Who Needs 3G Anyway?

A simpler, far less costly wireless Net standard called 2.5G could win out

Last October, in the heat of Europe's auctions for third-generation wireless-phone licenses, it looked as though Italy's No. 4 carrier, Blu, had blown its future. After two rounds, Blu dropped out of the bidding for a so-called 3G license when the price got too rich--more than $2 billion for each of the five winners.

Now that the frenzy has died down and the winners grasp how much 3G mobile services will cost, Blu isn't feeling so blue. It's banking instead on something called 2.5G, a long-planned upgrade to the existing Europeanwide wireless-phone system. It's set to come online this year, and should offer nearly all the benefits of 3G for a fraction of the cost. If 2.5G is a big hit, it could undermine demand for the high-stakes third-generation system. Indeed, says Nick Jones, a researcher in the British office of consultant Gartner Group Inc.: "3G's biggest competitor is 2.5G."

That idea must send shivers through already anxious telecom executives who have bet the farm on 3G. Deutsche Telekom (DT ), France Telecom (FTE ), Britain's Vodafone (VOD ), Spain's Telefonica (TEF ), and others collectively have gambled more than $95 billion on 3G licenses in the hope that speedy new networks will ignite the long-promised wireless Internet and stem the decline in voice revenues per subscriber. They'll have to spend $125 billion more to build 3G, figures analyst Durlacher Research Ltd., plus billions on marketing. The combined debt could be so severe--especially if 3G doesn't take off as quickly as hoped--that European telcos may face massive consolidation, or even financial ruin, over the next decade.

In fact, 2.5G's imminent arrival isn't entirely unwelcome to the 3G crowd. "Smart operators will milk [2.5G] and minimize [3G] rollouts," says analyst Lars Godell of Forrester Research Inc. in Amsterdam. Most of them also have spent the few million dollars necessary to upgrade their existing GSM (Global System for Mobile) networks to offer 2.5G, which could tide them over until the third generation is up and running--2003 at the earliest.

THE PROMISED SIZZLE. What's more, 2.5G will be a crucial testing ground. After an inferior wireless-Web technology flopped last year, operators have a chance to deliver some of the promised sizzle and get users hooked on mobile data. That's essential: Telcos are counting on information services, advertising, and transaction fees from the mobile Net to kick in nearly half their revenues by 2005, up from 7% last year. Success with 2.5G also will provide vital experience in delivering and billing for data, a skill companies must master to succeed at 3G.

As its name implies, 2.5G technology was conceived as a stepping-stone from second-generation GSM to 3G. In all the fuss over 3G, though, 2.5G's importance has been underplayed. Its big advancement: Data such as headlines, sports scores, and traffic updates travel in a channel separate from voice calls and flow in and out of a phone anytime it's on. By contrast, last year's crop of GSM phones outfitted with the wireless access protocol (WAP) required customers to place a call to a Web portal to send and receive data. Sluggish performance, dropped connections, and paltry content turned users off in droves. The reaction was so bad, says Juha Christensen, vice-president of Microsoft Corp.'s (MSFT ) mobility group, that the company worries about consumer "WAPlash."

The new 2.5G should fix that. Its "always-on" capability, coupled with data speeds two to three times faster than before, will make using the wireless Web easier, even though users will have to buy new phones to take advantage of that. It will also allow operators to charge based on the amount of data sent and received per month--not the time spent online, which was one of the drawbacks of WAP.

Such improvements could jump-start the mobile Web. Dutch operator KPN Mobile, for instance, figures new 2.5G services this summer could boost its revenues per subscriber by 35%, says Business Marketing Director Brian Stout. Durlacher Research figures nonvoice services will yield more than $70 billion in revenues for European wireless operators by 2005. That lucre will come largely from 2.5G users, whom Durlacher projects will still outnumber 3G users by nearly four to one that year. The likely moneymakers: instant messaging, games, and business services. "Our whole business model is changing," says KPN's Stout.

So what's the downside to 2.5G? First, operators have to make it work, or they're in a heap of trouble. Since the failure of WAP, investors have soured on the wireless Web. If telcos can't show they can market data services, investor skepticism over the financial risks of 3G will intensify, and raising capital will become even costlier. "If [2.5G] does not work well," cautions Fernando Gomez, senior vice-president for Motorola's (MOT ) European handset group, "it could really delay [3G]." And if 2.5G is too successful, it could steal 3G's thunder--or even, as Forrester Research analyst Matthew M. Nordan suggests, "forestall [it] indefinitely." Customers might resist upgrading to 3G handsets or paying more for services. That would leave telcos holding mounds of debt for substantially devalued spectrum licenses.

Navigating these shoals will require steady hands. For now, operators express commitment to both technologies. Vivendi Universal CEO Jean-Marie Messier, for instance, says his company is ready to roll out 2.5G later this year, but also will test a 3G network in Monaco starting in June. The same goes for equipment suppliers. Nokia Corp. (NOK ) says it will deliver millions of 2.5G handsets in the fourth quarter, with 3G models set to arrive a year later. Most insist that 3G will ultimately prevail because it's cheaper to operate and offers data connection speeds up to 10 times faster than 2.5G, permitting zippy services such as wireless videophones and digital-music players.

Not that there aren't problems to be ironed out with 2.5G. Handsets are late and scarce: Only Motorola, Ericsson (ERICY ), and Sagem ( have delivered any so far, and most others won't be available until late this year. The growing complexity of handsets also poses risks for both 2.5G and 3G. Nokia's first WAP phones, for instance, were duds, and its 2.5G models are seriously delayed. On top of that, 2.5G handsets will cost $300 to $500, or about twice as much as conventional GSM phones, until prices start to come down in late 2002.

PERVERSE OUTCOME? Even so, the problems of 2.5G pale in comparison to the risks of its successor. Experts say 3G technology is so complex that it will likely arrive years later than promised--perhaps not until 2004. That leaves telcos carrying license-fee debts long before they can start recovering 3G revenues. Plus, whatever prices operators settle on for 2.5G data are likely to set a ceiling on what they can collect for 3G. In the end, Europe's telcos are banking on a perverse outcome: That if 2.5G is wildly popular, wireless networks will become clogged with traffic and customers will switch to 3G for better performance. In effect, they plan to choke one golden goose to fatten another. Now, they just have to be certain neither one lays an egg.

By Andy Reinhardt, with Stephen Baker in Paris, William Echikson in Brussels, Kate Carlisle in Rome, and Philip Schmidt in Madrid

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