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. Vonage IPO – Too Little, Too Late?

Vonage will certainly make a good Art of the Deal feature when the time comes, but given their prominence in the VoIP world, the February 8 announcement of their IPO filing itself warrants some introspective analysis.

Skype/eBay may have been the biggest story in IP last year, but Vonage has far and away been the VoIP media darling longer than anyone. And with good reason; for better or for worse, Vonage has built a powerful brand, and created a strong connection in the consumer’s mind between VoIP and Vonage. They had long been the dominant residential VoIP provider, and looked to be the blueprint for the Vonage “wannabes” to follow.

That was then, and this is now. Market conditions have changed, and the Skype deal has had ramifications for Vonage’s plans. It was widely expected that Vonage would score the first VoIP mega-deal, but Skype beat them to it. With Skype setting the bar with the first billion-dollar valuation, all eyes have shifted to Vonage to see what they may be worth. The difficulty here is that these are not apples-to-apples comparisons. Skype has nominal revenues, an unproven business model, limited infrastructure, no marketing costs, but is wildly popular – with over 50 million users. It takes Skype less than two weeks to sign on more new users than all of Vonage’s subscribers combined.

Vonage, on the other hand, has notable revenues, a proven business model, and moderate infrastructure. Like Skype, they are also popular in relative terms, but unlike Skype, their marketing costs are out of sight. One estimate compares Skype’s customer acquisition costs at under $0.01 per user, whereas Vonage is paying in excess of $200 to acquire each user. This makes it very difficult to extrapolate what Vonage might be worth based solely on the Skype experience.

Of course these issues would be moot if Vonage had done a deal before Skype, and one could argue that in today’s VoIP market climate, it is easier to get a higher valuation based on the potential of your business than on how you are executing. In that regard, Vonage probably had a much better chance of getting a billion dollar valuation in the early days when they were truly disruptive and just beginning to have success attracting subscribers with their business model. Another example of how timing is everything.

Perhaps of greater importance to the success of Vonage’s IPO is how market conditions have recently changed. First, the market is more competitive now, mainly due to the cablecos finally launching their VoIP services. Not only do they have far greater resources than Vonage, but they have large customer bases and can bundle VoIP into some attractive packages along with video and Internet access. Vonage cannot presently match these bundles, although they have been developing some wireless combination plans. Aside from cable, Vonage must now contend with the IM platforms like Google, Yahoo and Microsoft. This has become a recurring theme impacting all service providers, so Vonage is not alone here, but nonetheless, the VoIP market is becoming more crowded, not less.

Another key factor is the regulatory climate, with two current issues acting as potential impediments to Vonage’s growth. First is 911 and E911 compliance, which has been well documented. The second is the net neutrality issue, which was commented on in our February 2006 newsletter. In addition, there are ongoing issues around last mile access, and the degree to which facilities-based providers – both telecom and cable – are obligated to open up their networks to competitors. In all of these cases, the rulings are favoring incumbents, which essentially raise barriers to entry, and increase the cost of doing business for existing competitors – like Vonage.

At a high level, it is evident what all of this means for Vonage. More telling, however, are their bottom line results, which must now be disclosed as part of the IPO filing process. As the market leader, these are numbers Vonage would rather not share, but such is the nature of public financial markets. In short, the numbers confirm what everyone has long suspected – to gain every dollar of revenue, they need to spend two dollars. As their filing indicates, for the first nine months of 2005, Vonage had sales of $174 million, against a loss of $190 million. During this time period, their customer acquisition cost was $213.77. This is considerably higher than the comparable time period for 2004, where the cost was $137.70 per subscriber. On top of this, monthly ARPU has fallen from $30.99 to $26.63 across these time periods. Both trends are going in the wrong direction, and reflect the increased level of competition.

