Phone Industry Faces Upheaval As Ways of Calling Change Fast

By KEN BROWN and ALMAR LATOUR
Staff Reporters of THE WALL STREET JOURNAL
August 25, 2004

In just over a year, one out of every eight households in the Portland, Maine, region has signed up for Internet phone service supplied by Time Warner Inc.'s cable-television unit. For many, the phone jack in the wall that connects to the phone company's network is now just a useless hole. Time Warner is rolling out the same service to millions of consumers nationwide.

It's one more sign of a telecommunications upheaval that's unfolding at warp speed. And it isn't good news for Bell phone companies such as Verizon Communications Inc., which through its predecessors has controlled local phone service in the Northeast since the start of the 20th century. Already, Verizon's traditional phone lines are down by nine million, or 16%, since the end of 2000, according to research firm Precursor Group.

Across the nation, the business models that have worked for decades for Verizon and other phone giants are showing signs of unraveling. The cable industry's push into the phone business and a torrent of innovations such as Internet calling and advanced wireless technology are threatening the foundations of the nation's $300 billion telecom industry.

"Our industry and our business is going to change more in the next five years than it has during the last 20 combined," says Duane Ackerman, the chairman and chief executive of BellSouth Corp., the local phone company in nine states.

Some compare this accelerating shift to the threat faced by railroads in the boom years following World War II. As the nation embraced the automobile and airplane, railroad officials worried about the new technologies that circumvented their network of tracks.

"The thought was, if you invested in old technology and made it look better and run faster, it would save the day," says Jim McClellan, a retired senior executive with Norfolk Southern Corp. It didn't work, and long-distance passenger rail service virtually disappeared in much of the country.

Phone companies are scrambling to avoid the same fate. AT&T Corp. is retreating from the traditional consumer phone business. The onetime business icon recently saw its bonds reduced to junk status. Other phone companies are feverishly trying to copy the services offered by newcomers.

Two years ago, the regional Bells that were created by the 1984 AT&T breakup looked as if they would emerge as the winners of the telecom bust. As owners of the nation's local phone systems, they had what appeared to be a surefire advantage: direct lines into America's homes and offices.

Now, new technology is hurting the value of that network. The Bells have lost some 28 million local phone lines since the end of 2000 -- a drop of more than 18%. This is the first time since the Great Depression that phone companies have seen their lines decline. The Bells are now losing 4% of their residential lines a year. The trend is worsening as cable companies rush to match the kind of success that Time Warner has enjoyed in Maine.

Cablevision Systems Corp. signed up 115,000 phone subscribers in just over seven months in its New York region. Cox Communications Inc., the Atlanta-based cable company, is already the 12th-largest phone company in the country, with 1.1 million Internet and traditional phone customers. Comcast Corp., the nation's biggest cable company, plans to offer Internet phone service to 40 million homes by the end of next year. And Internet phone start-ups like Vonage Holdings Corp. and Skype Technologies SA are signing up thousands of customers.

The phone companies are furiously trying to cut costs to stay ahead of declines in revenue. The Bells are trying to add new kinds of revenue by teaming up with satellite television companies, offering packages of phone, broadband and TV service. But their basic business still is selling a high-priced commodity in a market that is now highly competitive. Standard & Poor's has put three of the Bells -- Verizon, BellSouth and SBC Communications Inc. -- on "credit watch" for a possible downgrade.

Many industry executives expect consolidation, although deals have been few because buyers are afraid of paying too much for businesses that have uncertain futures. Last fall, BellSouth considered making an offer for AT&T. It later backed off, but many still believe the Bells will eventually buy the remaining big long-distance companies, AT&T and MCI Inc., formerly called WorldCom.

Transforming Commerce

Behind the telephone earthquake is a giant force in business history: Just a few years after the Internet investment bubble spectacularly burst, the Web is now maturing and irrevocably transforming commerce. Today phone calls -- just like music, photos, and video -- can be turned into digital information and delivered much like e-mail over the Internet.

While the upheaval is harsh for companies and their investors, it is a windfall for consumers, who benefit from ever-lower prices and new services.

A glut of fiber-optic networks built during the telecom bubble of the late 1990s, combined with the rise of Internet calling, is also making it easier for companies to outsource operations to India, China and other countries. And because there's now so much fiber-optic capacity, any new phone-service competitor that wants to tap into it can do so cheaply.

