million. The company’s underwriters confirmed that the over-allotment was fully exercised, resulting in about 9 million shares being sold, and netting the company around $80 million in cash from the IPO. Clearly the Mitel lawsuit did not provide too much of an overhang on the business to prevent it from completing its offering.

Similar to Espial, this is a relatively small company, but ShoreTel has been on a healthy growth path, and an IPO sends some strong messages to the IP PBX market. Their 2006 revenues were $61.6 million, more than triple 2004 sales of $18.8 million. They are modestly profitable, having achieved several quarters of profitability and posting earnings of $4.2 million at the end of Q1 07. Their market valuation around $500 million is a much higher multiple than the $691 million that Mitel is paying for Inter-Tel, which has revenues of over $450 million. Shoretel’s IPO puts the company closer to the top end of the IP PBX food chain, giving them far more control over their destiny than if they had remained private.

Aside from helping themselves, the IPO is good news for enterprises and SMBs, who are in a difficult environment for making buying decisions around telephony and communications systems. Considering just the aforementioned companies in this article, it is easy to see why businesses would be apprehensive about making investments in mission-critical technologies that also have a long lifespan. Telecom systems are often in place for 10 years or more, and given how IP is continuously evolving, buyers need to believe their vendor will be here for the long run.

All of ShoreTel’s offerings are IP-based, though some people argue that Shoretel’s combined switch/gateway architecture make it more of a legacy TDM PBX with an IP wrapper. Though designed as a next generation PBX from day one, it is not considered a pure IP PBX by some experts who look at software-based native SIP solutions as more elegant approaches. That being said, Shoretel is known for its high marks for simplicity and strong customer satisfaction, so for businesses ready to migrate to an IP-based phone system, Shoretel’s IPO may give a stronger sense of security as an established brand name.

The proceeds from the IPO will allow ShoreTel to continue its focus on innovation and R&D. We feel this is the best way for them to carve out a niche that can be defended, as competitive pressures from majors like Cisco, Avaya and Nortel will only increase. Their latest IP PBX release, ShoreTel 7, has several innovative features that are built around ease of use, and intuitive integration between traditional calling features and PC-based communications.

One is a programmable toolbar, which provides click-to-call functionality from the desktop. Another is Auto Find Me, which provides a nice twist from most Find-Me/Follow-Me features, in that a call can continuously be transferred until a call is picked up. This capability would be particularly useful in contact centers, as would another feature we like – customizable ring tones. Aside from these features, ShoreTel recently announced their Managed Services Program, which provides SMBs an affordable solution for IP telephony.

In closing, we think that the ShoreTel IPO is another example of a successful exit for a telecom company, though longer-term it remains to be seen if they can remain independent, competing against companies who are orders of magnitude larger.



4. Art of the Deal: Google Acquires GrandCentral

With billion dollar deals being the norm lately, it may seem unusual to feature such a small acquisition here. Though earlier rumored, official announcements were made on July 2 that Google had acquired GrandCentral Communications. There has been little public press about this deal, and we believe that the value was in the area of $50 million. This is minuscule by Google’s standards, but we think the business implications are far more important than the dollars involved.

GrandCentral has received a significant attention in the past few months, and is just one of many companies coming to market now with services and applications targeted at mobile users. Their application is built around the idea that people have multiple phone numbers, and it would be easier to manage them in a centralized manner. To do this, GrandCentral issues the caller a phone number to which all your phone numbers are attached. This allows people to just give out a single phone number, so callers do not have to keep trying multiple numbers to reach someone. Intuitively, this is a convenient service to use, especially since it is free, yet it is little more than a new twist on unified messaging. In April, they launched a mobile version, which has only served to increase GrandCentral’s popularity.

GrandCentral was launched in late 2005, and reportedly raised about $6 million. The company’s two founders were fresh from a successful exit with Dialpad Communications, which was acquired by Yahoo in June 2005. At the time, this deal was seen as a way for Yahoo to compete with Skype, as they had been late to market with voice. We see some parallels to what Google is doing here, and it stands to reason that the experience of GrandCentral’s founders was a key factor in this deal. It was during their recent second round of fundraising that Google recognized this opportunity, and bypassed the VCs by buying the company outright.

At first glance, it is easy to see how GrandCentral could complement Gmail and even GoogleTalk. Gmail would serve an inbox for voicemail across all your phone numbers, where messages can be played back (in MP3), forwarded, prioritized, deleted, etc. This utility makes Google much more interesting beyond Instant Messaging as a communications platform, and more importantly, helps drive voice traffic on to their network.

