Telecom's New Trailblazers

A band of upstart companies armed with digital data networks and Net knowhow could outrun the old phone giants

Bell-heads beware. In the high altitudes of Denver, the back roads of Tulsa, and the swamps of Mississippi, a band of maverick companies is popping up--and neither the $600 billion telecom industry nor your phone service will ever be the same. Qwest Communications International Inc. is now offering long distance for 7.5 cents a minute. A company called IDT Corp. will charge you a mere 5 cents a minute, or one-third of AT&T's popular One Rate plan. And you can send an international fax for 65% less than the going rate if you go to little-known providers such as UUNet Technologies Inc.

These upstarts, with no ties to the old world of Ma Bell's monopoly, are building telecom networks from scratch that take advantage of the computer industry's whizzy technology and potent economics. Companies such as Qwest, Level 3 Communications, and the Williams Cos. are laying fiber-optic cables and using Internet technology to build faster, cheaper systems than old phone networks. These new digital lines can swap information seamlessly with the Net. And by converging voice, data, and video on the same line, they can deliver snazzy new services--such as video voice mail--not currently possible elsewhere. "They're scaring the heck out of the big companies," says analyst Brian Adamik of market researcher Yankee Group Inc.

With good reason. This could be the rise of the next-generation telephone companies. Just five years ago, these upstarts were little more than niche players, hawking data networks to transport computer and Internet traffic. Now, data networks are catching on as the best way to handle voice calls, too. Today, the super-efficient lines carry less than 1% of the total voice traffic. But within four years, experts say, that could reach 13%. "This really challenges the fundamental foundation of the industry," says Mark Winther, International Data Corp.'s group vice-president for worldwide telecom.

To be sure, the upstarts have much to overcome before they reach titan status. Traditional phone companies still claim nearly all the customers--their revenues are 50 to 100 times greater than the $400 million average of the newcomers. And the giants have plenty of cash to acquire the troublemakers if need be. SBC Communications Inc. Chief Executive Edward E. Whitacre Jr. has floated the idea that the Bell could buy a company with a converged network, such as Denver-based ICG Communications or Tampa-based Intermedia Communications Inc.

Then again, the old guard could simply build converged networks themselves. "They haven't created the formula for cold fusion. They can't buy equipment we can't buy," snaps Brian A. Brewer, senior vice-president at MCI Communications Corp.

No, but they can shake things up. Already, Wall Street is betting on the new generation: Today, these companies are valued at 10 times their revenues, vs. traditional phone companies at two times revenues. One telling example of the new balance of power came on Mar. 9, when Qwest agreed to acquire LCI International Inc., the country's fifth-largest long-distance company, for $4.4 billion in stock. LCI CEO H. Brian Thompson explained why he sold out to a company with less than half the $1.6 billion in revenues LCI has, saying: "That's just a function of market caps." Qwest's market capitalization of $8 billion is more than twice LCI's.

Even if the new Telecom Turks should stumble or are snapped up by the majors, the looming shadow of their success will force the giants to change their ways. That will trigger deep, structural changes throughout the industry--from pricing and new services to throwing up for grabs which companies will be the dominant phone carriers and telecom-equipment suppliers into the 21st century.

The initial impact: Buzzsaw competition that could bring prices tumbling down. In part because of pressure from the newcomers, U.S. long-distance rates are projected to fall by a third over the next two years. International and fax rates are likely to drop even further--as much as 50%. That will leave traditional long-haul carriers fighting over a shrinking pie: The old phone networks will carry $77 billion in U.S. long distance in 2002 because of drastic price cuts, down from $83 billion last year, according to IDC.

CONVERGENCE. But lower prices will seem insignificant compared with what's ahead: The features that come with telephone service are set to flourish as traffic shifts to converged networks and the ability to develop applications is opened up beyond a handful of former monopolies to a whole new world of computer-industry inventors.

Forget Caller ID. In the next three years, consumers, now stuck with old twisted pair phone lines, could start to have their connections go digital. As that happens, it will throw open the door to space-age phone options. Consumers might be able to ask their telephone who's calling, and, thanks to speech-recognition software and the converged networks, it will tell them. A pricey video screen for viewing your old college chum while chatting would suddenly be affordable.

But it's businesses, which already have high-speed data networks, that could go hog wild. Hotel operators could talk to potential customers while simultaneously showing them the views from various rooms. United Parcel Service of America Inc., for example, is developing a way for customers trying to track a package at UPS's Web site to speak to a live operator over the same line. "What we can think of is only the tip of the iceberg," says Thomas Evslin, a former AT&T executive who now runs IXTC Corp., a North Brunswick (N.J.) company that provides services for the new networks.

How you pay for service will change, too. If your teenagers are monopolizing the phone, you won't have to go through the expense of getting a second telephone line. Instead, you'll order more bandwidth so you can handle multiple calls over one line. You will even stop paying for calls by the minute--the so-called death of the minute. Instead, perhaps as soon as three years from now, you could opt for a flat monthly fee of, say, $50 and get as many long-distance phone calls as you want.

