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Between a Rock and a Hardplace

Vonage In Print News

October 9, 2003
By Staff

With their core voice businesses in decline, incumbent fixed-line operators are shifting to broadband.

IT IS hard to get excited about fixed-line phones. You plug them in, you dial a number, you get through, so what's new? But Vonage, a small company based in Edison, New Jersey, has rustled up some magic with its breathtakingly clever phone technology. It makes you realise just how limited existing fixed-line phones are, and how much internet
technology can do to shake up the business of providing boring old telephony.

Vonage's phone service provides unlimited calls within the United States and Canada for $34.99 a month. Subscribers plug a standard phone into a small black box called an analogue telephone adaptor (ATA) and then plug the ATA into their existing broadband internet connection.

When they pick up the phone, they hear a normal dialling tone (which is faked by the ATA). If they dial a number, they are connected in the normal way. If someone dials their number, their phone rings. So far, so normal. The difference is that their calls are being routed across
the internet, which is why Vonage can offer such low prices.

Now things start to get more interesting. Because the phone is plugged into the internet, it can be anywhere. So you can take your phone and ATA (with, say, a New York 212 area code) to Europe or Asia and plug it into the broadband connection in your hotel room. Everything still works: people dialling your number from New York are still charged for a local call, and you can continue to call people just as if you were back in New York. For an extra $5 per month, you can associate a second phone number with the phone, perhaps with a different area code.

Another feature allows a subscriber to plug in lots of phones in different parts of the world, all of which ring when that subscriber's number is dialled.

Mobile phones have already introduced the idea of a phone that works around the world. But the Vonage model is even more disruptive, further undermining the connection between specific area codes and particular places. The company is expected to introduce a new tariff soon that includes unlimited calls to western Europe. After that, why not
unlimited phone calls to anywhere, for a flat monthly fee?

The logical conclusion of the Vonage model is the demise of distance- and time-based charges, with telephony becoming an internet-based subscription service.

That is not to say that Vonage is about to conquer the world. It is a tiny company, with a mere 50,000 customers. John Rego, Vonage's chief financial officer, says his firm is aiming for 100,000 customers by the end of the year, with the help of partnerships with internet-access
providers and cable operators, who are reselling Vonage's service in conjunction with broadband internet service.

For the incumbent telecoms operators, though, what is scary about Vonage is not the company itself but the disruptiveness of its model.

Vonage is a telecoms company with the agility of a dotcom. Everyone in the telecoms industry has heard of it, and has wondered what will happen if the model is widely adopted. "We're having fun, but the incumbent folks have issues to deal with," says Mr Rego gleefully.

Line Decline
That is putting it mildly. And the threat of internet-based telephony is just one of the many problems facing incumbent telecoms operators around the world, most of which are partly or wholly privatised former national monopolies.

They own the copper-wire network that runs into
their subscribers' homes, and have strong cash flows thanks to the monthly or quarterly standing charges paid by subscribers. But their businesses are in decline.

Their main problem at the moment is the rise of mobile phones, which are eating away at the incumbents' core business of fixed-line voice telephony. Such "fixed-to-mobile substitution" means people are making fewer calls on their land lines, and are doing away with second lines,
thus reducing operators' revenues. European incumbents' fixed-line voice revenues are expected to decline by 2.5% this year, according to J.P. Morgan, an investment bank. In some countries the drop may be as much as 12%. In America, the incumbents (the former Baby Bells) are watching fixed-line voice revenues decline by 7% a year. This is likely
to get worse with wireless number portability, which will soon let American subscribers transfer their fixed-line numbers to mobile phones.

Fixed-to-mobile substitution has gone furthest in mobile-crazy Finland, where the number of households with fixed-line phones has been falling since 1990, when it peaked at 94%. Nearly one in three Finnish households is now without a fixed-line phone. Switching to mobiles is easy in Finland, where wireless coverage is very good and users expect to be able to get a signal even in the most remote areas. But it is happening elsewhere too: 6% of British households, for instance, have already given up their fixed-line phones.

Incumbents are also losing subscribers to competing fixed-line operators. Regulations in most countries require incumbents to lease lines to other operators at low rates, to allow them to offer telephone services and introduce competition into the market without having to dig up roads and lay new phone wires. America's incumbents have so far
lost 10% of their customers to competing operators in this way. In some countries, cable operators are also offering telephony services and are wooing customers away from incumbents. The most technically savvy cable operators offer subscribers a seductive "triple play" bundle of
services for a monthly fee: telephone, broadband and cable TV.

