Telecoms: It's the network, stupid

NEW YORK (Fortune) -- At first blush, telecom flameouts SunRocket and Amp'd don't have a lot in common. (SunRocket shut down early last week; Amp'd's Web site says the company is "potentially suspending" U.S. operations July 31.) Amp'd is a wireless operator that targets teens and young adults, SunRocket delivered phone calls using Internet Protocol (IP) technology. Its intended audience: Bargain seekers who wanted the cost savings of VOIP service without the perceived complexities of a service such as Skype.

But both are now toast, and they shared a critical challenge: neither company owned the networks that carried its phone calls and services.

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Amp'd is (for now, at least) a so-called mobile virtual network operator, or MVNO, which is telecom-ese for wireless reseller. It leases its network from Verizon's wireless unit and repackages the service with its own menu of games, video clips and applications. SunRocket had even less control: Its service ran over broadband connections its customers had to purchase from SunRocket's competitors, the telcos and cable companies, which also sell calling plans.

Now we're not saying that lack of network control is the sole reason for the demises of SunRocket and Amp'd. (Nor is network ownership a guarantee of success: Companies such as Teligent and Winstar had access to wireless spectrum in the late 1990s but nonetheless crashed.) But there's no question that telecom companies without at least some of their own network assets have a hard time making it.

And that should give pause to investors who are considering buying shares in reseller Virgin Mobile USA's upcoming initial public offering, or those who think VOIP pioneer Vonage (Charts) is a bargain with its stock trading under $3 a share.

The challenge for upstart operators is cost, pure and simple. Well, you might ask, isn't it cheaper for a newcomer to lease space on someone else's network than to incur the cost of building a whole new system itself? Yes, only the companies that actually own networks aren't exactly leasing space on their phones lines for a song: Wholesale rates, coupled with high marketing costs, mean most resellers - wireless or otherwise - achieve super-thin margins at best.

To wit: Virgin Mobile USA, arguably the strongest wireless reseller in the country, late last week filed documents showing it had first-quarter operating income of $28.8 million on sales of $339.4 million - an operating margin of 8.5 percent.

In contrast, Alltel Corp., (Charts, Fortune 500) a wireless operator with its own network, posted an operating margin of 17 percent in the same period. Just this week Earthlink (Charts), parent of mobile reseller Helio, said the wireless company lost $83 million on sales of $33 million in the most recent quarter. Ouch.

For VOIP providers SunRocket, (RIP), there were two sets of barriers. First, it had to convince customers already getting broadband from the phone or cable company to make a separate purchasing decision for their voice calls. That kind of education - on top of building a brand and promoting a new service - costs lots of money. Just look at Vonage, which, like Virgin, is the biggest and best known of the independent VOIP providers: In the first quarter of the year, the company had $196 million in revenue - and spent $91 million on marketing alone, resulting in a net loss of $73 million.

On top of the marketing costs, independent VOIP providers really are at the mercy of a host of network operators, from access providers like the cable and phone companies to so-called backbone providers that move their customers' calls across the country via Internet Protocol. When those network operators experience problems, it can take down the VOIP company's service, too, as Vonage discovered a few years back when its phone service went out as a result of "routing issues" on the network of one of its wholesalers, Global Crossing.

Daniel Berninger, an independent telecom analyst, says future telecom upstarts simply have to do everything they can to avoid touching the traditional telecom and cable networks. He's helping VOIP pioneer Jeff Pulver relaunch a phone company called Free World Dialup as a so-called peer-to-peer phone service. That means customers act as nodes on the network to pass phone traffic around the globe, much the way Skype works. In so doing, the calls generally bypass the phone companies' traditional switches, and therefore, avoid some of the "tolls" charged by phone companies for completing some phone calls.

For an upstart, says Berninger, "You touch the telephone network, and you die." Of course, the deaths of Amp'd and SunRocket aren't going to make it any easier for existing players that lean on other phone companies for connectivity.

"As bankruptcies and closures proliferate there's going to be a flight to quality," says Rich Nespola, chairman and CEO of The Management Network Group (TMNG), a telecommunications consulting firm based in Overland Park, Kansas. "That's going to favor the larger players."

Indeed, Nespola says the stand-alone players in the consumer space, an even bigger challenge than high wholesale costs or lack of network control is the fact that they are flying solo. He contends consumers want bundles of service: broadband, home phone, mobile phone and even television. And they want to buy it from one provider. "The bundle is taking hold," he says. And that, too, favors the biggest operators.

Does that mean consumers will have no choice but to buy from the biggest operators, behemoths like Verizon (Charts, Fortune 500) and AT&T (Charts, Fortune 500)? Not so fast, says analyst Berninger. Companies such as Google talk about helping seed open phone networks that mimic the Internet model, and Berninger thinks someday we may see an Internet-like version of the phone system, whereby consumers pick the applications they want from a host of different providers.

Today, for example, you might use Google for search, Yahoo! for my home page and AOL's Instant Messenger for chat. Perhaps someday you'll choose basic connectivity from Verizon, voicemail from Google, text messaging from AOL and phone-based e-mail from some new company, one that manages to exorcise the ghosts of telecom start-up flops like Amp'd and SunRocket.