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. TMC ITExpo Preview

TMC’s semi-annual Internet Telephony Conference and Expo takes place in San Diego, from October 10 – 13. As with other telecom shows in the current market, the ITExpo keeps getting larger, and this edition certainly covers the gamut for IP communications. TMC – Technology Marketing Corporation - has been a leading trade publisher for over 30 years, and their flagship magazine, IP Telephony, is one of the most widely read in the industry. TMC also has several other media properties, mainly in publishing, web portals and conferences, but its ITExpo become a one-stop-shop for anyone looking to connect with this market, particularly for the enterprise arena.

TMC’s President and Group Publisher, Rich Tehrani and his team have put together an ambitious program that aims to cover many of the most important trends driving telecom and communications today. The first thing of note is show’s scope. With some 60 countries attending, the ITExpo will certainly be a global event. This is also an exhibitor-driven show, with over 9,000 attendees expected, and we are hoping for visible signs of commerce and deal-making. We see this as a key barometer for the health of the VoIP sector, as well as a way to validate which companies are really getting traction.

Aside from the business angle, ITExpo’s content is broad. The show covers an impressive range of topics from service providers to enterprise communications, which is also reflected in the high profile speaker roster, including keynotes from AT&T, Motorola, Microsoft, Nortel, Toshiba, Inter-Tel, Ditech and Citrix.

Enterprise is where the show really shines, and there are several tracks of note, many of which involve partners with industry groups closely aligned to the topics at hand. A real strength of the ITExpo is its hands-on nature, and there will be a number of sessions where attendees can see demonstrations and comparisons of enterprise solutions and emerging technologies.

Mercator has followed the IP PBX market closely, so a key panel of interest is the “Battle for the Enterprise/SMB”, which showcases six leading vendor solutions. The contact center space is an important enterprise vertical, and TMC has partnered with the Telework Coalition to produce "Call Center 2.0", a dedicated conference unto itself, but under the ITExpo umbrella. Continuing with the enterprise ecosystem is the “Reseller Solutions Day”, produced along with the Enterprise Communications Association. This will be of great interest to anyone looking to understand enterprise channels, and the strategies resellers need to adopt to successfully sell IP-based solutions.

Open Source has become a leading trend across the entire enterprise spectrum, and the ITExpo is running a series of sessions catering to the developer community – under the “IP Communications Development” banner – including a workshop conducted by Asterisk. Another important enabler of IP communications is SIP, and there is a day-long workshop dedicated to SIP trunking. Also on the enterprise front is the “Disaster Planning Seminar”, which is hosted by the Disaster Planning Communications Forum – an important topic that needs no further explanation.

TMC has partnered with the Robins Consulting Group to produce another new initiative called "VoIP Demo". The “Demo” name is somewhat confusing, since it is not connected to the long-running Demo event that the financial community regularly follows for emerging technology plays. VoIP Demo – subtitled “IP Communications Business Summit” has a similar focus, but is not a competitive event. The focus is on providing content to highlight key trends and opportunities for the investment community.

Finally, there is also a service provider focus. Similar to the aforementioned IP PBX session is the “Service Provider Shootout”. This session promises eight providers of IP services, including majors such as Covad, Earthlink, 8x8 and SunRocket. For investors more at home with the providers of these services instead of the infrastructure plays, this session will be of particular interest.

The service provider track also has dedicated content for many of the key trends being followed by investors, such as IMS, Triple Play, IPTV and VoIP Peering. Most notable of these is the IMS Expo, another standalone show-within-a-show. This expo covers the full spectrum around IMS, and is a partnership with two of the leading industry groups – the IMS Forum and the Multiservice Forum.

On the converged services front, there are two tracks of note. First is a day-long IPTV workshop titled “IPTV Evolution”, produced in partnership with Fierce Markets. A second track focuses on bundled services. This one is titled “Quintuple Play IP Services”, and is co-produced with IPDR.org. The interesting twist for this track is the focus on “emerging content” as a key element of the quintuple play, which consists of broadband, voice, IPTV, mobility and emerging content. (Wow, to think that only two years ago, "triple play" seemed like an innovative buzz-word – where will it end?)

Last but not least is the “Voice Peering Workshop”, another full day track produced along with the Voice Peering Fabric. Peering is an emerging space that we feel has some promising upside, and has been covered in recent issues.

