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. New Year, New Look

For two years, Mercator Capital has been delivering its newsletter to readers who are interested in the latest news and analysis of the VoIP sector, particularly from the view of a boutique investment bank. Over the past two years, we have seen an increased focus on VoIP, with numerous blockbuster deals happening in the sector.

We have also seen a broadening of scope for VoIP and related technologies, and the lines between voice, video, data and wireless are blurring as we finally move toward true convergence. We see this happening with our clients as well, as they morph their businesses and technologies to meet the needs of carriers who are demanding converged services. As a result, we are broadening the scope of the newsletter to cover the entire IP communications sector, including technologies such as VoIP, IPTV, IP wireless, and related applications. Mercator has historically worked with many telecom and networking companies outside of the VoIP sector, so for us this is a natural progression.

We are also changing the focus of the articles in each newsletter. While we try to strike a balance between business and technology, we have received the most positive feedback on article that focus on analysis of specific deals. As a result, each month we will try to highlight a specific deal that has happened in the IP communications sector, and analyze how the deal may impact other companies in the sector. These stories will be featured in our "Art Of The Deal" section starting next month.

In addition, we have received very positive feedback when we highlight emerging companies in the sector, and how their technologies may be relevant to the industry. We plan to offer these company profiles on a regular basis in our "Mercator Spotlight" section.

Finally, 2006 is also bringing a new format for the newsletter. With this issue, we are launching a new HTML delivery format that should result in easier readability than the old PDF format. In addition, the HTML format will allow us to link to dynamic content, such as external sites for more detailed coverage, and allow you to easily modify your newsletter subscription.

We think 2006 is shaping up to be an exciting year in the IP communications industry, and we hope that you will enjoy our coverage of the sector.

2. Microsoft Takes Aim At Telecom

2005 proved to be the year that Microsoft increased its focus on the telecom industry. In fact, the software giant’s recent flurry of activity - ranging from acquisitions to major partnerships - shows that Microsoft is serious about VoIP.

Last year Microsoft announced the acquisition of Teleo, a VoIP service provider similar to Skype. The announcement came shortly after Google had launched its VoIP-enabled instant messaging (IM) service Google Talk, seen by observers as a potential threat to IM services from MSN, Yahoo, AOL and Skype. Microsoft’s acquisition was also viewed as a counter move to Yahoo’s acquisition of Dialpad. Microsoft's main IM competitors are Yahoo and AOL; Yahoo's IM service had 78.8M users and AOL Instant Messenger had 64.4M users as of July 2005, compared with 189.7M users for MSN Messenger.

With the acquisition of Teleo, Microsoft will VoIP-enable its consumer applications currently under development. One of the key capabilities that Microsoft has acquired through Teleo is the ability to bridge IM calls to the PSTN. This feature has been integrated into the new version of MSN Messenger (currently in beta) and also into the MSN portal.

With another recent acquisition of Media-Streams, a privately held Swiss developer of VoIP applications, Microsoft plans to extend its VoIP capability to commonly used Office software applications such as Word, Excel, and PowerPoint to improve employee productivity and business processes. In particular, Microsoft is looking to enhance the real-time collaboration platform it is building through its Live Communications Server. Other areas that Microsoft is looking to apply VoIP include a unified communications system that encompasses email, text messaging, voice telephony, video, and web conferencing.

One area where Microsoft needs to partner is the network infrastructure. The company has long realized that its MSN ISP network infrastructure is not sufficient to address the latest telecom requirements, and has partnered with service providers such as Qwest Communications and MCI (now Verizon). Qwest will work with Microsoft to deliver VoIP services to the desktop in small and mid-size businesses, whereas MCI will help Microsoft bridge calls to the PSTN.

Microsoft’s plans are not only limited to the US market, as the company has also partnered with Softbank BB in Japan to bundle VoIP with email, Internet access, groupware, instant messaging, and other services targeted at business users. The bundled service brings together Microsoft's enhanced VoIP platform, Softbank’s BB voice service, and Japan Telecom’s managed network service. The Microsoft component includes Exchange Server 2003, Office Live Communications Server 2005, and Windows SharePoint Services, along with Sylantro Systems’ application server. Microsoft has been working with Sylantro since June 2005 on delivering such services.

To round up its VoIP partnerships, Microsoft has also been working with VoIP hardware manufacturers. Large corporate users that have installed Alcatel or Siemens IP PBXs will have the Microsoft IM feature incorporated in their systems. Microsoft IM residential users will also have the ability to use plug-and-play cordless dual landline-VoIP phones from Uniden America and Philips to make PC-to-PC and PC-to-Phone calls easier and more user-friendly.

