IP PBX vendor ShoreTel’s Feb. 1 announcement that it plans to acquire hosted communications company M5 Networks for $160 million a valuation three times revenue has excited the community of pure-play hosted VoIP providers, partly because they hope it bodes well for their own paydays and partly because they view it as a sign that hosted has won its long-standing battle with premises solutions. Don’t start picking out yachts yet, guys. You may be suffering from a bad case of wishful thinking. Analysts argue that most existing players cannot command the premium price, and that premises solutions still have a very long life cycle ahead of them.
“[The deal] bodes well for all of us in that space if we can get similar valuations,” said Michael Machonkin, vice president of sales and marketing for GLOBALINX, a hosted communications provider that bought competitor TMC Communications in 2010.
That’s a big “if,” said Roger Valdovinos, managing director for investment bank Blue Beacon Capital. He describes M5 Network’s valuation as an “outlier” much like Smoothstone IP, which was valued in the 3X-4X revenue range when it was acquired for $120 million in summer 2011 by West Corporation. “These are outlier companies and as such generated outlier exit valuations,” Valdovinos told Channel Partners, explaining that both demonstrated double-digit top-line revenue growth, strong gross margins, meaningful SMB traction, attractive ARPUs, proven sales channels and ability to scale. “This does not mean that all hosted communications providers are worth 3X revenue. The majority of hosted communications providers are still sub-scale and don’t present a platform acquisition.”
That said, Valdovinos agreed with most industry observers that consolidation in the hosted communications market will continue. “There is certainly interest among strategic buyers to purchase hosted VoIP companies, just at realistic valuations that are commensurate with their size from a financial, operations and customer base perspective,” he said.
Craig Clausen, principal analyst for New Paradigm Research Group Inc., said he expects transactions involving hosted VoIP providers to accelerate in 2012, particularly in the second half. He expects a majority of the transactions to involve unlike companies as in the ShoreTel/M5 deal, but thinks they are less likely to involve gearmakers as they are other service providers as was the case with Comcast’s acquisition of New Global Telecom in 2010. “They provide the acquiring entity a set of complementary services and offer the acquirer a ‘shot in the arm’ growth opportunity,” Clausen said.
It’s these types of acquisitions, which presumably also bring needed scale and deeper pockets, that are making it “increasingly more difficult for pure-play providers to stand on their own,” wrote Diane Myers, directing analyst for VoIP and IMS at Infonetics Research, in a Jan. 25 research note, just days before the ShoreTel/M5 deal was announced. “We expect further consolidation in 2012 as there are still a good number of smaller VoIP providers that would benefit from an acquisition or merger to sustain business,” Myers wrote, noting there are more than 100 such providers in North America.
The issue now is that there are “no other big guys left to buy most of them are smaller than $20 million,” said Dave Gilbert, CEO at hosted communications company Simple Signal. Investment banker Valdovinos puts GLOBALINX and Telesphere on his list of the next likely candidates for acquisition.
So, will the smaller players team up to achieve scale? It’s possible, but Vadovinos said any mergers among the hosted providers themselves would likely involve stock or distressed asset purchases. “Most of the hosted communications companies today still are early stage and underfunded,” he said. “The majority of them do not have the financial wherewithal to roll up their peers in cash transactions, especially at the outlier valuations we witnessed with the M5 and Smoothstone deals.”
One observer, Clark Atwood, president of Concierge Communications, a master agency that sells cloud communications, said the high valuation in the ShoreTel/M5 deal actually “may slow acquisitions as hosted VoIP providers hold out for a higher purchase price.”
That theory tracks with hosted providers’ overall feeling that ShoreTel’s willingness to pay a significant price for M5 means that hosted has “won” over premises-based solutions and, therefore, their businesses are worth more.
“This move [by ShoreTel] is a huge validation for the hosted VoIP model,” said Andrew Pryfogle, president and CEO of Terrapin Solutions, a cloud services master agency. “I think most hosted VoIP providers were pleasantly surprised by the price tag M5 fetched. Those focused on building great platforms and service delivery models designed for the 50-plus seat market are the ones that will win big.”
While analysts would agree with the use of the word “validation,” they would not pronounce “victory” for hosted communications. “Hosted is not winning over on-premises,” said Steve Hilton, the lead analyst for the Enterprise Solutions Program at Analysys Mason. “The old adage, ‘Different strokes for different folks,’ applies aptly in the world of UC. It makes good sense for some SMBs to keep their gear on-premises while for others a hosted solution will win the day.”
ShoreTel dealer Kyle Miley, president and CEO of Sonoran Integrations, offers first-hand testimony to this point: “Sonoran Integrations has been offering a hosted solution for about two years now while still being a ShoreTel Gold Partner. There are markets where a hosted solution is the right fit for the customer and places where it is absolutely the wrong fit.”
Valdovinos agreed. “It’s really about solving the customers’ needs and wants rather than pushing the method of service delivery,” he said, adding there is a market for cloud, premises and hybrid deployments. He also reminded that premises deployments are still pervasive and hosted voice accounts for a growing, but still small percentage of the U.S. telecom market.
ShoreTel’s move is “not as much a response [to market share gains by hosted providers] but a recognition that hosted VoIP products are gaining traction and will continue to grow at a faster clip than premises-based products until some balance is reached,” said Clausen.
Valdovinos added that as a public company, ShoreTel must focus on growth initiatives, which hosted UC represents. And while one would assume a hosted acquisition is not additive but cannibalistic to the premises business, in this case the two companies’ target markets are different. “ShoreTel will be well positioned to sell communications services to the sub-100-seat customers, a market that was unaddressed under their core model, which was more [small and medium enterprise] focused,” he said.
In fact, existing ShoreTel dealers selling to bigger businesses are wondering how the M5 deal will help them. “As we are focused on the larger midsize and enterprise accounts, we are interested to know how this platform can be leveraged to help us service customers at that size,” said Rick Hirsh, CEO of Transcend United Technologies.
Ultimately, ShoreTel’s acquisition reflects not only its realization that hosted VoIP is here to stay, but that it’s a lot easier to buy your way in than build from scratch, Hilton added. “Asking an on-premises vendor to build and grow its own hosted UC business is like asking a chef to start repairing Fords. They are different businesses and require dedicated teams.”
This is the general consensus among the sources Channel Partners interviewed. “For a premises-based vendor to compete in the hosted space they would have to become a service provider they don’t know how to do that,” said Simple Signal’s Gilbert, noting that it’s the operational systems and process not only the communications technology that must be mastered. This is a likely bet based on the fact that other vendors like Cisco Systems Inc. and Siemens Enterprise Communications have partnered with service providers to deliver their UC solutions as a services, and Mitel Networks Corp. may be the only vendor that has built its own.
Plus buying avoids the long delay in getting to market organically. Infonetics Myers estimated that it would take three to five years to build, taking ShoreTel out of contention in the hosted space altogether. Apparently, that wasn’t a price they were willing to pay.