As with the VON, Globalcomm, and other large vendor-driven shows with hundreds of exhibitors, our skeptical side says there are still far too many companies competing in this sector. We are convinced that further consolidation has to occur, and we are working with a number of companies on the M&A front who will be in attendance at this show. As always, Mercator is interested in meeting new companies who may be contemplating their own exit strategies, and would be happy to spend some time together at the show. Please contact Mike Myshrall at mmyshrall@mercatorcapital.com to schedule a visit.

2. AIM PhoneLine – Voice 2.0 for the Masses

On September 8, AOL announced their Open AIM PhoneLine Initiative. That’s a long way of saying that AOL Instant Messanger (AIM) embraces Voice 2.0, which we see as the next chapter in telecom’s transition to all IP. This move may seem radical or even puzzling, especially since so much was made of AOL’s TotalTalk as a Vonage competitor, but Open AIM is a big step forward, with important implications for the telecom market.

First, a brief review of what AIM has brought to market. There are two important pieces – the PhoneLine service itself, and the Open AIM Initiative. AIM’s PhoneLine offering has been available since May 2006, and is disruptive in its own right. Leveraging AIM’s substantial base of 43 million users, their IM platform took a SkypeIn-like move by offering unlimited incoming telephone calling to your PC for free. To facilitate this, they issued users a free local phone number, along with free voicemail and caller ID. One may wonder how all these local phone numbers can be made available – and given away for free – but considering that that the RBOCs are losing landline subscribers to the tune of 10,000+ a day, DIDs are not as hard to acquire as in the past.

AIM cannot attract subscriber revenues from IM chat or inbound calling, so they have added their “Unlimited” plan to give users the full package. For $9.95 a month, you can also make outbound calls from your PC, with free long distance both domestically and to over 30 international locations. As such, AIM PhoneLine is a hybrid between Skype and Vonage, but being natively IM-based, is primarily a PC telephony service.

Building on this is the Open AIM Initiative, which is where we see AIM taking the voice market in a new direction. Much like Skype, they have recognized the value that the developer community brings to VoIP, and their initiative is meant to tap into this pool. AOL’s stated intention is to introduce open APIs into the PhoneLine feature set and create value-added services. These services will be built around their Triton IM client, and by leveraging both presence and chat, the possibilities for new applications become very enticing. The goal is to create new revenue streams from what was initially a free service (something Skype has been slow to do), as well as differentiate AIM in an increasingly crowded and commodity-like market.

Given that successful business models for VoIP have been hard to come by, there are two signs that AIM is serious about this direction. First, they are willing to let developers share in their financial success via an Online Storefront. To encourage a flow of fresh ideas, AIM has also created a Developer’s Challenge competition, where cash prizes will be awarded to the best new applications submitted by the end of November.

The second part of this equation is more ominous. In late August, it was announced that AOL’s TotalTalk VoIP service was being terminated as of November 30, 2006. AOL was a late entry to the VoIP space, and we view this news as a white flag regarding their ability to make a profitable go of things in a market full of pure play Vonage chasers. TotalTalk may have been a perfectly good VoIP offering, but AIM PhoneLine is much better aligned with how the voice communications sector is evolving, and AOL likely saw fit to cut its losses. We think this is a move in the right direction.

To showcase what is to come from the Open AIM Initiative, three developer offerings were introduced at Fall VON in early September. Each offering brings something new to the online voice experience, and these are the types of companies that stand to do well when other providers follow AIM’s lead.

First is Iotum’s Relevance Engine, which provides a high level of call filtering, allowing subscribers to only receive the calls they really want. MyNuMo is the second developer, and their application enables personalized ringtones so subscribers can customize their calling experience. The third vendor is Mvox Technologies, who have a USB device that allows PhoneLine to be extended to other devices such as cordless phones.

We see these companies being at the vanguard of Voice 2.0, and are the thin edge of the wedge for exciting innovations to come as major operators like AOL adopt an open and standards-based approach to telephony. AOL, of course, is one of the Internet pioneers, and by extension, has more experience serving the online community than other types of providers. At this stage of the market’s development, we could not envision an RBOC or MSO launching such an initiative, and nor could we see them dropping out of the pureplay landline VoIP market altogether. We will continue to follow AIM PhoneLine and their developer program closely, and hope to see a steady stream of innovation that brings the promise of Voice 2.0 to the mass market.