The 5.8GHz Uniden phone, called the WIN 1200, is a digital cordless handset that has traditional landline capability as well as integrated VoIP capability. The Microsoft-enabled service offers free PC-to-PC calling through Windows Live Messenger while the MCI Web Calling feature will enable PC-to-landline outbound calls. Callers may also use the device for traditional landline service.

3. Private Label VoBB, Part 2

In last month’s article on Bellsouth, we mentioned some US ILECs that have adopted a private label Voice over Broadband (VoBB) offering as an alternative to investing in their own infrastructure. The driving factor for carriers to utilize a wholesale model from a third party is that the service provider does not have to worry about constructing its own network. The model also assumes that the customer has their own broadband connection on top of which they provide voice, which is a very narrowband application.

In the US, the ILECs have not been very aggressive with VoBB, for fear of cannibalizing their own local line service. At this stage, most deployments seem to be defensive moves against companies such as Vonage, and most ILECs are not actively marketing their VoBB capabilities. Many analysts assume that the ILECs are just buying time to offer some capability without having to invest lot of money. This strategy allows the ILEC to come up with a longer-term plan to migrate customers to a converged network, such as an IP-enabled IMS architecture.

That being said, the ILECs would rather have some alternative VoBB solution to keep customers happy and prevent them from moving to a competitor such as Vonage. Such a strategy allows the ILECs to hold onto their customers longer and perhaps bundle the service with other higher margin services, while they continue to work on their long-term plans. By offering a private-label VoBB during this interim period, they can also use it to gauge the demand for the service.

Once the VoBB customer base reaches critical mass, service providers are likely to invest in their own VoIP infrastructures, and begin to roll-out competitive offerings. The service will likely migrate from the wholesale VoBB model to an in-house model, which is bundled with DSL or FTTH Internet access. Once critical mass is hit, companies like Vonage could be in trouble since incumbents control the last mile and will be able to optimize quality of service. In theory, this control will also allow them to provide managed video and IPTV services. Many of the US private label customers are rural independent telcos. The private label model also allows IOCs to hedge their risk by postponing a decision to deploy their own VoIP infrastructures.

Interestingly enough, in Europe, the private label model is not as prevalent, and there are only a handful of examples of such an arrangement. Inclarity, for example, provides a VoBB solution to Pipex on a private label basis. Most European PTTs buy their VoBB platforms and operate their own VoBB services. France Telecom, British Telecom, Deutsche Telecom, Telecom Italia and others have all implemented their own networks for VoBB.

One of the factors driving the difference in Europe is that due to the dense geography, the cost per license is quite low and therefore it does not make a compelling case to outsource operations. For an operator who wants to offer VoBB services, the required investment at the low end can start as low as a few hundred thousand Euros to VoIP-enable broadband networks. At the same time the service provider is able to achieve healthy margins by not having to share the revenue with a wholesaler. However, for cable-based VoBB, a typical cable operator may not have the volume to justify the cost of VoBB infrastructure, since most cable operators are very small and cover only a few cities in a country. So smaller cable operators may partner with each other, they may outsource VoBB service a larger cable operator, or they may partner with a wholesaler like Net2Phone.

Some European LECs are compensating for competition in their established territories by creating subsidiaries to offer VoBB in other European countries. They are looking to leverage their networks across a broader customer base than they currently serve with growth outside the territory. This is contributing to aggressive growth and stiff competition, as well as several acquisitions in the sector. Also this fierce competition has forced some European operators to position themselves as both content providers as well as pipe providers. Many operators have progressed from pure Internet access, to VoBB and now IPTV. Such a migration requires carriers to operate their own infrastructure.

For VoIP services like IP Centrex, there is also a need for the wholesale solution. Many small operators offering IP Centrex services have previously been system integrators, who are looking at VoIP as a way to upsell their services by offering IP Centrex. For most small players, buying their own switches is cost prohibitive, so it makes sense to offer private labeling IP Centrex services in a “Bring Your Own Broadband” model.

4. VoIP Peering Exchanges Redefining Interconnectivity

Many of today’s so-called VoIP carriers such as iBasis specialize in receiving incoming VoIP calls and terminating them onto the PSTN. Over the next several years, such carriers may continue to see significant growth as more and more traffic originates as VoIP. A vast majority of that traffic today, and in the foreseeable future, will require PSTN termination.