Aside from these revenue metrics, churn is another key factor that will drive their valuation. Their filing indicates a churn rate of 2.1% during the first nine months of 2005. This is actually a respectable level for such a nascent market, especially when compared to typical turnover rates in the wireless or broadband access markets. That said, even a 2.1% monthly turnover represents a significant drag on revenues. Based on the metrics cited above, churn costs Vonage roughly $7 million a month, or $84 million annually. For a company of this size that is seeking an IPO to stay competitive with the Tier 1 operators, this is a lot of revenue to keep replenishing – just to stand still. They still need to spend on top of this to grow their business.

All of this adds up to a challenging environment where the growth trends to date cannot be sustained. Although Vonage just announced reaching the 1.5 million subscriber plateau, Time Warner Cable has by now come very close to matching this, if not surpassing it. The fact alone that Vonage is no longer the market leader – where for so long they could claim 50%+ market share – is cause for concern about their IPO valuation.

Management is another concern for Vonage. As part of the IPO filing, it was announced that co-founder Jeffrey Citron – the soul of Vonage – was relinquishing his CEO post to become chairman. The choice of Michael Snyder as incoming CEO raises some questions. Not only is he an outsider to VoIP, but his previous company, ADT was part of the Tyco empire, which is not the ideal role model for Vonage to follow in becoming a public company. This begs question as to why Vonage did not hire an experienced telecom executive to navigate the company through this crucial transition.

More recently, Vonage’s Chief Marketing Officer, Dean Harris, made a sudden departure, and shifted over to the travel industry. One could read this as a sign that their marketing model is broken, especially since Vonage did not make any public statements about his leaving.

On the competitive front, things only become more challenging with the latest consolidation move among the ILECs. With AT&T now controlling 100% of Cingular, and the footprints of both BellSouth and SBC, CallVantage can now become the VoIP competitor everyone thought it would be in 2004. Whether offering VoIP as a standalone service or bundled with wireless, AT&T now represents a threat to Vonage from an ILEC that is on par with the MSOs.

All of these developments lead to more questions than answers about Vonage. What are their growth options? How far can raising $250 million through an IPO really carry them? Can a pureplay VoIP offering really compete long-term against the bundle? Is there a profitable business model for them? And perhaps of greatest importance to the health of the IP sector itself – what will happen if the IPO is not successful?

It is in the best interest of the IP sector for their IPO to succeed. Otherwise, VCs and bankers may lose faith in this space and look elsewhere to invest their capital. This would be a serious setback to the ecosystem that is driving innovation in IP, and such a scenario would only please the most hard-line of incumbents.

2. Demo 2006

The annual Demo conference was held in early February, and much like a bullfight, it is a forum for high tech capitalism in its purest, most stripped-down form. Demo’s Darwinist nature largely explains its popularity and why it is widely viewed as the most elite showcase for up and coming technology companies.

Demo began in 1991, but assumed its current format in 1998 when Chris Shipley shifted the emphasis from demonstrating new technologies to one where companies presented market ready solutions that were set for commercial availability. This resulted in VCs becoming much more interested in Demo, and their evolution has continued along those lines to the present.

Comparisons to American Idol are often made for Demo, and rightly so. The field starts out with some 700 companies, and through process of elimination, they are reduced to 70. This is the group that gets to prepare for a serious audition – a screen test, really, They each get six minutes to “demo” their offering and convince the audience they have the right stuff. If successful, they get the Demo version of a movie role or a record deal – they get funding. Plain and simple.

An interesting element to Demo is the makeup of the audience for these presentations. While the majority are VCs, some are corporations, who are looking to outright acquire startups whose potential is a good fit for their strategic plans. Yet again, the familiar names of Microsoft, Google and Yahoo appear.