For decades, the only way to make a call was on a dedicated line over a phone company's network. Phone companies paid for those networks by selling calls by the minute. But now, those expensive networks represent just one of a number of ways to send a call, undermining the foundation of the phone companies' business model.

"Anyone who wants to go into the phone business can do it," says Bryan Martin, the chief executive officer of 8x8 Inc., in Santa Clara, Calif. His company offers unlimited local, long-distance and video calling service under the Packet8 brand name for $29.95 per month.

The shifts have intensified pressure on the long-distance companies. AT&T's revenue is down 18% in the past three years and is expected by some securities analysts to decline a further 30% over the next three years.

The Bells are also feeling the pain, with the weakest of the four, Qwest Communications International Inc., getting hit hardest. In Omaha, cable company Cox has replaced Qwest as the city's largest phone company. Qwest has lost three million lines since the end of 2000, including 200,000 in the second quarter alone. At that rate, Qwest is losing an estimated $200 million in high-margin revenue each year, according to Gimme Credit, a bond-research company. Qwest has laid off 10,000 people in the past two years.

Qwest Chief Executive Richard Notebaert's strategy is to jump over to the new technology as quickly as possible. Qwest became the first Bell to start its own Internet-calling service last year. Qwest is also testing advanced wireless technologies. "It has become one big communications sector. People really haven't grasped that," the Qwest CEO says.

He recently showed his board of directors a mock 19th-century argument for blocking the development of railroads to protect business on canals. His point: Such resistance to change is futile. "If you don't embrace new technologies as an opportunity, then you could find yourself like the riverboat. You can either grab it or be a victim," Mr. Notebaert says. The trouble is, the Bells have such high overhead that the upstarts can easily underprice them.

The other three Bells are far stronger than Qwest and are benefiting from their own wireless operations. But the U.S. wireless market is one of the most competitive in the world, with six national players. Meanwhile, the Bells all have contracts with powerful unions that make it harder for them to cut workers.

Over the past century, telephone companies invested $200 billion to build networks that give each call a unique path. The voices of callers are turned into a series of electric pulses that travel over a dedicated line between them, just as when Alexander Graham Bell invented the telephone in 1875. Although mobile phones transmit calls initially over radio waves to cellphone towers, the calls are then carried through those same networks in much the same way.

With Internet calls, the speaker's voice is converted into the zeros and ones of digital data and divided into dozens of packets that make their way through the public and private networks that form the Internet. Within a split second, they are reassembled and converted back to sound. Such calls usually require users to have a broadband, or high-speed, connection to the Internet. They can be carried over privately owned networks, such as those owned by cable companies, or over the public Internet. In most cases, the caller uses a regular phone that plugs, indirectly, into the computer's modem.

Getting into the Internet-calling business is fairly easy. With less than $100 million in start-up funds and just 450 employees, Vonage has signed up nearly 250,000 paying telephone customers in two years. "We're aiming to become what AT&T was not that long ago: a national local and long-distance player," says Jeffrey Citron, founder and chief executive of the privately held company in Edison, N.J.

Luxembourg-based Skype, started by the creators of the music-sharing program Kazaa, began offering software to make Internet calls via computers almost a year ago. Some seven million people have downloaded Skype software, and the service handles roughly 1.2 million calls a day. The software and the calls are free. Recently, Skype reached a deal to let its users make, though not receive, calls to regular phones for a small charge. Skype owns no network, spends next to nothing on marketing and is run by 50 employees.

In rural areas, historically a lucrative market for traditional phone companies, about 2,000 tiny telecom start-ups with names like Prairie iNet LLC are offering high-speed wireless Internet access and phone service for far less than the incumbents. Because their costs are far lower, they can be profitable with as few as 100 customers.

Prices are already falling quickly. With a slew of ads during the Olympics, AT&T is pushing an introductory offer of unlimited Internet calling for $19.95 a month. That's $10 less than similar plans at Vonage and Verizon.

Entrepreneurs who want to start a Vonage-like phone company can get access to software, ready-made Web sites and fiber-optic networks from wholesalers such as Covad Communications Group Inc. Covad charges $25,000 for a basic set of services needed to start an Internet phone business.

