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Skype Gives Telcos a Wake-Up Call

By Alex Salkever Niklas Zennstrom, founder of peer-to-peer telecommunication company Skype Technologies, is no stranger to controversy. As the creator of file-swapping software outfit KaZaA, Zennstrom unleashed the code that enticed tens of millions of Web surfers to become music pirates. The unrepentant Zennstrom and fellow founder Janus Friis distanced themselves from KaZaA two years ago through a series of byzantine legal maneuvers. Now Zennstrom and Friis are attacking another staid industry, global telecommunications. But their technology of choice remains P2P.

Skype's only product is a small and easy-to-use piece of software that allows two people on the Internet to communicate via high-quality voice calls for free. The interface resembles those found in instant-messaging applications from Microsoft (MSFT) and America Online (TWX). To make a call, users don a headset equipped with a microphone, select a name from their buddy list on their screens, and click the green telephone icon.

VIRAL GROWTH. Skype requires no configuration changes and easily passes through firewalls and other computer-security systems that trip up many voice applications. So far, Web surfers have downloaded 18.5 million copies of the software since it was released in August, 2003. Skype has also put out versions for computers running Linux and for PDAs running Microsoft's PocketPC operating system.

Zennstrom claims to have nearly 8 million regular users, making Skype one of the fastest growing viral applications ever. On July 27, he responded to critics' concerns about his revenue model by launching a pay service -- SkypeOut, a program that allows Skype users to make calls to regular telephone numbers anywhere in the world over the Skype network at dirt-cheap per-minute rates.

The real results will depend on Skype's ability to sustain revenue-generating businesses. It won't be easy, but it can be done -- as Yahoo! (YHOO) and MSN have shown with the huge number of repeat and captive visitors they've brought in by offering free e-mail.

HEAVYWEIGHT PARTNERS. "One day, we will look back and wonder why we ever paid for phone service, in the same way that we now look back and wonder why we ever paid for e-mail," says Steve Jurvetson, a managing partner at venture-capital firm Draper Fisher Jurvetson. His firm was one of the early investors in both Hotmail and Skype. Jurvetson and other investors see Skype as a massive multibillion-dollar business ultimately and hope it will be the next big tech IPO after search-engine Google goes public this month.

Many telecom insiders scoff at such predictions. They say Skype will remain a niche player and never hit critical mass because competition for voice calls has heated up markedly in the past year. As of the first week of August, 2004, Skype had barely made a dent in the $1 trillion global telecom industry. Since inception, the Skype network has carried 300 million minutes of voice traffic, a fraction of 1% of international voice traffic without even counting local phone calls. Critics further note that Skype's proprietary technology "will make it harder for them to connect with other networks, and that could work against them," says Lou Holder, an executive vice-president of leading Internet telephony provider Vonage.

Still, some companies are taking Skype seriously. Zennstrom has already signed deals with four global telecom heavyweights, including Level3 (LVLT) and Teleglobe (TLGB), for its SkypeOut service. Federal Communications Commission Chairman Michael Powell is a fan and has given kudos to Skype in public speeches.

TINY MARKET SHARE. Leading PC and telephone headset-maker Plantronics (PLNT), a grown-up company by anyone's standards, signed a deal last year to promote its headsets to Skype users and to plug Skype on its in-store packaging materials. And an executive from one of the world's largest telecommunications-equipment suppliers has taken a seat on Skype's board.

"They have a very interesting business with very interesting technology," says Sureel Choksi, an executive vice-president at Level3. And Skype seems to be in the right place at the right time. The voice-call biz is undergoing a sea change as more and more telecom operators turn to the same technology that powers the Web -- Internet Protocols (IP) -- to run their phone networks.

According to telecom researcher Telegeography, carriers using IP handled only 150 million minutes of international telephone calls in 1998. That's less than 0.2% of total minutes. That number soared to 18 billion or 11% of the international total by 2002. Telegeography expects the tally to increase to 24.5 billion, or 12.8% of the total, by 2003. Two of the largest voice-over-IP (VoIP) carriers, IXTC and iBasis (which has a deal with Skype), handled 2.5 billion minutes in international traffic in 2002, placing them in the ranks of the largest international telecom carriers in the world in terms of call volume.

