Why VoIP telephony is quickly coming of age

One of the pioneers of internet telephony this week reached a significant milestone. Vonage Holdings, a small New Jersey-based start-up, announced that, less than two-and-a-half years after it launched its first consumer services, one of the first consumer internet telephony services in the US, it had signed up its millionth paying customer. Jeffrey Citron, Vonage?s chief executive, talked of his company?s its having created ?a tidal wave of change? in a dormant telecommunications industry. or VoIP (Voice over Internet Protocol ) to give it its technical name ? claimed another success.?In a very short time, Vonage has woken up a dormant telecommunications industry,? and sparked a tidal wave of change,? said. noted, the announcement has much broader ramifications.

In the hyperbole-prone technology world, such claims might be easily dismissed. But most analysts agree that the recent dramatic growth of residential services and subscriber numbers using VoIP ? albeit from a relatively small base ? points to a big future for the technology.

wards the is a sign of future. Vonage is far from the only company involved: from the traditional incumbents in the telecoms sector to internet and media groups, a host of companies believe that VoIP will revolutionise the way people communicate. ?VoIP?s time has come,? says Michael Arden of ABI Research. ?Consumer VoIP is going to continue to grow.?

In its less developed days VoIP was for early-adopting ?techies?. of VoIP tended to be techies, but. The latest wave of converts, by contrast, are mainstream telephone users eager to capitalise on the generally low cost of internet telephony and the powerful features, improved features that it allows, such as call forwarding and the the chance to have calls directed to multiple lines.

Unlike most traditional phone calls, calls based on VoIP technology are digitised, chopped up into tiny electronic packets and then sent to their destination over the public internet. That translates into more efficient use of bandwidth and lower costs for VoIP service providers. This, coupled with the light-touch regulation fact that the ? for example the designation of VoIP as an ?information service? in the US exempts internet telephony from many of the taxes, fees, charges and regulations associated with traditional telecoms ? means cheaper services and smaller bills for consumers.

In the US alone, internet telephony services are expected to have about 4m subscribers by the end of this year. That is expected to grow to about 17m over the next few years, according to Jon Arnold, an independent VoIP analyst. In contrast, the number of traditional ?circuit switched? phone lines, currently about 125m, is declining steadily in part because of wireless and VoIP substitution.

Mark Main, an analyst at Ovum, a consultancy, predicts that within two years the US will overtake Japan, the world?s largest VoIP market with 8.3m subscribers, within the next two years. The Japanese are the real pioneers of VoIP where the entry of Softbank, the broadband services and internet group, into the market in 2002 drove rapid take-up. But it has been the accomplishments of Vonage and other independent VoIP pioneers, in the US and Europe such as the UK-based Skype Technologies, , the Luxembourg-registered UK company, that have grabbed attention as they internationalise their businesses. Their success has sent shivers down the spines of some of the world?s biggest telecommunications industry incumbents. already facing growing competition from mobile carriers and other operators. offering tradional analogue services.

It has also encouraged cable companies on both sides of the Atlantic to begin to offer versions of internet telephony. In the US, cable companies believe this will drive growth by allowing them to offer consumers a knockout ?triple play? package of voice, video and high speed internet services. Time Warner, the second largest US cable TV group, added 242,000 new internet telephony?subscribers in the second quarter. and Comcast, the largest US cable operator, plans to add 250,000 subscribers in the fourth quarter and 1m next year.

Across the Atlantic, cable operators in a sign of things to come could beprobably the most aggressive roll-out of VoIP services by cable operators is happening in the Netherlands, where levels of cable and broadband penetration are among Europe?s highest, the continent, have rolled out VoIP services aggressively. which along with Belgium is the most penetrated cable market in Europe. The Netherlands also leads the way in broadband penetration which now stands at over 50 per cent. Within a year of the roll-out, of VoIP all five cable suppliers are undercutting have undercut KPN, the incumbent phone company, on either call packages or line rental. or both. Roll-out only started last year but the incumbent?s KPN?s subscriber losses have already doubled within the year and Dresdner Kleinwort Benson estimates cable operators could gain 20 per cent of the voice market by 2008, up from 4 per cent today.

KPN in turn has reacted by launching a pilot stand-alone VoIP product (most others European incumbents still require customers to keep their traditional PSTN line alongside the broadband connection).

Also beginning to exploring VoIP are some of the internet world?s biggest names, such as Microsoft, Google and Yahoo. VoIP took centre stage recently with a string of announcements from three of the biggest internet names - Microsoft, Google and Yahoo! have now decided to play catch-up.Earlier This month Microsoft bought Teleo, a telephone internet company with technology that will allow anyone who uses Microsoft's MSN instant messaging service to make internet phone calls. A week earlier Google, Microsoft?s arch-rival, introduced Google Talk, a service that lets users of its increasingly popular Gmail web-based e-mail service talk to one another using a microphone and speaker. Yahoo?s purchase in June bought a company called of Dialpad Communications, a VoIP provider, will enable it to offer an internet telephony service. Meanwhile Skype is understood to be in early talks with eBay.

