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First Quarter 1998

Internet Telephony: A Threat To Telcos?


Begun as a rather primitive hobbyist toy in early 1995, Internet telephony is fast becoming a viable alternative to traditional voice and fax services. While only a fraction of telephone network traffic is currently being affected, the move to less expensive Internet protocol (IP) networks heralds a paradigm shift that telcos and their equipment suppliers can't afford to ignore.

Artificially high prices, sustained mainly by government regulations, have left phone services vulnerable. Limitations of IP voice are rapidly being addressed, and the Internet's widespread support makes the new technology a real contender. The evolving Internet may actually produce the long predicted integration of voice and data networks.

This fundamental industry transition is creating multi-billion dollar opportunities for service providers and equipment suppliers. New entrants and innovative suppliers have a good chance to gain significant market share. Many communications users stand to benefit from substantially reduced costs and new services. The changes also give flexible telcos the means to capture new markets and customers.

At first, Internet voice was an easily dismissed curiosity. Early Internet phone software for PCs had poor voice quality and only allowed one person to speak at a time, much like citizen's band (CB) radio. Moreover, communications could occur only between individuals who happened to be on line at the same time, and who possessed identical software. Nonetheless, the idea gained widespread attention and PC-to-PC Internet voice was catapulted into the mainstream in 1996 with product announcements by personal computer industry heavyweights Netscape, Intel, and Microsoft. By then, refined techniques for transmitting two-way voice conversations over the Internet, along with more powerful PCs, permitted much better voice quality, although still not up to phone network levels.

During 1996, the nascent industry reached consensus on basic interoperability standards for IP voice communications. A subset of the International Telecommunication Union's (ITU's) H.323 videoconferencing standard was adapted to enable communications among Internet telephony products from different vendors. By the spring of 1997, the first standards-based products began appearing.

Realizing that a network's value increases exponentially with the number of potential connections, Microsoft and Netscape began bundling Internet voice software with their popular Web browsers and Intel let anyone freely download its Internet phone software. Although these steps led hundreds of thousands of PC users to experiment with IP voice, the utility was still limited, compared to the regular phone network. Not only did the base of individuals with Internet voice software pale in comparison with the hundreds of millions of telephone users, there wasn't a way to ring called parties not online and no comprehensive Internet phone number directory was available.

However, these limitations were soon addressed as service providers and corporations began conducting trials with IP-to-public switched telephone network (PSTN) gateways that promised to extend the addressed market from individuals with powerful PCs and Internet connections to the huge base of telephone users. By providing links to the ubiquitous phone network, IP-to-PSTN gateways can remove some of the most important barriers to broad market acceptance. The biggest limitation of Internet phone PC software is the relatively small number of people that can be called. Gateways overcome this limitation by enabling PC-to-phone and phone-to-phone calls. With IP / PSTN gateways, users don't need special software, Internet connections or even PCs to place calls routed over the Internet.

Unfortunately, the lack of accepted standards for such gateways means that only equipment from the same manufacturer works together. Most IP-to-PSTN gateways are being implemented on powerful PCs. Although this approach keeps costs down, early versions lack the reliability, capacity, and sophisticated network management features associated with telephone switching equipment. What's more, the regulatory outlook for offering public services via IP-to-PSTN gateways is uncertain in many countries.

Although governments around the world are concerned about the potential impact cut-rate Internet-based services could have on their phone companies, regulation of Internet telephony is fraught with difficulties. It's virtually impossible to separately track voice or fax packets traveling over the multitude of data networks that comprise the Internet. While gateway operators requiring connections to local phone networks might be regulated and taxed, PC-to-PC Internet calls and internal corporate traffic are probably beyond the reach of regulators.

Hands On
A few countries, including the Czech Republic, Hungary, Iceland, Pakistan, and Portugal, have already moved to restrict Internet telephony. However, such restrictions will be short-lived for participants in the World Trade Organization's (WTO) telecom agreement. Nations accounting for the bulk of the world's telecom service revenues recently agreed to open their markets to facilities-based competition. New entrants can take advantage of this market opening by using Internet telephony to quickly - and relatively inexpensively - offer telecom services in these countries.

Hands Off
In the critical United States market, the Federal Communications Commission (FCC) has taken a hands-off stance. By providing a cheap alternative to traditional carriers, Internet telephony aids the FCC's efforts to force international phone rates down. Internet telephony service providers benefit from not being subject to the phone industry's regulatory encumbrances and subsidies, especially through their exemption from paying the usage-based local access fees which comprise much of U.S. long-distance carrier's costs. The FCC's laissez-faire attitude also reflects an unwillingness to interfere with the growth of the Internet, seen as critical for such important emerging businesses as electronic commerce.