As such, there are two different, but very real dynamics at work that keep the competitive energy of Demo at a high level. First is this tension between VCs and corporate acquirers. Aside from the VCs competing among themselves to fund the next big thing, they must also contend with deep-pocketed companies who do not think twice about spending vast sums for startups that fill a void for them. The scale of capital involved makes this a real challenge for the VCs, who typically would only seed these companies with a few million dollars. This is one of the realities of IP startups – increasingly, these businesses are software-based, can ramp up quickly, and do not require large pools of capital. Conversely, a company like Google, with its huge capital surplus, can easily acquire these startups outright for a relatively small sum. Their ROI timetable and criteria are very different from VCs, and they can afford to take more risk, if not simply to prevent a competitor from acquiring a startup.

The second dynamic is more traditional, and this is what really drives Demo – the inventors versus the investors. This really is the dating game where there are too many alpha dollars chasing a select group of mates, and both must learn how to do the dance. Startups cannot appear too eager, but playing too hard to get can also backfire. Similarly, some VCs may only be kicking the tires, or they may be overly determined to make a deal because an earlier winner got away.

At the end of it all, 10 companies emerged as the best of the best – the “Demo Gods”. In alphabetical order, here is the short list of companies to watch coming out of this event – Front Porch, Iotum, Kosmix, Krugle, Network Streaming, Panoratio Database Images, Riya, Sprout Systems, and Vsee Labs. Many of these companies are focused on business applications such as file sharing, web page categorization, email management, presence management, and a vertical market search engine.

Each Demo God will no doubt find their own path for funding and then commercialization, although there is no guarantee of success. With that said, previous Demo winners include home runs like Skype and TiVo. Good things can and do happen quickly following Demo, and Iotum is a promising example of this. In the few short weeks since being anointed a Demo God, Iotum has had multiple meetings with Tier 1 VCs, and prominent media coverage, including the Financial Times, Fortune and Business 2.0, where they were included in the Next Net 25 companies to watch. Few startups get this type of a boost, and when Demo yields such results, it serves as a leading indicator of the applications with the best funding potential.

3. Is the PBX Dead?

This question is not a welcome one for PBX vendors, and the vast majority of enterprise telephony, of course, remains PBX-based. However, as with the PSTN, the legacy private branch exchange is in terminal decline and being rapidly displaced by IP-based alternatives. Some recent launches along these lines give rise to this broader question about the future prospects of the venerable PBX, which will be briefly examined here.

First, it must be noted that all the legacy PBX vendors have been transitioning to IP PBX for several years, and they are well aware of the sea change that is occurring. Most analyst reports tracking this space indicate that the volume of new lines shipped from these vendors has now tipped in favor of being IP as opposed to TDM. The installed PBX base is primarily TDM, but as these deployments reach end of life, they are increasingly being replaced with IP.

While the natural evolution of these switching solutions will ensure continuity for many of their customers, there is a growing range of non-traditional alternatives that represents a threat to the longer-term dominance of PBX systems. In short, IP is enabling a variety of new approaches for managing voice communications. Some are simply more economical, while others provide a richer communications experience that goes well beyond voice.

PBX platforms have always been wireline-based, but mobile communications has been growing in importance for enterprises. At last month’s 3GSM conference in Barcelona, several enterprise mobile solutions were demonstrated, but the one of note for this article was Microsoft. Their software may dominate the desktop, but their presence to date has been limited for voice. This is starting to change with their latest version of Office Communicator. Announced at 3GSM, the news is that instant messaging and presence will now be integrated with Outlook, bringing a unified messaging capability to email. This is not really a threat to the PBX vendors, but the added capability of wireless VoIP is.

With the advent of IP in the enterprise, it is more feasible now to bring voice to the desktop, which is where Microsoft wants to retain its dominant role. PBX systems are voice-centric, and cannot compete as a platform to host the applications that today reside on the desktop. Microsoft’s mobile voice will not displace the PBX, but it will certainly divert minutes away from landlines, and enable end users to rely more on their mobile devices.