How is it that these still-tiny upstarts will have such a big impact? Credit techno-economics. The newcomers are bringing the low-cost, high-tech converged networks of the computer industry into the lumbering world of telecom. In most cases, these companies are using what's shaping up to be the communications standard of the future: Internet Protocol (IP). The same standard used on the Internet, IP chops data into small bits so more pieces can zip along the network at the same time. That enables it to carry voice, data, fax, and even video traffic for as much as 50% to 75% less than traditional networks. Analysts estimate that IP networks will carry at least 13% of the total voice traffic in four years. That will be worth some $24 billion, up from $700 million last year, according to Framingham (Mass.)-based IDC.

RING LEADER. The success of the converged networks may not stop there. Several industry experts predict that all the calls that now run over the U.S. phone system will switch over to the new networks in as little as 10 or 20 years. "No question about it," says Eric A. Benhamou, CEO of network-equipment maker 3Com Corp. Frank Ianna, the AT&T executive vice-president responsible for keeping its network up to date, also sees big change ahead. "Certain carriers may get nailed," he says. "The paradigm switch may catch them sleeping."

AT&T doesn't plan to be one of the nappers. The giant carrier is probably the most vulnerable to the technology shift because it holds the lion's share of the long-distance, international, and fax traffic. It also has the highest overhead in the industry--29% of revenues. AT&T has a hard time matching the prices of MCI and Sprint, much less those of the next generation.

But new CEO C. Michael Armstrong is determined to change that. To become more competitive, he's cutting up to 18,000 jobs to reduce overhead to 22% within two years. At the same time, AT&T plans to offer a version of IP voice through its WorldNet Internet-access business this spring.

And it's upgrading its network to prepare for the Digital Age. By yearend, the long-distance giant plans to have completed a new network of 55 fiber-optic rings throughout the country. While the rings carry mostly traditional voice traffic now, they will be able to carry data packets with the installation of new electronics and photonics. Advances in technology will expand the capacity of those rings fivefold by next year, the company says. "I don't know about the other carriers, but AT&T is sure as hell getting ready for this," says Ianna.

Count MCI among the believers, too. The long-distance carrier is devoting 50% of its capital expenditures to converged networks. That has helped it develop a proprietary technology called Vault that helps old networks share traffic with the new ones. "We take Qwest and [the others] very seriously," says MCI's Brewer.

What makes all-in-one networks so important strategically is that the technology allows carriers to cash in on the explosion in data traffic at the same time they're carrying voice calls. Traditional phone systems simply aren't very good at transporting data. They were built for three- or four-minute phone calls, and 30-minute connections to the Net clog up their capacity. The result: Voice traffic is growing about 8% per year, while data traffic is soaring 100% annually. "Five years from now, data is going to be the dog, and voice is going to be the tail," says Richard Christner, vice-president at New York-based Mercer Management Consulting Inc.

That presents tremendous challenges for the traditional U.S. phone companies. The infrastructure the titans have spent a century building may turn from assets into anchors as consumers and businesses demand lower costs and better-integrated voice and data services. They also have to step up the pace: Telecom companies that have taken years to roll out services, such as voice mail or Digital Subscriber Lines, will find high-tech rivals bringing new products to market every few months.

Most traditional telecom companies are vulnerable. Consider how the next-generation phone companies are poised to wreak havoc in several of the old phone players' most lucrative markets, especially fax, long distance, and international calling. ICG Communications Inc., for instance, expects to offer long-distance service for 5.9 cents a minute in 238 U.S. markets by the end of the year. AT&T and others may not have to match that rate, but experts say they will be forced to cut prices. "What happens to them when they can only charge 9 cents a minute?" asks ICG's CEO, J. Shelby Bryan. "I wouldn't want to be in that position."

The business that will move most quickly to the converged networks is fax, already a form of data. About 8% of long-distance calls and 40% of international calls from the U.S. are faxes. Losing that business would cost AT&T and its rivals up to $10 billion a year. "Even if they just lose fax, that could be really problematic for the voice networks," says Mercer's Christner.

Customers are starting to get a taste of what converged networks can do. Ford Motor Co. is using integrated networks to coordinate the efforts of 120 design engineers on five continents. This means that over a single connection, the workers can discuss designs for new cars and share sketches. Clothing retailer Burlington Coat Factory figures that it will shave 30% off its long-distance bill by diverting calls made between its 250 stores to an internal network for data and voice.

PACKETS. And Internet bookseller ABC Bucherdienst is giving its customers better service because of its converged networks. Based in Regensburg, Germany, where labor laws forbid employees to take customers' calls at night or on Sundays, the company has found data-voice networks critical. During those hours, people who visit their Web site can click on a button to ask questions of representatives in Florida--where no such restrictive laws exist. "It gives us the ability to answer the calls for nothing," says Michael Gleissner, president of ABC's U.S. operations.

Indeed, the rise of the next-generation telcos stems from a fundamentally new technology. Since Alexander Graham Bell invented the telephone in 1875, the U.S. telephone system has been based on what's called "circuit switching." In its simplest form, this means that an entire telephone circuit is dedicated to a phone call between point A and point B. This is like a driver reserving the whole lane of a highway for a trip from New York to Boston.