While small Internet telephony service pioneers posed little immediate challenge to telecom giants, recent announcements by major players including USA Global Link, WorldCom and Quest Communications served as a wake-up call to traditional phone companies. USA Global Link, the leading provider of international call-back services, is leveraging its extensive network of offices and sales agents by installing IP voice and fax gateway servers in more than a dozen countries. WorldCom's UUNet subsidiary is deploying IP fax servers in 100 business centers throughout the U.S., Europe, and Asia. Quest plans to use its state-of-the-art U.S. fiber network to offer IP voice services for just 7.5 cents per minute.

U.S. long-distance carriers risk losing traffic to Internet telephony from their most important customers, businesses and heavy-user households. Spending for these customers is high enough to make Internet telephony attractive for certain types of calls. Businesses can deploy inexpensive, PC-based gateways behind their PBXs to selectively route calls over IP networks. For instance, all internal long-distance calls might be sent over either an intranet or the Internet. Corporate intranets can be designed to provide acceptable reliability and voice quality. This intranet application alone could eventually cost telcos billions of dollars. Businesses will be able to demand substantial rate reductions by merely threatening to implement such gateways.

Internet telephony's impact on international phone traffic will be even more dramatic. On most international routes enormous profit margins provide ample incentives for savings. Although the cost difference between providing domestic and international long-distance services is no more than a few cents per minute, international phone charges are generally several times as high as domestic charges. International rates, established through bilateral agreements among carriers, have been largely insulated from market forces. Since Internet telephony can be used to completely bypass the international pricing system, the pressure for reforming this cartel will intensify. As the quality and the reliability of Internet telephony improve, and gateway operators introduce phone-to-phone services around the world, traditional carriers will have to reduce artificially high international rates to retain their customers.

According to a recent research report, the use of IP networks for voice and fax calls is expected to cost phone companies $8 billion worldwide during the next four years. The report concludes that business customers and international callers will be the main beneficiaries of these huge savings. Initially, most of the impact will be on fax traffic.

Although Internet telephony threatens international, domestic long-distance and access businesses, the outlook for phone companies is not totally bleak. Telcos stand to gain new revenues from burgeoning Internet usage. Internet service providers (ISPs) have become important customers for business circuits and leased lines. Phone companies can also profit by providing high-speed backbone network services to ISPs. Moreover, Internet access is an important demand driver for added phone lines. Businesses often lease high-speed lines for Internet access, and many consumers get extra phone lines for data use.

Strategically, local exchange carriers (LECs) must participate in the ISP market. Internet access is the fastest growing segment of the local access business. Especially as they add voice capabilities, ISPs are fast becoming important local access competitors. If regulators compel LECs to offer sub-elements of local loops, ISPs are likely to quickly offer affordable, high-speed access based on digital subscriber loop technology. LECs failing to establish a strong position in the Internet access business may lose customer control to ISPs and long-distance companies. Although LECs could still participate by wholesaling local loops and some local switching capacity, they risk becoming subordinate players.

On the other hand, the voice business is attractive to ISPs. While enjoying rapid growth, most ISPs are struggling to find a profitable business model. ISPs can use IP-to-PSTN gateways to offer voice services, thereby increasing revenues from existing customers and expanding their customer bases. The added voice revenue streams can help overcome losses from flat-rate Internet access. Voice and fax services, including Internet accessible mailboxes, can also help ISPs distinguish their offerings and cement customer loyalty.

The shift to IP also has major implications for equipment suppliers. Research indicates that impressive sums will spent on gateways, directory servers, billing systems, and other gear needed for Internet telephony. Recognizing the importance of this emerging market, such mainstream vendors as Nortel, Lucent, and Cisco recently joined the smaller companies that launched the category. By legitimizing the concept, the entry of these well-known suppliers is expected to accelerate the business use of IP fax and voice and to boost network investments by service providers. Not only do these big suppliers have considerable marketing resources, their credibility helps offset customers' reticence due to the lack of standards. Though they face increased competition, smaller suppliers stand to benefit from the resulting market expansion.

Sim Hall is vice president of research for Action Information Services, a communications market research and consulting firm based in the Washington, DC area. Hall's 18 years of practical industry experience include senior marketing and product management positions at ITT Telecom and MCI Communications. Call 703-847-9805 for more information on the Internet telephony research report described in this article.

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