3. SMB Market Beckons for VoIP

Most of the topics in this newsletter are driven by major developments or news items from the previous month. Not so for this story. The Small and Medium Business (SMB) market has been slow to develop within the IP sector, but things are improving. We are writing about it now not because a big story broke in September, but rather, three modest and independent news items from last month signaled to us that momentum is building.

First was the release of current research from Savatar, a research consultancy based in Boston. Savatar has a strong niche covering the SMB market, and have been tracking the adoption of IP there for quite some time. Their findings were widely covered in the press, including the Wall Street Journal, with the main conclusion being that IP offerings catering to SMBs have become mature, with the value proposition being built around cost savings rather than high-end, advanced features.

The leading providers of these services have focused on cost savings, simplicity, educating their market, and providing strong after-sales support. This has not been the strong suit of the incumbents, and these are certainly not the value drivers for large enterprises.

One such provider is Whaleback Systems, which brings us to the second news item. On September 25, they announced a $7.5 million Series B funding round. This provided a visible example of the confidence investors are beginning to have in this emerging space. Whaleback provides a very attractive managed service offering that exactly fits the profile identified in Savatar’s research.

Of course, many other companies are going after this space, with notable examples being Covad, M5 Networks, Cbeyond, XO Communications, Voila IP Communications, Converged Access, Bandwidth.com, Shift Networks, Natural Convergence and Pandora Networks. The incumbents are trying to serve this market as well, but it is fairly low on the value chain for them. Both AT&T and Qwest have been using the Sylantro platform to offer IP to its SMB customers, while Verizon has been doing the same with BroadSoft.

Before moving on, voice over broadband operators like Vonage and SunRocket need to be mentioned, if not just for their sheer numbers of subscribers. While these are essentially landline replacement services, most do offer small business and SOHO packages. At face value, they can certainly offer savings and feature upgrades for this market, so they do have a stake in the ground. However, since they are not network operators, they cannot control QoS, and hence are not true business-class alternatives. They will have their place at the low end of the business market, but are not a realistic alternative for a business requiring switched telephony or enterprise-class features.

Extending the Internet model even further, one must also acknowledge the potential for IM-based platforms to enter the SMB market. Although the basic offerings from Skype and Google cannot truly compete today with operators like Whaleback, they certainly have designs on this market, and do not lack the resources to make a play here. We believe the IM players will find a way to impact this market, but likely in ways that have not yet been realized.

Rounding out the ecosystem is the vendor side of the market, and our third story. At VON last month, Digium announced the October release of Asterisk 1.4. This release succeeds Asterisk 1.2, and is their most mature offering yet for the booming Open Source PBX replacement market. Although SMBs are generally less tech savvy than their enterprise counterparts, the value proposition of Open Source telephony is strong enough to lead many into this camp.

It should also be noted that Digium raised its first round of funding in August, $13.8 million. This is a lot of money for an Open Source company, even if just for the hardware components. Their funding is another sign of confidence in this space, and we would look for their prime competitor, Sangoma Technologies, to not sit idle as the stakes get higher for market leadership.

Open Source is still a work in progress, but Asterisk 1.4 is a major step forward in becoming a mainstream alternative to traditional telephony systems. The key upgrades for this release include improved call quality, IP fax capability, unified communications support, and expanded interoperability with hardware vendors.

Asterisk is the dominant Open Source platform, and rivals such as SIP Foundry and FreeSwitch will no doubt be following suit. Collectively, they represent a significant trend that is impacting the entire PBX sector. Channels are needed to support the SMB market, and Open Source has given rise to VARs like Fonality and VoIP Supply, who offer a variety of telephony solutions built on the Asterisk platform.

We expect to see a proliferation of these channels that understand both the mechanics of Open Source as well as the challenges SMBs face in adopting new technologies. This combination of competencies is in short supply, and is a key reason why the incumbents will have difficulty retaining their SMB customers once Open Source and IP-based alternatives become mainstream.

The ripple effect has noticeably extended to the PBX vendor market, where major players have made various moves to address the SMB market with lower priced systems. Avaya has embraced the peer-to-peer model via its Nimcat acquisition, which has been rebranded one-X Quick Edition. Last year, Nortel launched a scaled-down version of its Business Communications Manager – the BCM50 – for the under 50 seat market, and Cisco has done the same with Call Manager Express. Whether responding to the disruptive presence of Open Source or the inevitability of VoIP, there is a lot at stake for these vendors, and the market is evolving too quickly to stand still. We would not at all be surprised to see these vendors make strategic acquisitions along the lines of Avaya as a means of broadening their product portfolios and strengthening their SMB channels.