In that regard, GrandCentral would appear to be better off as the gatekeeper in a large and growing network, than to be a standalone offering that anyone can use for free. Despite being well received at last year’s Demo conference, and the subsequent critical acclaim from the press and users, there is no apparent business model here. This supports our view that it is very difficult to build a business around an application or utility, especially without a user-based revenue stream. Furthermore, users can only benefit from GrandCentral by changing their behavior.

For GrandCentral to be successful, users must adopt new approaches. In order to make the service useful, users would have to add a new phone number to their letterhead, business cards, etc., and they must also get all the people who call them to get in the habit of using this single number. Unless this happens, there is no real benefit to using GrandCentral. And if it does happen, the service needs to work properly, all the time. Since GrandCentral is still only a Beta release, we question whether it is the right technology for Google to invest in. There have been several accounts of missed calls, dropped transfers, etc. during their beta, and when a free service for something as important as telephony does not work, it will not last long.

The bigger question is what Google plans to do with GrandCentral. Aside from the complementary nature of GrandCentral described above, we believe there is something bigger and more fundamental to Google’s aspirations. Our view is that Google is looking to extend their advertising-driven business model from text and video to voice. Search provides the basis for a very profitable, self-perpetuating text business. YouTube does the same for them in video with an endless stream of free, user-generated content.

Google lacks such a generator in the voice space, and we believe this is why they launched GOOG-411 in April, which is a free directory assistance service meant to compete directly with toll-based 411 calls. The same logic applies to GrandCentral, because once their application runs on Google’s network, they will have access to a host of voice messages, generated either by the subscriber or the callers leaving messages. Clearly, this raises some privacy issues we cannot address in our analysis, and is an example what Google is doing that is causing many to question their reach into our personal lives.

That aside, voice data may be of long-term strategic value to Google, and GrandCentral is a good way to begin to acquire it. Simply put, the more voice traffic they can aggregate, the more data points they will have to develop speech recognition expertise, which is a fundamental building block for their business model to work with voice. It can be argued that Google could develop this expertise more quickly and efficiently by licensing speech recognition from vendors such as Nuance. However, it appears that Google wants voice to be a core competence, so they appear to be less interested in partnering.

Regardless of the valuation, we are a little puzzled as to why Google chose GrandCentral now compared to some other potentially more valuable options. GrandCentral seems to bring only one piece of the speech recognition and unified communications pie, and it is not yet a revenue generating service, still operating in beta. Clearly there are still other independent companies available that could complement GrandCentral, including established companies such as Iotum and Parus Interactive, both of which have been mentioned in previous Mercator newsletters. Only time will tell if Google will be able to make GrandCentral a central part of its grand plans to dominate the Internet.



5. Financial Highlights

Company Product/Services Development Details
Andrew Communication equipment and systems provider Acquisition Acquired by CommScope for $2.7B
Aventail Provider of SSL VPN remote access solutions Acquisition Acquired by SonicWall for $25M
CableMatrix Technologies Offers software platforms for enabling broadband operators to deploy Internet services Acquisition Acquired by Sandvine Corporation for an undisclosed amount
Digital Envoy Provides Internet protocol intelligence technology solutions Acquisition Acquired by Landmark Communications for an undisclosed amount
Fonav Provider of unified communications platform Acquisition Acquired by Trolltech AS for an undisclosed amount
GrandCentral Communications Provider of unified communications solutions Acquisition Acquired by Google for estimated $50M
Neon Communications Provider of network transport services Acquisition Acquired by RCN for $260M
NewHeights Software Internet software Acquisition Acquired by CounterPath Solutions for $14.7M
Tegic Communications Provider of communication technologies Acquisition Acquired by Nuance Communications for $265M
VoIP Solutions Provides Voice over IP (VoIP) solutions to the communications industry Acquisition Acquired by WQN for an undisclosed amount
Aylus Networks Provider of multimedia sharing technology for mobile networks Financing Raised $15M
BroadLogic Network Technologies Provides broadband networking equipment Financing Raised $17M
Hammerhead Systems Provides aggregation, interworking, and migration solutions for Ethernet services Financing Raised $10M
LiveVox Provider of hosted and tailored Internet voice services Financing Raised $7.1M
Nimbuzz Provider of VoIP and telecommunications applications Financing Raised $10M
Ortiva Wireless Provider of mobile content delivery solutions Financing Raised $15M
PermissionTV Provider of Internet video technology Financing Raised $9M
Radlive Provider of enterprise telephony solutions Financing Raised $7.7M
Revision3 Internet television network Financing Raised $8M
Tatara Systems Provider of converged mobile solutions Financing Raised $8M
Veoh Networks Provides a system for distributing television and video content Financing Raised $26M