Faced with competition from mobile on the one hand and fixed-line and cable operators on the other, as well as the longer-term threat of internet telephony, incumbents are fighting back in several ways. For a start, they are using new pricing structures, reducing their call charges and raising their monthly line-rental charges. This makes their
call charges look more competitive but shores up their revenues even as call volumes decline. That way, says Laura Mills, an analyst at Merrill Lynch, "even if people use mobiles, you still get paid." But by raising line-rental charges, she notes, incumbents risk prompting people to
give up their fixed lines altogether.

Taking this approach to its logical conclusion, some operators are doing away with call charges altogether, instead offering unlimited local and national calls for a flat monthly fee. This trend is most prevalent in America at the moment, but is also in evidence in other parts of the world, such as Britain and Scandinavia. Again, some
subscribers seem to prefer the simplicity and redictability of a fixed monthly charge, even though they may end up paying more as a result.

"Consumers will pay a premium for the predictability of flat-rate," says Vasa Babic of Mercer, a consultancy.

Several American operators are now offering bundles that include local, national and wireless calling, and sometimes broadband internet access too. This summer, many
operators struck resale deals with satellite-TV providers, adding TV to the mix.

But not everyone is convinced that such increasingly elaborate bundles make sense. Richard Klugman, an analyst at Jefferies, an investment bank, suggests that bundles are being driven solely by operators' desire to retain ustomers, rather than by actual consumer demand, which "makes it difficult to see these bundles as long-term solutions."

Joao Baptista of Mercer is also sceptical that stodgy telecoms firms can move into areas such as TV. "Companies are prisoners of their own DNA," he says. "They find it hard to expand beyond their core services."

In many European and Asian countries, the incumbent operator owns the largest mobile operator, and can therefore influence the rate of fixed-to-mobile substitution. France Telecom owns Orange, for example,
and Deutsche Telekom owns T-Mobile, the largest mobile operators in France and Germany respectively. Once the stockmarket recovers, however, this could prove problematic. Floating their mobile arms would
allow these two debt-laden incumbents to raise some much-needed money, but increased competition from mobile might then hasten the demise of their fixed-line businesses.

Regulation is another tool that incumbent operators have been using to defend their positions, notes Andrew Heaney of Spectrum, a consultancy.

In most parts of the world, however, regulatory decisions are going against incumbent operators as regulators strive to increase competition--though newcomers complain that incumbents are still making it hard for them to gain access to their networks.

Just as their voice businesses have gone into apparently terminal decline, however, a new market has opened up for incumbent operators: broadband internet access. By installing special equipment at telephone exchanges, operators can supercharge old-fashioned telephone wires and
turn them into fast broadband pipes, using digital subscriber line (DSL) technology. Subscribers in Europe and America typically pay around $50 a month for a DSL connection, so this provides a valuable new source of revenue for incumbents, which they are now racing to
exploit. Around the world, DSL is booming and has become the dominant means of providing broadband access to homes and small businesses.

Until a couple of years ago, many operators soft-pedalled on DSL deployment or made it prohibitively expensive. This was usually because they were trying to protect other parts of their business, such as ISDN (an old-fashioned form of data transfer over telephone wires) or frame
relay (an expensive way of providing always-on connections between two points), both of which cost far more than DSL. "Within telcos, you had different parts warring with each other over pricing, saying you're undercutting my product," says Sam Paltridge, a broadband guru at the
OECD. Regulations forcing incumbents to lease their facilities to competitors also discouraged some operators from investing in DSL equipment which they would then have to share with rivals.

Go For It
Eventually, however, incumbents decided that the benefits of embracing DSL outweighed the drawbacks. Many would-be competitors ran out of money and folded their tents. In some countries, cable operators began offering broadband access over their cable networks. Incumbents realised that if they did not cannibalise their own businesses, someone
else would, and that in any case DSL would massively expand their market. Indeed, the technology can help to dissuade customers from giving up their landline telephones, since it piggybacks on an existing telephone line which can still be used to make calls.