Uptake of broadband, which most VoIP services require, has been a key?gating factor? or bottleneck for VoIP. But the global broadband internet market is forecast to pass 190m subscribers by the end of next year and will approach 440m by the end of 2010, according to a reportpublished recently by Informa Telecoms & Media, the a market research firm and consultancy. In the US, the Federal Communications Commission estimates that 38m subscribers now have broadband connections.Niklas Zenn?strom, the founder and chief executive of Skype, says rapid broadband growth drives the take-up of VoIP. is being driven by the rapid growth in broadband, both via cable and the traditional telephone networks.?Over the next five to ten 10 years all traffic will migrate to VoIP. This is a function of internet penetration with broadband becoming ubiquitous,? he says.

?We are signing up new subscribers at an incredible rate,? claims Kevin Martin, the recently appointed FCC chairman.

Informa expects Sweden and Finland to have penetration rates at over 30 per cent, along with Japan and South Korea. It also expects growth in China and India to take off while it slows down in more mature markets like Western Europe and North America.

Since most VoIP services require a broadband connection, the uptake of broadband represents a

The most developed VoIP market in Europe is France where an attractive regulatory environment allowed Free, a rival to France Telecom, to take full control of subscriber lines, via a process known as unbundling, and began offering VoIP as a free service to broadband customers in August 2003.

Its success saw France Telecom respond aggressively by launching a VoIP product as a second line offering last year. Alice Enders of Enders Analysis says that a fifth of the 7.9m broadband customers in France now use VoIP. ?In France, there is no doubt that voice over broadband [VoIP] is so widespread because Free put a lot of pressure on France Telecom.?

Still, Many telecoms of the incumbents that formerly dominated national telephony markets ? and are these days already under intense pressure from traditional voice competitors, mobile operators and regulators ? are only just dipping their toe in the water with VoIP. Most face declining revenues in their fixed-line business as competition and the take-up of broadband, with its flat-fee model, eats into their traditional per- second charging. model.

At the same time, most of the incumbent telephone operators are engaged in upgrading their ageing ?public switched? telephone networks (PSTN) to IP technology, driven by the promise of huge cost savings. In the UK, for example, BT plans ?21CN?, a project one of the most ambitious projects by replacing to replace its entire analogue network with IP a project dubbed 21CN (21st century network), by the end of the decade ? which inevitably means VoIP will take centre stage. ?As we move to deploy 21CN and offer better and better products?.?.?.? like Broadband Voice we will be effectively replacing PSTN with VoIP services,? says Wendy McMillan-Turner, acting general manager of voice at BT.

Unleashing VoIP will further eat into revenues. Most incumbents are trying to manage the transition and at the same time offset the resulting revenue loss by developing more the premium services that the IP technology allows. France Telecom believes the flexibility of IP technology can halt the decline. ??PSTN revenues per user are going to decline but we don?t know at what pace. We are developing new services and customers will progressively benefit from broadband services instead,? says Olivier Sichel, head of France Telecom?s fixed- line business.

While many early adopters were attracted by the relatively low cost of VoIP services ? typically they cost half as much as traditional phone plans packages in the US ?. Vonage and other VoIP providers say that many subscribers place a high value on features such as include call logs, ?follow me? call transfer and automatic call blocking. In addition, Mr Arden says, the quality of VoIP service, a constant source of complaint, has improved markedly over the past 18 months. Such improvements make it increasingly difficult for traditional telephony providers to dismiss VoIP services as inferior or second-class.

compared with ?Pots? ? plain old telephone service. Nevertheless, VoIP providers still have to counter some negative perceptions. In particular, broadband internet phones are vulnerable to power outages, unlike ordinary phone lines, which carry their own power. In the US the FCC has also mandated required VoIP providers to make it possible for emergency services quickly to identify the location of a VoIP caller ? something that that early VoIP services lacked.

These limitations are still cited by some traditional telecoms companies as reasons why they do not yet offer stand-alone VoIP services. Others suggest that the incumbents in this radically changing industry are loath to embrace VoIP until they have to. ?Many traditional carriers have yet to fully depreciate all their investments in [circuit-switched] equipment and do not want to start offering VoIP yet,? says Mr Arden.

Time may be running out ? and Mr Main at Ovum believes the incumbents will come out emerge weakened from the expected huge transformation.

at the other end. ?It is likely that, in 10 to 15 years? time, PSTN as we know it won?t exist and it will be packet voice [internet telephony] in some form or other. It is hard to say what the market will look like but I think the incumbents will still be there, albeit weaker, and you will see the ISPs, like Yahoo, coming in with a number of other players on the horizon. It is all to play for.?