TELCOS JUMP IN. Most of these calls were conducted using IP on private networks, but it's still progress in the effort to make the Internet the preferred medium for voice communications. And the proliferation of broadband connectivity at work and at home has finally made Internet calling a potentially viable business. As of May, 2004, 47.8% of home Internet users in the U.S. had broadband connections, according to Web traffic tracker Nielsen/NetRatings. And at work, 79% of U.S. workers have a high-speed connection. In Korea, Canada, and Japan the percentage of home users with zippy hook-ups is closer to 75%.

To tackle this market, a host of companies, including Vonage and Lingo, have garnered hundreds of millions of dollars in startup capital to build systems that use the public Internet to make phone calls. Some of the biggest names in the telecom and cable broadband businesses, including Comcast (CMCSA), Cox Communications (COX), and AT&T (T), have joined the fray by bringing out their own IP-based phone services. These offer local and long-distance service for a flat fee. Fearful that these offerings will accelerate the slow-motion implosion of the local telephone access market, the Baby Bells have decided to offer Voice-over-IP (VoIP) services as well -- which will be competing directly with their own more lucrative legacy services.

Overseas, Internet calls are offering even fiercer competition to legacy telcos. Japan's Yahoo!BB, a Softbank subsidiary, throws in free domestic long-distance and local calling with a high-speed DSL connection. It costs less than $40, about half of what such a package might cost in the U.S. today. All of this market upheaval is presenting opportunities for newcomers, including Skype.

MEN OF MYSTERY. Skype is an unusual competitor with a shadowy past, staffed by the same Estonian programmers that produced KaZaA. Fearful of a lawsuit related to its piracy battles with the Recording Industry Association of America, Zennstrom and Friis refuse to travel to the U.S. and maintain a veil of secrecy over Skype and the location of its offices. Investors or partners seeking audience with Skype and its founders have to e-mail a generic information address via the company's Web site.

This veil will have to lift soon, Zennstrom admits. Skype currently has about 70 employees at its two offices in London and Talinn, Estonia. That's up from 30 in January, 2004, and Zennstrom is still hiring. "We plan to grow for now, but if the revenues don't develop, then we can cut back and continue to operate indefinitely with the $18.8 million we have already raised," says Zennstrom.

Those numbers may sound small, but the cost of adding a new user to the Skype network is effectively zero. In effect, Skype hitches a free ride on the broadband connections its users are already paying for while shouldering none of the upkeep costs inherent to maintaining a big data network. Unlike the traditional telephone systems or the IM networks, Skype requires no central servers to direct traffic.

"CERTAIN TYPES OF USERS." Is the service any good? Zennstrom claims it has greatly improved over the past 12 months and is now even better than the voice quality of the public telephone network, let alone the sometimes jumpy connections offered by other VoIP startups and the current versions of AOL and Yahoo's voice-IM software. It's a bold assertion, and the big telcos dispute it. But the key word here, however, is free.

It isn't that Zennstrom has no interest in making money. Skype plans to start charging for services such as voice mail soon. Meanwhile, its user base guarantees advertisers a captive audience. Still, Zennstrom is careful to say that Skype will not replace the public telephone networks any time soon -- if ever. "We will serve certain communities and certain types of users," he says. And while he wants to grow Skype into a big business, he envisions an outfit employing 1,000 people or so. That's a far cry from the telecom behemoths.

Still, grabbing even a small portion of such a massive sector could turn into a boffo business. And just as KaZaA altered the music landscape forever by making free tunes readily available, Skype has already played a key role in what will likely be a revolution in the telecom business. Prodded by Skype, instant-messaging providers are souping-up their voice capabilities and further blurring the line between phone networks and the Internet.

FIGHT FOR RICHES. Furthermore, a raging price war has broken out in the global VoIP market, sparked in part by Skype's free model. One new entrant, StanAPhone, is offering free Internet calls from the PC to the public telephone network. Another carrier, Primus, has started a program that offers unlimited calling within the U.S., Canada, and Western Europe for only $20 per month.

Is this all a race to the bottom? Perhaps. But Skype stands to make a decent amount of money on the ride down. Salkever is Technology editor for BusinessWeek Online

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