The Future Is On The Line Meet VOIP, the hot new technology that promises to cut your phone bill and change the way you communicate (never mind the geeky name).
(FORTUNE Magazine) – Parade, the happily middlebrow magazine that comes with Sunday newspapers, is hardly the place you'd look for technology that is about to rock a $750-billion-a-year industry. Yet on June 6, sandwiched between the gossip column and an essay by Miss Teen USA, there it was: a blurb recommending a phone service from a company called Vonage, which promises cheap rates by shipping calls on the Internet.
Vonage, a New Jersey startup that has received similar buzz in such high-tech journals as Cigar Aficionado and the Killeen (Texas) Daily Herald, is the froth on a vast wave of change that has begun to engulf the telecom world. Cable television giants are jumping into the same body of water: They've just started to offer phone service using Voice Over Internet Protocol technology, or VOIP (pronounced "voyp"). AT&T, which invented phone service, is in the game too: It hopes to ride VOIP back into the local phone business. And Cisco Systems, which has long dominated the Internet router market, is betting big on the technology (see following story). It wants to be to the new Internet-based phone network what Ma Bell was to the phone system of the 20th century: chief architect and equipment supplier.
Like most revolutions, this one isn't going to happen overnight. The most optimistic forecasters predict a scant three million American homes will use VOIP by the end of next year. But what's clear is that VOIP is at an inflection point. A vision of how change might unfold comes from the Yankee Group: Starting in 2006, the research firm predicts, VOIP will really take off, and by the end of 2008 some 17.5 million users, or about 16% of U.S. homes, will be VOIPing--the beginning of mass-market acceptance. Those guesstimates may be high or low. But the economics and features are too compelling for VOIP not to happen.
The new technology promises to change the way you make phone calls and whom you pay to handle those calls--if you pay for them at all. VOIP's impact will be more profound than that of either cellphones or the Internet, largely because it encompasses both. Like the wireless and Internet phenomena, VOIP has the potential to buoy a raft of new household brands. Fortunes will rise and fall as traditional phone companies, cable operators, and upstarts fight to sell you more convenient, cheaper, and way cooler phone services. And it will increasingly marginalize the century-old traditional phone network, replacing it with a sleek new system of interconnecting data pipelines that will deliver calls, movies, messages, games, and whatever else can be digitized.
Yes, we know it all sounds like rhetoric reheated from the mid-1990s, when everyone was babbling about cable and telecom "convergence." But the revolution is very real. Federal Communications Commission chairman Michael Powell believes that VOIP will irreversibly alter the world of communications. VOIP, he has said, represents the "most significant paradigm shift in the entire history of modern communications since the invention of the telephone."
What makes VOIP exciting and potentially explosive is that it promises to fuse two parallel communications universes: the phone system and the Internet. Since its inception, the plain old telephone network has operated on the same basic principle: Every phone call opens up a dedicated circuit for its duration. This method is reliable but inefficient. With the Internet, on the other hand, data are chopped into little packets and traverse the network in random order, to be reassembled at their destination. Chaotic, yes, but incredibly economical and flexible.
The ascendance of VOIP means phone calls are becoming just another kind of data, no different from e-mail, instant messages, and digital pictures. It's a bigger deal than it appears: When phone conversations start speaking the same language as data, amazing things can happen. Monthly phone bills can go down significantly, as readers of Parade are now aware. Calling also gets more manageable and more personal. With VOIP, you can customize your phone service to do exactly what you want. Want to forward calls from your boss to your cellphone? Log on to your friendly VOIP website and activate the call-forwarding function. Want to caucus about dinner plans with your ten closest friends? Set up a conference call online by entering their numbers and clicking your mouse a few times. And because calls are basically data applications (you might think of them as talking e-mail messages), callers eventually will be able to "attach" other data to a call--faxes, say, or moving images, thus enabling the long-awaited arrival of videophones.
Unlike traditional residential phone service, which is "fixed" to a jack in the wall, most VOIP services will work anywhere. Say you're spending the week at your beach house but want to make and receive all the calls you would at home. You can use your VOIP service to simply forward your home calls to your cellphone. Or, perhaps better, you can unplug the gadget that comes with most VOIP services today, attach it to the broadband connection at your summer place, and voila!--when your freeloading friends call, none of them will even know you're at the beach. Plus, you're not stuck paying a second phone bill or using up your wireless minutes.
Another minor benefit: Because VOIP doesn't tie you to a location, there's no reason your area code has to correspond to your actual address. A wannabe San Franciscan can mask her Oakland digs by picking digits that start with "415." Vonage and other providers say area codes 212 (Manhattan) and 310 (Beverly Hills) are in especially high demand.
This is the kind of stuff that makes Bellheads envious, if also a bit scared. Edward Whitacre, chairman of the nation's second-largest Baby Bell and therefore a major guardian of the circuit-switched phone network, thinks VOIP is like catnip. "It offers things that most consumers would like," he muses. "Wireless-wireline integration, convenience, nifty features... It is richer than circuit-switched [service]."
