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| Summer 2007 Newsletter | El Dorado Ventures website |  |
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By Mark Floyd It seems that people from BusinessWeek to Wall Street to the participants at the recent NXTcomm show in Chicago (mainly equipment vendors) are opining that Telecom might be back from the dead. I guess it depends on your perspective. I would argue that Telecom is still in significant trouble, specifically in the North American market. The consolidation of carriers has put capital expenditures in the hands of a few purchasers. AT&T and Verizon along with a distant Qwest and BCE control greater than 90% of this spending. AT&T and Verizon Wireless have about 55% of the wireless subscriber base, but most importantly, they have about 65% of all net adds. An equipment vendor that is trying to sell into the core of the wireline or wireless network would have to be able to manage and support a very large scale deployment, a significant OSS and network integration, and, very importantly, have the ability to forward price its products by at least two to three years with much lower margins. Carriers are looking for infrastructure vendors that can offer end-to-end solutions with support and integration services, plus compete with the pricing strategy that Huawei introduced to the telecom market. The number of companies that are able to do this today can be counted on two hands with several fingers left over. Large carriers seem to be unwilling to buy from small-to-medium businesses for core products, including copper and fiber access, class 5 switching and soft switching applications, routers, optical core, IMS architecture, IPTV, wireless infrastructure, radios and handsets. One interesting data point is the new five year exclusive deal that Apple struck with AT&T for the iPhone. Why do you think Apple has limited its market for this over hyped cell phone to just AT&T's network? The answer is that AT&T can command such a deal. The major problem with this scenario is that most of the innovation for these products comes from startups and other smaller companies. So what happens? If startups can't sell directly to large carriers, venture capitalists and other investors will stop funding these companies. Innovation will slow down to the pace of the much larger companies and the carriers will be left with noncompetitive products compared to their cable and other emerging rivals. I have had this conversation with several senior executives from different large carriers and they all agree with this scenario, but they will not take the risk to buy from a small company. So, the road for small telecom equipment companies is through the M&A route, but only when one of the larger equipment companies can't sell their own out-of-date products to the carrier. This all sounds pretty grim for the telecom industry. Ask the investors of Gluon, Photuris, White Rock, Luminous, Pedestal, Riverstone, Mahi, Tropic, Terawave, Quantum Bridge, Optical Solutions, Santera, Taqua, Procket, Avici, Pluris, Caspian, Chiaro, Hyperchip, IronBridge, Axiowave, Proxim, etc., etc., etc. So is Telecom dead? Maybe not if you look at non-infrastructure market segments such as security, video applications, messaging, web services, policy controls, bandwidth management, test and measurement, CPE, mobile access software, downloads, software PBX applications, wireless applications and communication software. Recent IPOs of telecom related companies like Infinera, Veraz, Aruba and BigBand, coupled with the current filings of Airvana, LimeLight, and Starent, suggest that maybe the telecom market is coming back. But, if you look a little deeper, the future might not be all that bright. The combination of Acme Packet, Aruba, BigBand, F5, Isilon, Network Appliance, Riverbed and Sourcefire has significantly underperformed the market in the last three months. While the NASDAQ index is up 8.7%, these companies are negative 0.7%. But there is good news, telecom IPOs are happening. This is extremely positive considering the state of the telecom market over the past five years. Companies that can find or create a market segment that is underserved by the larger telecom equipment companies can survive and grow. These market segments tend to be non-infrastructure and usually generate opportunistic revenue for carriers with quick implementation and little downside. One interesting telecom market segment is carrier Ethernet. Carriers have been searching for a way to integrate Ethernet over a period of time into their networks without cannibalizing their existing transport services immediately. There are a lot of start-ups and smaller companies trying to succeed in this market, including Gridpoint, Hammerhead, Soapstone, World Wide Packets, Extreme, Hatteras, Adva, Aktino, Ciena, Zhone, Atrica, and many more. They will all have to compete with larger companies including Cisco, Nortel, Alcatel Lucent, Ericsson and Siemens Nokia to win in the carrier Ethernet market. If any of these companies can get a piece of the market segment, it will probably be acquired by one of the larger telecom equipment companies for the reasons earlier stated. Broader communications companies that offer web applications, such as Google, YouTube, MySpace, ManiaTV and VideoEgg have done exceptionally well and will probably continue to do so since they created their own market and the larger telecom equipment companies do not have products in this space. Consider what the two software application giants are doing, Microsoft with its Unified Communications Platform and Google introducing Gtalk and click-to-call. Both these companies, and many startups, are trying to develop software applications that bridge normal voice calls with messaging across multiple platforms, which enable many new communications opportunities. So, is the Telecom market coming back, or not? I think you can argue on both sides of the question. Are there going to be good investments in telecom start-up companies? Yes. Will they have the chance to grow substantially and go public and become a major supplier to a large carrier such as AT&T or Verizon? Probably not. If investors want to continue to invest in telecom companies, they should find companies that have 1) a product that carriers clearly need today or in the near future, 2) products that are software based or have a significant amount of value-added software in their platform, 3) a very good margin structure, and 4) an established entry into the carriers, specifically at the senior management levels. These attributes along with the traditional qualities could make for a profitable return.
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Telecom: Back From the Dead? Maybe, Maybe Not.
