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Investors Warm to Web Calling

The rally that's propelling Vonage and 8X8 and luring venture capital to private Web-calling providers is likely to continue

For many consumers, the appeal of low-cost Web-based calling has long been clear. But many investors have kept their distance from companies specializing in Internet telephony out of concern the industry would struggle to make money.

Until recently. The most high-profile indication of newfound love for Web calling came Sept. 1, when investors led by venture fund Silver Lake said they would pay eBay (EBAY) $1.9 billion for most of PC-to-PC calling giant Skype.

The demand doesn't end with Skype. In the past seven months, venture capitalists poured tens of millions of dollars into mobile Web-calling provider Fring, Internet-calling software maker Twilio, and service provider Ooma, which had multiple funding offers in June, when many startups couldn't get a dime.

Vonage on a Tear

Public markets have warmed to Web calling, as well. Shares of Vonage (VG) have rallied almost fourfold, to 1.62, since early August. The stock of rival 8X8 (EGHT) has risen 26.4%, to 91¢, since Aug. 1, and the company is getting "a lot of interest" from potential acquirers, says 8X8 CEO Bryan Martin.

The companies that have stuck it out this long overcame the technological glitches that plagued Voice over Internet Protocol (VoIP) communications early on, and have made the cost reductions and strategy adjustments needed to spur growth. "This is not a 1999 or 2000 dot-com deal, where you buy a company with no revenue," says Mark Wiseman, senior vice-president for private equity investments for the Canada Pension Plan Investment Board, which invested in Skype along with Silver Lake. "You are buying a real company, with real revenue…and real earnings."

In the second quarter, Skype's sales rose 25%, to $170 million, while its registered subscriber base increased 42%, to more than 480 million. In the same quarter, Vonage posted its first net profit, of $2.3 million. "We are generating positive cash flow, we reported record earnings," says Vonage CEO Marc Lefar, a former chief marketing officer at AT&T (T) who joined Vonage in July 2008. "People are starting to realize there's a good business model here. It's absolutely a business that can be very profitable."

A Developing Industry

Advances in technology will make it even easier and cheaper to deliver Internet calling in the future, analysts and investors say. For instance, providers can deliver Internet calling through wireless networks through software downloaded onto smartphones such as Research In Motion's (RIMM) BlackBerry and Apple's (AAPL) iPhone. "There are many unexploited opportunities," says Egon Durban, a managing partner at Silver Lake.

Vonage made steep cost reductions to bring itself back from the brink.

Jajah switched tack to survive. Like many providers, Jajah initially catered to consumers but recently has begun targeting large businesses. It now provides Web-calling services for Yahoo (YHOO) and dating sites and eHarmony. Jajah is profitable and expects to increase sales fourfold this year, though it doesn't provide the amount. Initially, "it was a myriad of people doing the same thing, and you've seen the market shakeup," says Jajah CEO Trevor Healy . "Now we've turned the corner."

Opportunity in Smartphones

Helping them around the bend was the public's growing demand for low-priced communications amid a global recession. Now almost 25% of Americans use Internet technology to make calls.

Initially, Ooma only sold its gear online. But after a recent management shuffle, Ooma now sells through some 5,000 outlets of brick-and-mortar retailers such as Best Buy (BBY) and Costco (COST). As a result, it has sold out four times since February. It's now roping in tens of thousands of new customers a week vs. about 1,000 a month via online efforts. And the company is on track to turn a profit early next year. "This company can have software margins," says Tim Weingarten, consultant at Worldview Technology Partners, which has invested $22 million in Ooma. He says he'd like to see Ooma sell shares to the public in as early as 18 months "as the window opens for IPOs."

VoIP providers see a big opportunity in the smartphone craze. Vonage is currently testing software that makes its service available to iPhone users. "We expect this will expand our market significantly," says Vonage's Lefar. Apps for the Apple iPhone from Skype, Fring, and Comcast (CMCSA), the largest U.S. Web-calling provider, have been runaway successes. Since its release in July, Comcast's iPhone app has been downloaded more than 300,000 times.

Google Eyeing In-Call Ads

Services for small and midsize businesses represent a large untapped market for companies like Skype, as well. Search giant Google (GOOG), a relative newcomer to Web calling, is likely to try its hand at in-call advertising. The search giant is expanding the user base of its Google Voice service, which allows consumers to forward calls and read voice-mail transcripts. "They may be able to get better [ads] relevance on each individual customer," says Ronald Gruia, principal analyst at consultant Frost & Sullivan.

Web-calling companies will need to contend with wireless carriers' reluctance to open their networks to such services. They'll also likely engage in price wars, particularly when confronted by such free services as Google Voice.

For now, investors are taking heart from the Skype deal. "You probably use this as a benchmark for valuing other companies," says Peter Falvey, managing director of investment bank Revolution Partners. "It shows the promise."

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