The new telcos use a more efficient technology, called packet switching, which breaks the sounds of a voice call into little packets for transport. The packets from many voice calls can be crammed into a single circuit at the same time, interspersed with data packets. It's similar to many cars traveling in the same lane between New York and Chicago. The cars also are more compact: While standard voice circuits are 64 kilobits wide, the typical packet is only 8 kilobits.

Once the sound of a voice is broken into packets, it looks just like a packet carrying data, fax, or video clip. That results in tremendous efficiencies: The same network that carries voice can carry everything else. And because the kind of packet switching the newcomers are using is IP, the networks can use the same infrastructure that has been built to access the Internet. In most cases, though, the calls don't actually go over the Internet because private networks send packets faster and more reliably than the clogged public Net--essential for a conversation.

The new telephone companies can also ride the boom of the Internet and get ever-cheaper, ever-more-efficient equipment from such suppliers as Cisco Systems Inc. and 3Com. Already, companies such as Qwest can buy network equipment that's 25% to 33% less expensive than traditional gear, according to analysts. Even bigger savings come from the additional capacity of the new networks: Analysts say they can carry 6 to 10 times the traffic of traditional circuit-switched networks. Overall, Level 3's James Q. Crowe estimates that his network will cost less than 10% of the price of traditional lines. "Being an incumbent means having a more difficult time than a new entrant," says Crowe.

Even so, the telecom giants aren't giving up. The Baby Bells think the technology could jump-start their push into the long-distance business and several, including U S West Communications Group and SBC Communications Inc., are asking the Federal Communications Commission for the right to build converged networks. "We're not going to wake up and find [our voice business] is gone," says SBC Executive Vice-President for Corporate Planning Mike Turner.

"CONCERNED." Most of the Baby Bells snort at the notion that these upstarts will horn in on their core businesses. "You have to separate the hype from the reality," says Ameritech Corp. CEO Richard C. Notebaert. "We have customers, real customers, paying hundreds of millions of dollars to us today. When you look at Level 3 and Qwest, how many customers do they have?"

The difference is orders of magnitude. But the mavericks do have an advantage: They can avoid paying the Bells access charges. These are fees that long-distance companies pay the local players to carry a call from a home or office to the long-distance network, and on to its destination. They're about 4 cents a minute. Because voice calls over converged networks are considered data, these companies pay little if any of these fees.

Four cents a minute adds up. If 13% of the long-distance traffic travels over converged networks in 2002, as consultant Frost & Sullivan projects, the lost access charges would cost the Bells about $4 billion a year. The Bells are not happy about the prospect. They argue that it is fundamentally unfair for voice calls over converged networks to avoid access fees, while traditional voice calls pay the freight. "Clearly, it's something we're concerned about," says Lawrence T. Babbio Jr., president of Bell Atlantic Corp.'s network group.

The Bells are hardly alone in their complaints. Legislators whose states use the access charges to subsidize telephone service are bristling. Senator Ted Stevens (R-Alaska) has asked the FCC to review the situation, especially since he feels AT&T and WorldCom with MCI could try to avoid the fees, too. "You've got the potential for bypass on a massive scale, and it's not too far off," says Mitch Rose, Stevens' chief of staff. "It's coming at us like a freight train." Still, it looks as if the mavericks won't get hit with full access charges anytime soon. There's tremendous public sentiment to leave the Internet untaxed.

So which of the traditional telecom companies are most prepared for the impact of the converged networks? WorldCom Inc. stands head and shoulders above the rest. With the purchase of UUNet Technologies, WorldCom CEO Bernard J. Ebbers landed the largest carrier of Internet traffic in the world. If WorldCom merges with MCI as planned, it will control by some estimates more than 50% of the Internet backbone--enough that the trustbusters in Washington are voicing concerns.

So far, WorldCom has kept its voice traffic on traditional networks and is using UUNet to pursue new growth opportunities, such as fax, over IP. But as voice, data, and video converge, WorldCom will have the expertise and the assets to cash in on the boom. "Our vision is to build a phone company that looks more like a Silicon Valley startup," says John Sidgmore, president and CEO of Fairfax (Va.)-based UUNet.

GTE Corp., headquartered in Stamford, Conn., is the most aggressive old-line phone company. Last year, it bought BBN Corp., a company that helped create the Internet and has extensive Net assets, and it acquired the rights to one-quarter of the capacity of the high-tech network Qwest is building. It's conducting trials with voice and fax over the same network that now carries its data. The company thinks it's inevitable that all the traffic eventually will flow over a converged network. "We're not upgrading--we're putting in brand-new technology from the get-go," says George H. Conrades, executive vice-president at GTE.

Looking at the economics of the new networks and their potential for new services, analysts say the message for the old phone companies is simple. "You can either cannibalize your circuit-switched network, or you can have someone else do it for you," says James H. Henry, an analyst with Bear, Stearns & Co. That should be a wake-up call.

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