One of its customers is Unity Business Networks LLC of Denver, which has been selling Internet calling services since March 2003. With 20 employees, Unity has signed up about 70 small businesses as customers. "It's unbelievable how much we can offer for such a small investment," says Bob Paulsen, Unity's co-founder and president. The company has revenue of roughly $750,000 and says its cash flow turned positive earlier this year.

Analysts predict that roughly a third of U.S. households will have high-speed broadband connections by sometime in the next year, up from 21% at the end of 2003. Once people have broadband, they're likely to end up using an Internet phone. In Japan, around half of the 14 million broadband households are using Internet phones -- so many that the government has created a new area code for them. The number of U.S. households with Internet phone service -- about 100,000 at year-end 2003 -- is on pace to hit 800,000 by the end of 2004.

The transformation in the industry is not exclusive to the U.S., and could ultimately break down the national boundaries that often restrict the telecom industry. Indeed, Internet calling technology makes it easier for European phone companies to offer phone service in the U.S. -- or anywhere else in the world where there are broadband Internet connections -- and vice versa.

The most ominous assault on the traditional phone business is coming from cable companies, which increasingly need to move into a new business because of competition from satellite-TV companies.

Cablevision recently offered new customers a package of high-speed Internet access, digital cable television and Internet phone service for $100 a month. Time Warner Cable aims to have phone service available in all of its 31 markets by the end of the year.

Doreen Toben, Verizon's chief financial officer, says she isn't overly worried about the rise of start-ups such as Vonage because they have only a small number of customers. However, she calls phone service from cable-TV companies "a real threat."

U.S. businesses, from Morgan Stanley to JetBlue Airways to the Boston Red Sox, are embracing Internet phoning to save money and take advantage of its features. One example: With an Internet phone, a manager can leave voice-mail messages for dozens of staffers with a single call.

The Visiting Nurse Service of New York, which has about 10,000 employees, expects to slash its payments to Verizon and other phone companies by $250,000 a year by using Internet phones. Operators at the service's after-hours call center are next to the midtown Manhattan site where the Republican convention will be held next week. They have to move temporarily. Because they have Internet phone accounts, that will be relatively easy. Since the operators will have a high-speed hookup at their new location, they'll automatically have phone service too -- without the need for a service visit by a phone company.

New Internet technologies could also help people make an end run around traditional cellular networks. One such technology is Wireless Fidelity, or Wi-Fi, which many people use for high-speed access to the Internet at coffee shops and other public places. Just as broadband connections designed for computers paved the way for Internet calling from home, wireless broadband connections for computers could transform the traditional cellphone.

In July, Motorola Inc. announced it would start selling a combination WiFi-cellphone later this year. The phone is designed for businesses that have installed a Wi-Fi station in their offices. The phone works as an Internet phone via the Wi-Fi link when the caller is in the office. Elsewhere, it must use the regular cellphone network.

One limitation of Wi-Fi is that the range of the base station is only a few hundred feet. But a Waltham, Mass., company called TowerStream Corp. has installed transmitters in Boston, New York, Chicago and other cities that can serve businesses in a radius of five to 10 miles. The private company says it can offer wireless broadband service for half the price of traditional phone companies. TowerStream customers include the Boston Public Library and the corporate headquarters of retailer TJX Cos.

Base stations using a new standard called WiMax can send and receive signals from as far as 30 miles away. Executives at Intel Corp., a big WiMax backer, boast that base stations to supply the entire city of San Francisco with broadband signals could be built for just $250,000. Intel would benefit by selling more computer chips.

The regional Bells hardly consider themselves endangered. With their marketing muscle and big research budgets, the companies believe they'll be the ones to bring the masses into the Internet-phone age.

Qwest has run trials of WiMax, for example. And at a lab in Dallas, Verizon is building a souped-up phone called Verizon One. It looks similar to a regular phone but includes a high-speed Internet modem as well as a color screen. One future possibility: Verizon could offer rebates on the new phone as part of a package of broadband Internet access, unlimited Internet voice calling and free video-conferencing.

Verizon and other Bells are also investing billions to run fiber-optic lines into homes and offices, hoping to offer faster and more reliable broadband service than the newer competitors. Says Shaygan Kheradpir, Verizon's chief information officer: "We can wait for disruptive technologies to create new markets we have to try to catch up to, or we can be our own transformation machine."

For additional information contact:
Neil J. Mulholland, Prairie iNet, 515/440-0848, ext. 106