Related to this is another fundamental trend driving increased use of mobile devices – Fixed Mobile Convergence (FMC). FMC represents the evolution of network architectures to support the seamless flow of traffic between wireline and wireless carriers. Several vendors are developing enterprise FMC, as they recognize the changing needs of the always-on workplace. One of the leading FMC solutions vendors is Personeta, who also announced their enterprise-oriented offering at 3GSM. Their solution enables end users to be reached on any with device with a single number, so calls made via the PBX to their desk phone would automatically be routed to their GSM phone if not in the office. Aside from voice, however, the solution enables mobile access to corporate databases, allowing end users to be more productive on the road. IP is creating more intelligent endpoints, and as presence becomes more integral to how we communicate, the underlying implication is that voice-only platforms will have increasingly less utility for enterprises.

The above are but two examples of IP-based alternatives that will challenge the PBX’s prominent role for enterprise communications. There are numerous others coming from the bottom up that will further crowd this space. Most businesses are too small to justify the capital investment for a PBX, but generally speaking, they aspire to have the features and functionality of a PBX. To a large degree, this segment of the market is served either by Centrex or key systems, both of which are more affordable, but light on features.

As with everything else, IP is quickly changing this landscape. TDM Centrex is giving way now to IP Centrex, of which there are many flavors. In all cases, however, these hosted or managed solutions deliver a richer feature set than TDM Centrex, and are coming close to feature parity with PBXs. We at Mercator Capital are well aware of the benefits and perils of hosted IP Centrex, having made the transition last year. Despite some early deployment challenges, we are stabilizing now and finally reaching a point where we are comfortable with the quality of service and capabilities of the system.

Two other IP-based technologies are quickly proving to be very disruptive, and may ultimately be more threatening to the PBX. One is peer-to-peer, and the other open source. Skype is the name most commonly associated with P2P, but for the most part, they have not yet penetrated the enterprise. However, the underlying principles of P2P have been successfully applied elsewhere for this market. Two examples will be cited. First is Nimcat Networks, who were recently acquired by Avaya. Nimcat developed an embedded software solution that enables IP handsets to have plug-and-play PBX functionality for a fraction of the cost of a PBX. This is an ideal solution for fewer than 40 lines, and demonstrates how cost effective IP can be in creating a premise-based alternative to the PBX.

The second example is Popular Telephony, who in February launched PeerioBiz 1.1. This is a serverless P2P platform, which, like Nimcat, provides PBX functionality, but using an ASP model. The basic platform provides PBX features, but end users can also download additional enhanced features such as CRM and instant messaging for a very low price. At face value, the Nimcat and Popular Telephony solutions fit well in the SMB market, which is not really served by the PBX. The serverless nature of Popular Telephony, however, raises many possibilities for P2P to migrate upmarket and displace the PBX. Their platform scales with little added cost, and offers far more flexibility for customizing the end user experience.

Finally, we have open source, which is a further extension of P2P. Companies such as Asterisk and Fonality have adopted the open source movement to telecom, and have been quite successful in providing a PBX alternative that is equally at home with SMBs and enterprises. This is still early adopter technology, but open source is finding many applications in the enterprise, and it is clearly gaining acceptance for mission critical functions such as voice. As with P2P, open source will not totally displace the PBX, but has quickly emerged as a bona fide alternative, and is another example of what PBXs must compete against, as IP becomes the norm.

4. Art of the Deal:
IDT and Net2Phone

On February 17, IDT Corporation formally announced its acquisition of Net2Phone Inc. At face value, this deal sounds fairly simple, but as with many things in the ever-changing world of IP, this deal was not quite straightforward. We feel that this deal is of interest for several important reasons, which is why it is our “Art of the Deal” feature for March.

Both IDT and Net2Phone are IP pioneers, and N2P was actually spun out from IDT in a 1999 IPO that eventually saw N2P’s market valuation reach over $4 billion with a share price of $85 at the height of the bubble. Although IDT had always maintained some ownership in N2P, the companies have operated independently since the IPO. However, since late 2004, IDT has had controlling interest when it acquired Liberty Media’s share of N2P. That deal gave IDT a 41% share stake and 57% voting control of N2P.