It wasn't long ago that VOIP was little more than a geeky niche. To make Internet calls, you'd typically need a microphone attached to a PC, and so would the person you were calling. Those primitive early versions appealed mainly to nerds and skinflints willing to endure horrid sound quality for the cheap thrill of talking on the Net.
Today VOIP has become amazingly easy to use. Consumers no longer need special phones or headsets for their computers. Vonage sells do-it-yourself installation kits through retailers such as Best Buy and Radio Shack. The technology generally appeals to people who already have cable modems and who are looking to ditch their home phones. People like me.
I recently gave AT&T's CallVantage a try. A few days after I signed up, a FedEx box arrived at my house containing an Ethernet cable and a gizmo the size of a cigar box. Like a kid on Christmas morning, I connected the device (new buzzword: It is called a telephone adapter, or TA) to my home phone, my laptop computer, and my cable modem. Miraculously I was able to install the service without summoning tech support (my husband), and in less than an hour I was making phone calls using my broadband connection. As if talking for peanuts over the Net weren't thrilling enough, I was able to set up a quick conference call via the CallVantage website. And the next day I used my computer at the office to check the voicemail that had come in on my home phone--again by logging on to AT&T's web page.
There are things I don't like about the service. Since my conversations are going over a data network, they have to share my broadband connection with e-mail, illegal music downloads, spam, and other junk. So the sound quality isn't always so good. Also, if I get in trouble and need to call 911, the emergency dispatcher wouldn't necessarily know my location. (For now, 911 callers must be careful to give the dispatcher their address.) And because your calls are being relayed through an electricity-powered cable or DSL modem, the phone won't work if there's a blackout.
Overall I was pretty pleased. Of course, I'm right smack in the VOIP demographic--I'm under 35, I like technology, and I'm solvent. I pay my cable company $100-plus a month for digital cable and broadband Internet, and my phone company another $45 or so for local and long-distance service. So at $35 a month, CallVantage cuts $10 from my total bill and gives me a ton of calling features. I like VOIP so much that I'm seriously considering recommending it to my parents.
Unlike me, though, my parents aren't likely to install VOIP themselves--and therein lies a fat, delicious opportunity for the cable companies. Now they can use their battalions of installers to turn on the phone when they hook up your cable and Internet connection, and thereby seize a huge slice of business from telcos. Cablevision in New York is offering VOIP to its entire service area of 4.4 million households. Comcast, the nation's biggest cable operator, plans to roll out its version of VOIP in the next several months. Comcast's closest competitor in size, Time Warner Cable, expects to offer VOIP to most of its customers by year-end. (Time Warner Cable, like FORTUNE, is a unit of Time Warner.) "Employees ask me what I'm most excited about, and I tell them, 'Voice over the Internet,'" Richard Parsons, CEO of the multimedia company, told company executives in June. "It is going to be a really big deal for us."
It's hard to overestimate the potential of VOIP for cable operators. Cox Communications, which sells an earlier version of cable phone service in markets like Omaha, has wrested as many as a third of households from local telcos. And VOIP is a lot cheaper to build and maintain than a traditional phone system. Because the calls behave like data, VOIP operators don't need to buy the huge switches the local phone companies have employed for decades--rather, they can use much cheaper routers with special software to ship IP calls. For cable operators, the savings are huge. Tom Rutledge, chief operating officer of Cablevision, says the incremental cost of adding a non-VOIP phone customer to its network would be more than $700--vs. $150 per customer using VOIP. "That's a significant savings that allows us to offer a very inexpensive product," he says. "In fact, in our focus groups people found the pricing so compelling it scared them--they thought there must be something wrong with the offer."
Another big appeal of VOIP: Customers are already primed for it, thanks to the proliferation of wireless and broadband services. Most VOIP services today "ride" on a broadband connection--either cable modem or DSL. Just as I did, you hook your home phone, computer, and broadband modem up to a special box that translates the phone signal into Internet language. Now that more than 20% of homes have high-speed connections, more consumers can readily make the switch to VOIP. And thanks to scratchy wireless calls, we have all become inured to phone conversations that sound less than pristine. "Mobile services have definitely changed people's perceptions" about VOIP, says Cathy Martine, head of Internet telephony for AT&T. "Customers say, 'Wow! It's better than wireless.'"
There's another big driver behind VOIP, namely the cable operators' hunger for growth. They face tough competition from satellite operations such as EchoStar and DirecTV in the $35-billion-a-year video segment, and they know growth in their high-speed cable-modem business will soon start to slow. New offerings such as high-definition television and video-on-demand could provide added revenue. But the biggest opportunity by far is the $65 billion residential phone business dominated by the Bells.