THE INTERNET PORTALS

With an estimated quarter of a billion users of instant messaging between them, three leading internet companies ? AOL, Microsoft?s MSN and Yahoo ? already have a big stake in real-time communications over the internet. Add voice and video to these messaging platforms, as all have been racing to do, and a battle with the worldwide telecommunications industry might seem to be looming.

That is not how the internet companies see things. Instead, they say that their particular brand of voice calling will co-exist with traditional telephone service. ?E-mail didn?t put the postal service out of business,? says Brad Garlinghouse, head of communications products at Yahoo. Such comments, though, may underplay the impact on traditional communications networks over the longer term.

Google last month also took its first step into voice communications ? though, with little to set it apart other than the company?s well-known brand and claims of superior voice quality, the Google Talk service may struggle to build the sort of big following of the established instant messaging companies.

For now, instant messaging still has clear drawbacks as a base for a creating a mainstream communications business. For a start, a desktop computer is not the ideal piece of equipment for personal voice communications ? though companies such as Yahoo aim to extend their services to mobile handsets, entertainment devices in the living rooms and other gadgets.

Another limitation is that the culture of instant messaging has in some ways grown up in opposition to voice communications. The teenagers who have been among the biggest users often employ simple text messages in preference to talking. As Allen Wiener, a research director at Gartner, says: ?IM allows them to communicate out of their parents? earshot.?

A further disadvantage lies in the fragmented nature of the messaging networks. AOL, MSN and Yahoo have dragged their feet on linking their networks together. ?There are no compelling business reasons for it to happen,? says Mr Wiener.

Also, their services do not connect to the public telephone network ? though in the past three months both Yahoo and MSN have bought companies with the technology to make this possible. Trial services that link messaging to the telephone system are expected before the end of the year.

Within these limitations, however, the internet companies still see plenty of scope to expand into voice calling. As more of the things people do move online ? from searching for information and shopping to playing video games and finding new music to listen to ? the built-in communications networks of the internet companies are likely to assume a more significant role.

The aim is to integrate voice calling into other internet activities, says Mr Garlinghouse. Examples he lists include using a search engine to find a restaurant, then clicking on a link that places a call directly to the restaurant?s reservation line.

Players of video games might want to talk while competing online ? as they already do on Microsoft?s Xbox Live service. Future audiences for films or television shows that are distributed online might use a built-in communications network to discuss their favourite entertainment.

Turning voice calls into another feature of life on the internet in this way may not seem an immediate challenge to the telecoms industry. But if more interaction takes place over the private networks such as Yahoo?s, that cannot bode well for others in the communications business.

THE TELECOMS INCUMBENTS

For the old-style telecommunications industry, the advent of internet telephony represents a challenge that some players have embraced but others still resist.

In the US, AT&T launched its consumer VoIP service, dubbed AT&T Vantage, after it decided to scale back its traditional consumer telephone operations in the face of mounting competition and regulatory changes. SBC Communications has indicated it is likely to adopt the service after it completes its acquisition of AT&T but has yet to make clear whether it will market the service aggressively.

Verizon Communications launched its VoIP service, called VoiceWing, a year ago and says it is ?happy? with the uptake although it declines to provide numbers. It targets VoiceWing, which costs from $20 a month, at market segments including early adopters, its own broadband internet subscribers and customers who call to cancel their regular phone line. ?We are not trying to convince everybody that they need this,? says the company.

The New York-based group acknowledges that voice traffic is gradually migrating to the IP standard, saying: ?One day VoIP will be the norm.?

Verizon and other big regional carriers are paying close attention to the cable network operators, which have spent billions of dollars upgrading their networks and preparing them to support VoIP services. Most cable operators have begun marketing broadband telephony alongside their video and internet data services. ?We see Internet telephony as the next growth driver,? Comcast, the country?s largest cable company, said recently.

US cable VoIP subscribers leapt from 911,000 at the end of March to more than 1.38m at the end of June, according to Kinetic Strategies, publisher of Cable Digital News. Over the next 12 months, nearly every big cable operator in the US is expected to offer broadband telephony services, which could add to downward pressure on voice pricing and, some analysts believe, accelerate line losses among the telecoms incumbents. Verizon reported a larger than expected decline of 518,000 consumer telephone lines in the second quarter, in part because of competition from cable companies.

In Europe, the picture is starting to look similar. KPN of the Netherlands is among the privatised former telecoms monopolies feeling the pinch from the cable companies, which actively started marketing VoIP last year, having failed with previous telephony offerings. Eelco Blok, KPN?s director of strategy and innovation, is a 23-year telecoms veteran and says the advances in technology have shaken the industry up. ?Things are changing incredibly fast. It is unbelievable what is happening.?