Incumbent operators are now repositioning themselves as broadband operators. When Ben Verwaayen took over as chief executive of BT at the beginning of last year, he declared that broadband would be at the heart of BT's business. "The threat of DSL is to ignore it, to put your head in the sand," he says. But embracing DSL requires incumbent
fixed-line operators to do the same as mobile operators: to switch from a predominantly voice-based business to one in which voice and data are equal partners. That entails a learning process for operators and, as with mobile data services, it means pricing and marketing broadband to
appeal to the widest possible audience.

Although broadband is growing fast, in most places this is not fast enough to offset the decline of voice, which accounts for 70-90% of most fixed-line operators' revenues. If they can move a significant proportion of their customers over to broadband, however, operators
should be able to offer a range of new data services on top of it.

"Operators are realising that broadband is going to be their future, and they need to migrate customers to it, but in a managed and controlled way," says Michael Philpott of Ovum, a telecoms consultancy.

To start with, that means careful control of pricing. Operators generally start with high prices, but once everything works smoothly, they bring them down to boost uptake.

Most operators in western Europe, says Mr Philpott, are pricing their broadband services to achieve 10% penetration, but that goal is still a long way off. To expand the market beyond that, as South Korea has done, requires a different approach in which operators provide
different levels of service at different prices. Instead of the usual DSL data rate of around one megabit per second, they offer faster connections (up to 6 megabits per second) to high-end users at higher prices, and slower connections (down to 0.15 megabits per second) to bring in more subscribers at the bottom of the market. Several
countries are also trying usage-based pricing, in which the monthly bill depends on how much is downloaded, but so far this has proved unpopular with users.

Another innovative service, already available in some Scandinavian countries, allows DSL subscribers to boost their connection speeds for a limited period, for a small fee. "If someone is going to send you a
large file, you might pay EURO1 to boost your DSL rate for an hour or two," says Mr Philpott. Mr Verwaayen calls this concept "liquid bandwidth". The idea, he says, is to be more responsive to customers.

Next, operators can start to offer different DSL services aimed at different types of user. Mr Philpott gives the example of QSC, a German DSL provider that offers specific DSL services for game-players, teleworkers and so on. On top of DSL, operators can sell extra features, just as on top of voice telephony they sell extras such as caller ID, call-waiting and voicemail. Teleworkers, for example, might
be offered secure links to their offices. Home users could be offered firewalls, anti-virus services and parental-control software to prevent children from looking at the wrong websites. Some operators are even offering DSL-based video services, music downloads and online software
stores. "We're more and more treating customers like members," says John Polumbo, the boss of AT&T's consumer business, which has just launched a software-download service. "We have a great opportunity here, to become the conduit."

This all sounds marvellous, but to get growth from DSL, incumbents will have to learn new tricks. They will have to become more data-savvy, form partnerships with content providers and market themselves in a different way. Mobile operators have been doing this for a while, and have made good progress in transforming themselves from stodgy
utilities to vibrant consumer brands. Incumbent fixed-line operators must now follow in their footsteps. Broadband is the key to their future growth, but the transition will be hard to manage.

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†AK and HI residents pay $29.95 shipping. ††Limited time offer. Valid for residents of the United States (&DC), 18 years or older, who open new accounts. Offer good while supplies last and only on new account activations. One kit per account/household. Offer cannot be combined with any other discounts, promotions or plans and is not applicable to past purchases. Good while supplies last. Allow up to 2 weeks for shipping. Other restrictions may apply.

1Unlimited calling and other services for all residential plans are based on normal residential, personal, non-commercial use. A combination of factors is used to determine abnormal use, including but not limited to: the number of unique numbers called, calls forwarded, minutes used and other factors. Subject to our Reasonable Use Policy and Terms of Service.

2Shipping and activation fees waived with 1-year agreement. An Early Termination Fee (with periodic pro-rated reductions) applies if service is terminated before the end of the first 12 months. Additional restrictions may apply. See Terms of Service for details.

HIGH SPEED INTERNET REQUIRED. †VALID FOR NEW LINES ONLY. RATES EXCLUDE INTERNET SERVICE, SURCHARGES, FEES AND TAXES. DEVICE MAY BE REFURBISHED. If you subscribe to plans with monthly minutes allotments, all call minutes placed from both from your home and registered ExtensionsTM phones will count toward your monthly minutes allotment. ExtensionsTM calls made from mobiles use airtime and may incur surcharges, depending on your mobile plan. Alarms, TTY and other systems may not be compatible. Vonage 911 service operates differently than traditional 911. See for details.

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