There is much more to explore in the SMB VoIP arena, and we anticipate strong growth as market demand becomes real and the offerings deliver on their promises. We expect funding to continue in this space, and in time, several of the public companies will become consolidators as the market becomes saturated with providers. Look for us to revisit this market in the first half of 2007, as we expect more developments in the sector.

4. Art of the Deal:
Alcatel Acquires Nortel’s UMTS Access Business

On September 1, Alcatel made a modest acquisition (by recent standards), but one that has notable implications on a number of levels. The transaction was relatively small, given that both parties are Tier 1 incumbent vendors, and the deal only involved one product line within a single business unit. In short, Alcatel has acquired the UMTS access business from Nortel Networks for $320 million, in a deal that is expected to be finalized before the end of the year.

Any mention of Alcatel at this point in time must be tempered by their pending merger with Lucent, which will create the world’s largest network equipment vendor. But for now, we will focus on the Alcatel-Nortel deal.

In the UMTS transaction, both buyer and the seller have different motivations, so we will first look on the selling side. There are two pieces of Nortel’s UMTS business, which serves the 3G wireless market – access and core equipment. Nortel has a stronger market position for core – estimated at around 10% – while they are a minor player for access gear, at around 2% share. Building on the GE model of striving to be a number one or number two player in each market segment, CEO Mike Zafirovski’s has said that it will only compete in sectors where Nortel can hold a 20% share or better (which many argue is an impossible task for Nortel within any segment). This goal explains Nortel’s willingness to exit the access business, and by holding on to the stronger core UMTS segment, they maintain a meaningful presence in 3G, which has yet to reach its peak.

On a strategic level, Nortel has recognized it cannot scale the access business enough to be worth keeping, and this move is another step towards becoming a more focused company. This is important not just on the balance sheet, but also for investors, who need to see Nortel stick to its strategy, and re-shape the company into something the market understands and feels good about.

The UMTS deal is positive for Nortel in three ways. First, it brings in fresh capital, which can be deployed to strengthen Nortel’s core businesses. Second, the UMTS access business was bleeding – losing around $200 million per year, despite revenues of over $200 million – so the divestiture makes good fiscal sense. And third, it helps bring clarity to where Nortel plans to focus. Wireless has long been a strength for Nortel, but they see more growth potential in 4G, so backing away from 3G reinforces that direction.

It is also worth noting that this deal seems consistent with Nortel’s overall direction. The shift to 4G positions them as a potential market leader in areas where they have solid expertise, namely WiMAX and CDMA DO. Another pillar of Nortel’s game plan is enterprise and services applications, and to support this strategy, they have already made their deal with Microsoft (covered in our August issue). As such, the pieces are beginning to fall into place for Nortel’s makeover, which can only be good news as the vendor space continues to consolidate.

On the buyer side, Alcatel sees Nortel as a key piece in their bid to become a major player in the UMTS access market. Their share is reportedly only 4%, which pales behind the two dominant players, Ericsson and Siemens, each believed to hold about 30%. When the Alcatel-Lucent deal closes, the combined product lines of Alcatel, Lucent and Nortel would make them a solid number three player in the UMTS access market. In particular, Nortel’s footprint would give Alcatel access to strong 3G markets such as South Korea and the U.K., as well as emerging 3G markets like China.

With that said, of course, Alcatel and Nortel are still competitors, and both have a strong presence in WiMax and CDMA DO, especially once the Lucent assets are factored into the equation. As such, it remains to be seen how things will unfold when they go head-to-head after this deal closes. A wildcard to watch in this milieu is Sprint, given their recent decision to adopt WiMax in favor of CDMA as their technology of the future. CDMA has long been a hallmark of Lucent, and with Nortel’s shift from 3G to 4G, Alcatel has cause for concern as to whether it bet on the right horse.

Some analysts have argued that the deal could have fetched an even higher pricetag – as much as $500-$600 million – but the willingness to sell at a lower price may have meant there were few potential buyers for the business. Others also question the strategic motivation of selling the unit to Nortel’s fiercest competitor, though in the end, money talks. Finally, many feel that the pending Alcatel-Lucent and Siemens-Nokia mergers should signal to Nortel that much bigger deals will be required to compete on a global scale. We feel that this transaction clearly indicates that the strategic direction within the company has still not crystallized and that priorities remain in a state of flux under the Zafirovski regime.

5. Financial Highlights