KPN is rolling out stand-alone VoIP, which does not require customers to keep their analogue line. Mr Blok says ?several thousand? have signed up but the company is taking no further subscribers for two months as it seeks to resolve quality issues with the service. ?We still have some problems. We are looking to offer at least mobile quality but as near to traditional quality as possible.?

He acknowledges that the threat is not only from the cable operators but the likes of Vonage, Skype and big internet players such as Yahoo and Microsoft. ?There is not one who is very high on the list: we are watching them all.? Like other incumbents, the Dutch carrier is hoping to replace lost revenues with premium services, such as home security and remote health monitoring.

France Telecom has not gone for a stand-alone broadband voice product but has responded aggressively in the most highly penetrated VoIP market in Europe. Since it entered the race in June last year, the take-up has accelerated and more than 1m customers use a VoIP offering from their broadband supplier. Olivier Sichel, head of the company?s fixed-line business, says: ?I see a process of five to 10 years. This is part of a major trend of digitisation [across industries], so it will come as no surprise that voice at one stage will all be digitised too.?

Other incumbents have been more reticent about deploying the new technology, largely because of different competitive pressures in their domestic markets. BT in the UK, for instance, is facing intense competition in traditional telephony services and broadband but regulatory conditions have made it less attractive for would-be VoIP suppliers, though that is changing.

Wendy McMillan-Turner, head of BT?s voice services, says the incumbent is gearing up to push its two VoIP services, which have so far attracted fewer than 70,000 users. ?Watch this space for more on VoIP in the coming months.?

In Japan, the birthplace of consumer VoIP, NTT, the fixed-line incumbent, has been slow to compete with the rival Softbank as it looks to hang on to its legacy network rather than invest in fibre optics to meet standards the regulator requires before it will drop the stipulation that VoIP numbers must have a separate an obstacle to uptake.

NTT, which has just 32,000 VoIP subscribers, is aiming to increase that figure to 1.6m by March. As of March this year, Japan had 8.3m VoIP subscribers out of 60m phone lines.

THE STAND-ALONE PIONEERS

When Vonage Holdings launched its first VoIP service in 2002, few outside the US telecommunications industry took much notice. Earlier internet telephony services based on computer-to-computer communications had made little impact beyond technology enthusiasts.

But Vonage was different. Instead of relying on software downloads and limiting VoIP calls to computer users running the same software, its service is based on a low-cost adapter that plugs into a cable or DSL broadband connection and a standard telephone.

Once installed, the hardware enables users to make calls over the internet to any phone number, typically for a fraction of the cost charged by incumbent telecommunications companies. Like other independent VoIP service providers in the US, Vonage offers its customers monthly call packages starting at $15 a month ? less than half the cost of a similar 500-minute plan from one of the incumbents.

That simple formula has enabled the New Jersey-based start-up to sign up 1m users and expand its workforce from 50 to more than 1,500. Vonage has launched similar services in the UK and Canada and has plans to expand into other overseas markets. At the same time, the company is increasing its range of services and products. It recently launched a broadband-enabled cordless phone and will launch a Wi-Fi VoIP handset next month.

In addition, Vonage continues to cut prices. Last year, the company reduced its charges by nearly 30 per cent, twice undercutting the list price of AT&T?s rival service, called CallVantage.

Vonage?s success has prompted speculation that the company, which has raised $408m in the private equity markets to date, could soon tap the public equity markets with an IPO designed to raise up to $600m. Vonage declines to comment on the rumours.

Similar speculation has been swirling around Skype, an internet telephony company launched two years ago by Swede Niklas Zennstrom and Dane Janus Friis, who also set up Kazaa, the file-sharing company. Some analysts have suggested that Skype could be worth up to $3bn. Others have their doubts, pointing out that it could be difficult for the company to monetise its model.

Officially headquartered in Luxembourg but run out of London, Skype developed software that allows users to make free computer-to-computer based phone calls over an internet connection. Most of the company?s 27m active users use only this service, but 2m are paying for value-added services, including SkypeOut, which allows subscribers to call fixed-line numbers at about 2 euro cents a minute. Calls to mobiles are not necessarily at the lowest rates available, costing up to 25 euro cents a minute.

Mr Zennstrom says a core aim of Skype is to charge customers as little as possible. Skype is disruptive, he says, because its customer acquisition cost is close to zero, unlike Vonage, which he claims spends around $400 per customer. ?Our model is to make very little from each customer. We think the less we can make per customer the more competitive we will be.?

Steve Blood, telecoms analyst at Gartner, estimates that paying Skype users may only spend around ?50 ($62) per year, giving the company revenues of ?100m. This would make a $3bn valuation extremely steep and makes many in the industry nervous.

?It is only five years since the dotcom boom and so it is surprising that people would base super-high valuations on users who are mostly downloading stuff for free. You would have thought they would learn their lesson,? says Lars Godell, telecoms analyst at Forrester.