As tech stocks were exploding in the late 1990s, companies offering video conferencing technology were all the rage. Investors assumed that all business meetings would eventually be replaced by video and audio feeds, allowing for virtual face-to-face collaboration. A decade later, the industry has made major inroads (if not completely replacing business meetings), dominated by industry leaders like Sweden-based Tandberg and Polycom (Nasdaq: PLCM).

Investors in Polycom were handed a nice gift when Cisco Systems (Nasdaq: CSCO) announced plans to acquire Tandberg in October 2009 for $3 billion. In ensuing months, shares of Polycom rose from the low $20s to the low $30s as investors assumed that Polycom would also soon be acquired.

But in early June, a little-noticed announcement from Hewlett-Packard (NYSE: HPQ), which re-sells Polycom’s products, should have spooked investors. HP announced that it was also going to re-sell video-conferencing gear from an obscure company named Vidyo. HP apparently found another date to bring to the dance. For Polycom, this move could spell real trouble.

Better and cheaper
The real challenge for this industry has always been cost. Sure we can all have a video chat on Skype, but to get many users plugged in to a high-quality video network, companies need to invest hundreds of thousands of dollars in dedicated hardware and software. For very large companies, that may be a worthwhile investment. But for small and medium-sized businesses, that’s a lot of dough.

HP realized that Vidyo was on to something special. Users can buy a video-conferencing set up from the company for just $6,000. More importantly, the system is configured to work on almost any platform, from PCs to tablet computers to smart phones. Vidyo took out patents that control how much information needs to be included when video streams are sent, stripping out various segments when necessary, so the video can still stream quickly on smaller, less robust devices.
HP will not start selling the Vidyo gear (which will be sold under the HP name) until this fall, but it’s unclear if HP will seriously stand by expensive Polycom-branded video conferencing gear once the Vidyo products are available.

Here comes Cisco
Adding insult for Polycom, Cisco has finally integrated last winter’s acquisition of Tandberg and is expected to make a big push this fall. Cisco has stated clearly that it sees the Tandberg deal as a way to move deeper into enterprises and cross-sell other gear. This has led analysts to speculate whether Cisco will be very aggressive on price, since it can secure profits on other hardware, software and service offerings. Polycom is in no position to handle a price war.

It gets worse. Microsoft (Nasdaq: MSFT), which is ostensibly a re-seller of Polycom’s gear, has also announced plans to become a serious player in video-conferencing with its own software. China’s Huawei has made similar boasts. Standalone Polycom, which used to simply have to worry about Tandberg, now has to compete with the likes of Cisco, Microsoft, Huawei and perhaps Hewlett-Packard. That’s not a fight it can win.

We may have seen a glimpse of the building competitive pressures when Polycom released quarterly results in mid-July. Backlog declined for the second straight quarter while inventories rose +11% sequentially. This helps explain why management predicted sequential sales growth would cool to +2% to +3% in the current quarter, from +7% in the June quarter.

Thanks to a rebound from absolutely depressed spending levels in 2009, Polycom’s sales should still rise a healthy +20% to +25% in the current quarter when compared to a year ago. And then the deceleration begins. Sales are expected to grow less than +20% in the December quarter and could slow to around +12% to +13% according to analyst forecasts.

But in light of all of the competitive moves being made by HP and Cisco, even that forecast is starting to look too optimistic. Instead, Polycom may struggle to grow at all next year, and if the economy doesn’t improve, sales could actually shrink as they did in 2009.

Shares of Polycom languished below $15 back in early 2009 when investors questioned the prospects of the company’s fairly expensive video-conferencing solutions. Since then, shares have rebounded nicely in large part to expectations that the company will be acquired at a nice premium. Yet as potential acquirers start to identify their own video-conferencing strategies — without Polycom — it becomes increasingly doubtful that a suitor will emerge. Once all of this is digested, shares could steadily fall from the current $27 back into the teens.

Action to Take –> Polycom looks ripe for shorting. If Polycom became spooked by all of these competitive changes and announced that it was seeking a buyer, shares could spike higher — that’s the key risk to this short thesis. But more than likely, Polycom will remain as the last independent player in the video conferencing business. That’s not a good position to be in when the industry is playing musical chairs and the music has just stopped.