Video Conferencing Consolidation in Full Swing

Ever since I first covered Polycom (NASDAQ:PLCM) two years ago, I have speculated about consolidation in the sector. Videoconferencing has gained importance due to globalization, offshoring, the financial crisis and the attendant recession, and the need to save more in travel dollars. Now there is a flurry of acquisition activity and consolidation in video conferencing which began with Cisco’s proposed $3 billion acquisition of Tandberg (OSL:TAA). The bid has yet to be approved by Tandberg’s shareholders, but yesterday Logitech (NASDAQ:LOGI) acquired LifeSize, another videoconferencing player for $408 million. What are the implications of this trend?

Before discussing details and consequences of the deal on the videoconferencing market, it will be useful to give some background on LifeSize. LifeSize was founded in 2003 and is based in Austin, TX, with subsidiaries in the Americas, EMEA, and Asia Pacific. Its investors include Austin Ventures, Redpoint Ventures, Sutter Hill Ventures, Pinnacle Ventures, Norwest Venture Partners, and Tenaya Capital. It has about 9,000 customers in 80 countries and adds about 800 customers every quarter. In August, LifeSize  reported that its sales increased 45% versus the first eight months of 2008. It expects 2009 revenues to be $90 million.

According to Wainhouse Research, Polycom and Tandberg dominate the videoconferencing market with 35% and 31% share respectively while Cisco has only a 1% share. The installed base of group videoconferencing systems was about 900,000 as of mid-year 2009. Of this base, Polycom has 41% share and Tandberg 26%. The expensive “telepresence” systems into which Cisco entered accounts for a minuscule part of the videoconferencing industry. With the Tandberg acquisition, Cisco would bring in Tandberg’s network infrastructure and video conferencing equipment and aim for a larger part of the videoconferencing industry. The video conferencing products market is expected to nearly double to $8.6 billion by 2013, according to Gartner. In 2008, the video conferencing market was worth $1.4 billion, and according to Andrew W. Davis, senior partner with Wainhouse Research, it is expected to reach $1.6 billion in 2009. That would put LifeSize’s market share at 5.6%.

LifeSize was named “Videoconferencing Company of the Year” in 2007 by Videoconferencing Insight. The company recently introduced LifeSize Passport, which delivers HD video communications for less than $2,500 and delivers Skype audio calls. This product and others like it would fit in well with Logitech’s webcams, but for Logitech, it is still a new but promising business. LifeSize’s acquisition by Logitech is expected to close in December, and Logitech plans to operate LifeSize as a separate business unit under the leadership of Craig Malloy, LifeSize’s co-founder and chief executive. Though the deal has taken everyone by surprise, it is not expected to change the competitive scenario in video conferencing as much as a Cisco-Tandberg deal.

Tandberg is the leading provider of video infrastructure and video endpoints products. It entered the videoconferencing market back in 1989, and since then has consistently been the first to market with innovations in the space. It has dual headquarters in Oslo and New York, offices in 34 countries, and more than 1,500 employees. For the past 10 years, its annual revenue has been growing at about 30%.

Tandberg’s annual revenue in 2008 was $808.8 million, up 28.3%. Net income was $134.6 million or $1.18 per share versus $102.4 million or $0.92 in 2007. Gross margin was 66.0% down from 66.4% in 2007. The industry ASP increased from $5,366 in 2007 to $5,876 in 2008 while Tandberg’s overall ASP increased from $7,877 to $8,064 in 2008. The company ended the year with $174.8 million in cash and $20 million in interest-bearing debt relating to its Codian acquisition.

By region, revenues from the Americas grew 20% to $386.1 million driven by Tandberg’s end-to-end offering and accounted for 47.7% of revenues (vs. 51.1% in 2007). Revenues in EMEA grew 36.0% to $327.9 million and were 40.5% of total revenues. Revenues in Asia Pacific (APAC) grew 41% to $95 million and accounted for 11.7% of total revenues.

Tandberg has always been a strong proponent of open standards and has partnerships with HP, Microsoft, IBM, and Avaya for smooth integration of its products. In 2008, it expanded its reseller agreement with HP and its alliance with the computer manufacturer to jointly promote open industry standards in order to drive broader telepresence and video conferencing interoperability among vendors and companies.

Within video endpoints and network infrastructure, Tandberg accounted for 40.7% of revenues. Endpoint units sold accounted for 28.9% of revenues and network infrastructure products 19.2%; this last segment grew 81.5% y-o-y. Tandberg’s network infrastructure products include Tandberg Management Suite, Multipoint Control Units, Gateways, Video Communication Server, Gatekeeper, Border Controller, Content Server, and Video Switch. Its personal systems range, comprising the TANDBERG 150, 1000, 1500, 1700 and E20 represented 36.0% of all systems sold, while the mid- through high- range group systems accounted for 64.0% of systems sold.

In its third quarter results, Tandberg reported revenue of $234.7 million, up 11.6%. Operating profit was $50 million or $0.23 per share versus $45.3 million or $0.35 last year. Gross margin was 65.6%, compared with 65.9% last year. The company ended the quarter with a cash balance of $245.7 million and no debt.

By region, Q3 revenue in the Americas was $129.7 million, EMEA was $78.1 million, and APAC was $26.9 million. By market, Tandberg sold 18,260 endpoints in the quarter, a 4% y-o-y increase.  Revenue from network products grew 34%, and service revenues grew 18%.

Tandberg is currently trading around $153. According to a recent report, over 90% of Tandberg’s shareholders snubbed Cisco’s offer. The acquisition needs the approval of at least 90% of shareholders. Cisco has extended the deadline to November 18 and hasn’t changed the terms of the deal, which it says are fair. Last week, Cisco said that it will work with shareholders to close this deal.

Cisco’s foray into data centershas soured its relationship with HP and IBM, and the they might not want to continue the Tandberg partnership with Cisco in the picture. Polycom, which has annual revenue of $1.1 billion, is likely to benefit here. In fact, as I suggested earlier, it Polycom might even end up being acquired by HP, although given yesterday’s 3Com acquisition, HP will need a bit of time to first digest 3Com before taking Polycom on. And it is still an attractive target for Ciscoif the latter’s Tandberg bid fails.

Now let’s take a look at Polycom’s financials: on October 20, Polycom reported its third quarter results. Q3 revenue declined 12% to $243 million. Net income was $14 million or $0.16 per share, down from $18 million or $0.21 per share last year. Adjusted earnings were $0.31 per share versus analyst estimates of $0.32 per share on revenue of $236 million. Q2 analysis is available here.

By segment, video solutions revenues were down 7%y-o-y and 2% q-o-q to $165 million. Voice communications revenues were down 20% y-o-y and up 13% q-o-q to $78.0 million. Within video solutions, video communications revenues were down 10% y-o-y and up 1% q-o-q to $130 million. Network systems revenues were up 3% y-o-y and 6% q-o-q to $35 million.

Polycom generated over $39 million in positive operating cash flow. Gross margin fell from 60.2% to 58.8%. The company ended the quarter with $408 million in cash and investments and no debt. It bought back shares worth $20 million.

Polycom is trading around $24 with market cap of about $2 billion after hitting a 52-week high of $27.96 on October 1 after Cisco’s $3 billion offer for Tandberg.