The cable companies have vastly different approaches, though none plans to market its services using the consumer-unfriendly term "VOIP." Cablevision sought to get out of the gate quickly with a product called Optimum Voice that requires customers to subscribe to the company's broadband Internet service. Time Warner and Comcast are going with a different kind of service without such requirements.
That said, all the cable operators are looking for ways to lock in customers by bundling phone service with cable-modem and video services. Cablevision last month began promoting a package of unlimited phone calls, high-speed Internet, and digital cable for a special rate of $90 a month. Offers like that are likely to end up driving broadband adoption in the U.S., which still lags behind places such as South Korea. Say a consumer already pays $25 a month for a dial-up service, plus $50 a month for phone service and another $50 a month for cable. If she takes the Cablevision offer, her monthly broadband service essentially will be free.
So more broadband means more VOIP, which means more broadband, and so on. It's this virtuous cycle that's creating so much excitement in the communications industry. "We think VOIP is the killer application for broadband," says Jeffrey Citron, founder of Vonage, the leading residential VOIP player today, with 200,000 customers. Citron believes Vonage isn't a commodity, like wireline long distance, but a value-added service along the lines of an HBO--something people are willing to pay a premium for.
But most analysts believe Vonage is a lot like TiVo: a great, innovative service that will be undermined as cable companies roll out their own VOIP offerings. And it's not just the big guys that threaten Vonage; it faces competition at the low end too, from Internet insurgent groups that offer phone calls free. The most famous is Skype, a service started by the team behind music-sharing service Kazaa. Founder Niklas Zennstrom argues that when voice is just another application on the Net, it should be free. Your Internet provider wouldn't charge you to load a web page, he says; why should you pay to make a phone call on the Internet?
Even if Zennstrom is only partly right, the very existence of free phone calling on the Net puts pricing pressure on the companies that want to get paid, eating into profits. (Just look at what file sharing is doing to the music industry.) That could force some big companies to rethink their business models altogether.
The VOIP revolution will land hard on the Baby Bells, which still control the majority of the residential phone lines in the U.S. A study by Sanford C. Bernstein estimates that the Bells will lose 15% of their residential phone customers to cable companies' VOIP services over the next five years. On top of that, they will also continue to lose residential customers to wireless: An estimated 5% of Americans have disconnected their home phones and use a mobile device exclusively.
For years the Bells have managed to offset their losses to wireless by owning their own wireless properties; they're similarly trying to mitigate the pain of VOIP by embracing it. SBC, BellSouth, and Qwest offer VOIP calling services to business customers; Verizon and Qwest will offer VOIP to consumers this year. "You have to have a low-price alternative to compete against cable," says Qwest CEO Dick Notebaert. "If you do this right, you can add features to your VOIP product, differentiating it and moving it away from becoming a commodity business."
The challenge for the Bells is that even as they roll out VOIP, they must simultaneously maintain their old circuit-switched networks to serve the tens of millions of customers who aren't ready for the new technology--and may not be for years. That blocks them from reaping savings from VOIP.
Nevertheless, SBC has chosen an ambitious strategy remarkably similar to one the cable operators adopted a few years back. In the 1990s the cable industry invested some $85 billion to upgrade its neighborhood networks using optical fiber--today that serves as the basis for digital cable TV and high-speed Internet. Whitacre recently announced plans--contingent on favorable regulatory treatment--to drive fiber-optic cable deeper into neighborhoods in SBC's 13-state territory. The idea is to offer many megabits of data per second to residential customers--bandwidth robust enough to deliver movies and let SBC compete head-to-head with cable. Verizon, too, has announced plans to push fiber closer to its customers for ultra-fast broadband connections.
If the Bells' ambitions are to be believed--plenty of analysts doubt they'll actually pull the trigger on an expensive fiber expansion--then the communications industry is heading for a clash of the titans: Big Cable vs. Big Telecom. "You'll have the cable operators and the Bells battling over pricing," says Erik Zamkoff, an analyst at Independent Research Group. "It is going to be a battle of the bundle."
Bundles of services are just the beginning of the story. Already we're starting to see hints of VOIP's true promise: Vonage, for example, will soon offer a Wi-Fi phone that lets customers make or receive VOIP calls from any hot spot. Say you are sitting in an Internet cafe in Paris; you can call people back home, or have them call you, without incurring international long-distance charges. Eventually, when 3G upgrades are complete and all wireless networks are broadband networks, you'll be able to carry the benefits of VOIP in your pocket. That conference call with ten friends? You'll be able to set it up on your BlackBerry. VOIP will open the door to new generations of gadgets and devices: phones with videoscreens, for example.
As the Internet did in the crash, VOIP will end up weeding out lots of weak companies. "Inevitably some companies will lose and some companies will win," says David Roddy of management consultant FTI Consulting. "I'd say the big companies are going to acquire the small companies with good ideas, and the other companies will go bankrupt." And whatever happens, customers win.