Increasingly, however, established carriers like AT&T and BT are striving to pass IP-based traffic from one network to another by expanding their high-quality routes and peering points. With VoIP peering, high-quality feature-rich direct connections can be transported to various locations in the world, and handed off from one carrier to another. Bilateral peering provides a direct connection between two operators, whereas multilateral peering provides additional efficiency by enabling a service provider to have virtual direct connections to a variety of operators with a connection to a single provider. Usually such multilateral peering occurs at a node called a VoIP peering exchange.

BT sees VoIP peering through exchanges as a way to expand their offering to carriers who they would not meet or sell to. Also given the cost advantage of a single interconnection, the risk and logistics of interconnect are greatly reduced. Furthermore, with direct connections via VoIP peering, important signaling information is preserved enabling service providers to offer a wide array of value-added services which may also contribute to increased revenues.

Over the last couple of months, there have been two major RFIs for VoIP peering. One is from CableLabs, a standards body for cable MSOs. CableLabs issued an RFI to enable VoIP peering between all major MSOs, a very significant move for the industry. The standards body had set a deadline of December 14, 2005 to collect information from manufacturers and third-party service providers. They are hoping to better understand the technologies, products and service solutions which could enable the development of a production-grade VoIP peering infrastructure to allow a VoIP traffic exchange among MSOs, and between MSOs and other service providers.

MSOs in the Netherlands, which actually has one of the highest cable penetration in the world covering around 95% of the population, also recently issued an RFI for VoIP peering between all MSOs within the country. These two RFIs are indicators of where the world of VoIP peering is moving. The interest among standards bodies stems from the motivation to create an unbiased third party to help move this effort along. It is ultimately hoped that VoIP peering exchanges could have a positive impact on voice quality and cost since VoIP peering brings all calls on-net rather than off-net, fundamentally allowing for a complete bypass of the PSTN.

Some peering exchanges currently offering service include Interoute, InfiniRoute, Xconnect, and VPF. XConnect launched the service in March of last year. The company is directly or indirectly providing services to over 75 VoBB players around the globe. Their prime focus is on VoBB-to-VoBB peering. XConnect launched in North America by signing iBasis, VoicePulse and Yak Communications. Earlier members were Gossiptel, a consumer VoIP service based in the United Kingdom, Telio a VoIP service provider based in Norway, and Spanish consumer VoIP provider VozTelecom Sistemas S.L. There are some 50-60 other providers, which the company has not made public. These VoBB customers are already dealing with over 50M minutes per month and the company anticipates supporting 1M end users by early 2006, and 3M-5M by the end of 2006.

Interoute's Virtual Voice Network (VVN) and associated community is the largest VoIP peering network for tier 1 carriers in Europe. Interoute is currently processing about 200M minutes per month and doubling its traffic each quarter.

VoIP peering, from a technical perspective, deals with layers 5 and up in the OSI model. This differs from simple IP peering which only provides interconnection at the circuit level or at the packet level where you have your Border Gateway Protocol (BGP) routing that deals with the physical connectivity. IP peering essentially just ensures that IP packets are properly routed from one network to another.

VoIP peering, on the other hand, needs to handle all of the higher-level issues. An example would be routing and addressing to ensure that dialed calls (typically a standard E.164 PSTN number) are routed to the most appropriate ITSP of the destination number. This requires a number directory service and the ability to perform packet inspection to ensure that calls are routed properly.

In addition, VoIP peering requires an understanding of the signaling protocol in use. There are a number of common protocols, including SIP and H.323. VoIP peering exchanges will have to process a variety of signaling protocols used by VoBB providers. Furthermore, issues which look simple on paper, such as SIP interoperability, are more complicated in practice, so a VoIP peering exchange must be able to accomplish these services as well.

One of the major implications for VoIP peering is security, such as dealing with SPAM over Internet Telephony (SPIT). SPIT is becoming an increasing concern to VoBB providers as they interconnect with more and more providers. As more and more providers become prevalent, it becomes easier for SPIT to be introduced into the network, and therefore the onus on the VoIP peering exchange for increased security is higher than ever.

Enterprise peering is clearly the next logical step. While technically possible now, enterprise peering requires coordination between various companies along with their service providers. Enterprise peering could turn off-net toll calls into on-net free calls, resulting in dramatic savings for larger enterprises that interact a lot. Though the opportunity for the enterprise is huge it offers much greater challenges than service provider peering.

5. Financial Highlights