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Major Carriers on Collision Course With Voice Over Internet Protocol

January 2005
By Henry S. Kenyon

Improved sales to drive industry in 2005, but new technologies challenge established pricing schemes.

After several years of depressed revenues, the telecommunications industry is poised to recover in 2005, experts say. Rebounding from the historic lows of the past several years, the equipment manufacturing sector can expect robust growth while gains for services will remain modest. But storm clouds loom on the horizon as emerging technologies such as broadband and voice over Internet protocol threaten to radically change traditional service carrier arrangements.

The immediate market forecast predicts a healthy year for sales of communications hardware, says William L. Hahn, a senior telecommunications market analyst for Gartner Incorporated, Stamford, Connecticut. Based on data from the third quarter of 2004, Hahn predicts that the market peaked at $1.4 trillion between equipment and services last year. Compared to 2003, the market grew by nearly 9 percent in 2004.

However, the recovery is primarily restricted to the manufacturing sector, which has begun to recover from the industry’s historic losses in 2001 and 2002. Conversely, the service sector will remain largely flat, with a mid-single-digit growth curve extending over the next five years. “I think the net result is tremendous growth in some sectors and really an absolute decline—at least in developed markets. It’s going to work out to healthy growth overall, but there is a lot going on within the sectors,” Hahn explains.

The reason for such mixed results is the introduction of several new technologies. These new capabilities are creating turmoil in established service sectors, placing the market on the brink of major change. Although he is unsure about the money-making opportunities presented by these coming developments, Hahn is certain that they will affect how individuals and businesses use and access telecommunications systems.

A driving force behind this change is the convergence of several technologies such as broadband and voice over Internet protocol (VoIP) systems. Broadband services have done well in consumer markets, even during the recent recession in the United States. But, while its growth is encouraging, Hahn is unsure about pinning the hopes of an entire industry on this one capability. Likewise, VoIP services continue to penetrate the market, but no single money-saving application has yet to attach itself to the technology.

Gartner research indicates that no single killer application will drive the market in the near future. Instead, capabilities such as Internet protocol (IP) telephony will lead a critical mass of converged applications that will have a transformational effect on the market, although the outcome is hard to predict. “I think that we’re going to go back to the entrepreneur’s level. Individuals are going to figure out really cool things that can be done,” Hahn says.

Typically in such entrepreneurial opportunities, individuals and small to mid-size companies will find and develop new products and applications while the major telecommunications carriers take a more cautious approach, notes Hahn. Although major providers such as Verizon and AT&T will make sure their networks are ready for these future applications, their size and business approach are not suited to be on the leading edge of this change, Hahn observes. “They have to wait and see where the new Google and eBay come out and what people want from them,” he explains.

By providing bundled services such as voice, data, video and wireless communications, telecommunications providers will continue to attract customers. VoIP also allows this convergence to be more efficient because a network can run voice and data on the same lines with the same protocols. This added capability allows carriers to generate additional revenues on what are now very thin margins.

Because VoIP systems operate on the Internet, however, they present a threat to established telephone network providers in a number of global markets. For example, in the United States, a carrier such as Verizon must lease its lines to competitors’ IP services. Hahn notes that Gartner’s analysis generally supports claims by major carriers that current Federal Communications Commission (FCC) regulations are causing them to lose money because they cannot make a profit from mandated lease rates. “The competitor can grab that lease line—just the portion they want—however much service they are prepared to offer, and then they can approach the customer and offer them a voice over IP number. Or they will offer a DSL [digital subscriber line] modem and broadband service over VoIP. They will give you your telephone, and they probably won’t even mention that it’s provided by VoIP,” he says.

This approach allows new contenders to save money by providing converged applications while major carriers must lease their lines to them. However, Hahn notes that the FCC recently sent a letter to the top 200 U.S. carriers urging them to consider negotiating more reasonable leasing terms. He believes that this is a sign that the industry is realizing that the unbundled network regime is unwieldy, produces litigation and traps regulators in arguments about inconsistency of services. “As a      long-term experiment in increasing facilities-based competition, unbundled networking does not appear to have been successful. So we think the recent FCC letter is a nice step forward. It may also signal that [the FCC] intends to move away from such strict regulation in the future,” he says.

Another area of contention is the issuing of separate numbers for VoIP lines. The United Kingdom has regulations that create a specific code for users of the new system, but in the United States, the FCC has ruled against a separate listing. The British method helps incumbent systems because the VoIP provider is identified while the U.S. approach favors small service providers. Although this system protects competitors from being stigmatized, Hahn believes that issuing regular telephone numbers to VoIP lines will ultimately mean that area codes will have little real geographic meaning in the United States.