The current deal was done at $28.1 million, or $2.05 per share for the shares IDT did not own – a far cry from the $85 share price in 1999. This latest deal follows two tender offers made by IDT last June at $1.70 per share, and again for $2.05 in December. When finalized, N2P’s NASDAQ shares will be deregistered, and they will again become wholly owned by IDT, though N2P will continue operating under its existing name. SEC filings indicate that the acquisition was unanimously approved by both boards of directors.

Note how this deal has been described as both a merger and an acquisition. This is one of the twists of the story. In straight up financial terms, this is an acquisition – no ambiguity there. It is also a merger in that both companies will continue operating, and it is not clear yet how management will run the businesses. N2P is really just returning to the fold, and time will tell if their brand name will live on, either within IDT, or perhaps down the road with someone else should IDT choose to divest.

The financials do not suggest any hidden value in N2P that somehow IDT will unlock. As such, the question of why still remains, as well as why the on-again off–again process took so long. The deal’s financials translate into an enterprise value of about $110 million on annual sales of about $80 million; fairly valued, but by no means a high multiple relative to other telecom service providers.

N2P certainly has longevity in VoIP, and a strong international presence – but so does IDT. Perhaps N2P’s greatest asset is their turnkey, hosted VoIP solution, which is deployed primarily by smaller cablecos looking to add VoIP services, similar to Deltathree’s turnkey offering for Verizon and SBC.

A closer look at each company’s operations and current directions provides more clues. First is the wireless market, which still supports all comers. N2P is about to enter the market with a mobile offering, and IDT has carrier arrangements already in place. This would make it easy for N2P to launch or support an MVNO offering. Another benefit will be cost reductions for VoIP transport. IDT has termination agreements across the U.S. with various CLECs, and having N2P in-house means cheaper termination, as N2P will no longer need to pay a mark-up to IDT. A third area is shared R&D expertise. This is a real strength of N2P, and IDT stands to benefit by leveraging N2P’s capabilities to drive more innovation for IDT. As recently as December 2005, N2P was awarded their 31st patent, which helps cable operators better manage the flow rate of network status messages. And finally, there should be some natural efficiencies in operations and administration from any functions that can be shared by both companies.

Initially, N2P focused on the retail VoIP space, and has routed “billions of VoIP minutes globally”. In 2003, they made a major shift into wholesale VoIP, which is how their focus on cable telephony evolved. Their strategy seemed correct, and the timing was right, as evidenced by their ability to raise $58.5 million to support this in a stock offering. Before broadband operators like Vonage were a factor, few residential VoIP platforms existed, and N2P sought to capitalize on their experience to provide cablecos with a quick route to market with VoIP. In fact, Vonage took the same path initially, as they recognized the difficulty at that time of competing head-on with the incumbents.

N2P does, in fact, have a very attractive turnkey platform for cablecos, and they have established a niche serving Tier 2/3 operators. Their solution is PacketCable compliant, and supports both SIP and carrier-grade VoIP. This means that their customers can offer both primary and second-line VoIP, as well as the ability to bundle and bill multiple services. N2P has deliberately chosen to focus here, since these cablecos are more likely to outsource VoIP than major MSOs. By choosing this path, N2P has not developed a high profile in the cable telephony space. This has led to a perception that N2P cannot compete for Tier 1 business, which is not good news for their share price. The reality is that they have chosen to not compete there, and have in fact come to dominate the Tier 2/3 cable market for outsourced VoIP.

Any of the above are plausible reasons behind the merger, but none really jump out to explain why as well as why now. Perhaps IDT is looking for N2P to grow their cable customer base as an entry point for the content produced by IDT’s various entertainment companies. Or they may simply have wanted to acquire the balance they did not already own. Regardless of the reasons, the deal is done, and the consolidation in the VoIP sector continues.

5. Financial Highlights