Israel is an example of some of the potential pitfalls of this incumbent approach. The Israeli government helped cable companies package their services to compete with traditional telephone carriers. As in the United States, Israel did not designate a separate telephone code for these bundled services. Because VoIP resides on the Internet, service can be provided from anywhere in the world, and this can potentially cause problems. For example, Hahn speculates, “What if people living in Tel Aviv suddenly discover that this vital net service—this cool thing they want with this number that appears to be local to Tel Aviv—is actually sourcing in Syria or Palestine?”

Such a situation could generate a huge outcry, even if the services provided are benign, because some customers would object to their numbers being sourced in an Arab country. Hahn adds that this situation could apply to the United States if what appear to be local numbers are actually based in Asia.

VoIP systems also can affect network providers’ pricing regimes. For example, a New York-based business with offices in the Philippines could get a number with a 212 area code and have it ported to the United States. This would allow the company to communicate with its overseas offices as if it were a local call. Such overseas connections can be done through a relatively crude dial-up Internet connection costing as little as $10 a month. “In reality the call is traveling thousands of miles both ways, but there’s no access charge and no international settlement fees. It does an end run around all that,” Hahn says.

However, in the United States and in many other markets, major carriers such as Verizon have the option of copying these services and trying to win over customers who might sign up with competing VoIP providers. The challenge is to make money from this, Hahn says. In the mid-1990s, long-distance settlement fees were very high until the FCC took steps to lower rates. But, for places like the Philippines, these fees are still above market levels.

VoIP providers manage to avoid this structure entirely. “It’s going to create a market that flows completely around the present charging scheme. This scheme subsidizes trillions of dollars a year worldwide. It subsidizes residential users at the expense of business; it subsidizes long distance at the expense of local calls. All of this is potentially going to go out the window when VoIP connections make it to the access side,” Hahn says. He notes that VoIP already is used to transport calls between switches, but the system is still overwhelmingly circuit switched. It is in this circuit-based realm where the charging mechanisms exist, and these are the pricing structures that are threatened by VoIP.

Service providers are bracing themselves for this change, but additional rules may be difficult to come by because VoIP is so intimately connected to the Internet that it is a potential hot potato for regulators. “No one wants to be seen as anti-Internet, and the Internet is free. That’s the whole nature of it—it’s radically open—and the idea that even if it were technically feasible you’d impose some kind of access charge regime on VoIP calls is politically very distasteful,” he says.

Hahn believes that it is unlikely that any sort of access charge regime will be imposed on U.S. Internet protocol telephony providers. He notes that while new firms like Vonage are winning permission to have their calls considered free of access charges, some carriers like AT&T attempted to classify the shunting of data between switches as VoIP. The FCC rejected this notion.

Social considerations may blunt some of the jump to Internet telephony. An important issue is whether VoIP operators should be required to provide their customers with the ability to make free 911 calls because this feature is not built into VoIP systems. Unlike circuit-switched systems that track the location of emergency calls, the decentralized nature of the Internet makes it very difficult to locate a 911 caller. “People aren’t going to like it if the ambulance didn’t get there because somebody had an IP connection. Even if a new entrant makes it clear in their fine print that they weren’t required to do it, they’re probably still going to get sued,” Hahn says.

Growing pressure ultimately may require new entrants to provide a 911 capability, but this will cost money and eat into their profit margins. IP telephony also must comply with the Communications Assistance for Law Enforcement Act of 1994 and the Homeland Security Act to permit authorities to conduct wiretaps and locate suspects. This compliance will lead to additional expenses and cut profits further, he says.

Despite these hurdles, VoIP technology will continue to make inroads on traditional circuit-based systems, but this revolution will be mostly transparent to the customer. “They are never going to really notice that they have this new way to place their calls,” Hahn says.

Gartner’s analysts view the coming merger of technologies and services as more of a collision than a convergence for the telecommunications industry. A possible outcome of this impact is that the major carriers may be reduced to owning the infrastructure like utility companies. Meanwhile, smaller firms and other businesses may use IP telephony to provide targeted services. “It’s not hard to foresee a scenario where the big media and entertainment companies, who have the video content, and the professional services companies, who are adept at serving business, could merge together and squeeze telecom out,” he says.

Web Resources
The Gartner Group: www3.gartner.com
How VoIP Works:
http://computer.howstuffworks.com/ip-telephony.htm
Pulver.com: www.pulver.com
Vonage: www.vonage.com