The Wireless Challenge

Can big phone companies prevail in a brave new world of mobile and the Internet?

Since the days of Alexander Graham Bell, Finland's

national phone company has provided service for customers from the shores of the Baltic Sea to the upper reaches of Lapland. But last summer the Helsinki-based telco, now part of $9 billion Swedish-Finnish TeliaSonera, did something remarkable: It ran radio and newspaper ads urging its own customers to drop fixed-line voice service and switch to wireless.

Huh? A phone company asking its customers to cut the cord? To the cell-crazed Finns, "the idea makes perfect sense," says Jukka Vatanen, a freelance photographer and part-time taxi driver in Helsinki. That's because TeliaSonera also operates Finland's No. 1 mobile-phone carrier and provides speedy digital subscriber line (DSL) connections for Internet access. Vatanen is the company's ideal customer: Two years ago he dropped conventional voice service in favor of his cellular phone, but he kept a line into his house for DSL. That suits the company just fine. Sonera's long-term strategic plan is to shift all its voice calls to wireless, reserving the 3.2 million copper lines it runs into Finnish homes for broadband connections only.

Finland is but one example of telecom's wild new frontier. Consider the strange case of Britain, where the two independent halves of the country's former telco monopoly are chasing each other like hungry wolves. BT Group PLC (BTY ), the fixed-line carrier that spun off its mmO2 PLC mobile business in 2001 to reduce debt, has decided to get back into wireless. For customers who want to buy all their telecom from a single source, BT resells mobile services provided by an mmO2 rival, Deutsche Telekom's (DT ) T-Mobile International. Meanwhile, mmO2 (OOM ) aims to start siphoning off its former parent's fixed-line customers next year by hitting where it hurts -- in the home. The company will bring out innovative new cordless phones that skip over the BT voice network entirely, instead directing calls over residential broadband hookups.

A decade after deregulation shook the world's phone companies, and three years into the worst downturn the telecom industry has ever seen, the tumult is far from letting up. From Seattle to Singapore, the big telephone companies that once dominated the business are battling new competitors, sharply declining prices for conventional voice calls, and a relentless movement toward wireless calling. Just as bad, young people are drifting to other forms of communication, such as e-mail, online chat, and mobile-phone messaging instead of the good old phone. "There is a tremendous shift taking place," says Rudi Lamprecht, who heads the mobile-equipment business of electronics giant Siemens (SI ).

There's no doubt the old order is crumbling. Although the total number of fixed phone lines in the world is still creeping up, wireless is growing six times as fast. This year, figures London telecom researcher Ovum Ltd., the number of mobile subscribers will exceed fixed lines for the first time. Wireless carriers now take home nearly half of global voice revenues, up from 9% a decade ago. In Finland, an estimated 25% of households are now mobile-only. Even worse for fixed-line operators, the amount of money they take in from each line has fallen by one-third since 1997. As a result, global revenues for fixed-line voice services are expected to fall by 2.2% this year, according to the Geneva-based International Telecommunications Union.

Turmoil, however, doesn't mean termination. Fixed-line phone companies will still pull in $455 billion in revenues this year from voice services. And the telcos remain veritable cash factories: The world's leading carriers will spin out $131 billion in free cash flow this year, estimates brokerage Merrill Lynch & Co., up 10% from 2002, thanks to aggressive cost-cutting. Next year, Merrill says, cash flow will edge up a hair, to $132 billion. Growth may no longer be what it was in the 1990s, but the 45 stocks in the Standard & Poor's Global Telecommunications Services index are up 9% for the year.

The fixed-line carriers have an ace in the hole: their wires. "The biggest factor in their favor, bar none, is that they still own the local network," says analyst James Eibisch of market researcher IDC. How is that an asset if the world is going wireless? Because the wired network will always have the advantage of higher bandwidth, or communication speed, and in the emerging world of digital media, faster is always better. That's why outfits like Sonera are betting on DSL. "Broadband has become the driver for fixed operators," says Bruno Duarte, a partner at consultant Arthur D. Little's telecom practice in Paris.

Telco broadband is indeed finally taking off. After a slow start caused by muddled regulations, immature technology, and skittish financial markets, the number of DSL lines worldwide will nearly double this year, to 36 million, figures Ovum. By 2007, it's expected to hit 160 million. That's still only 13% of the world's phone lines, but in many developed countries, rates are already much higher. Sure, the phone companies also face a challenge from cable television operators offering high-speed Net links over their wires. Outside the U.S., however, DSL outpaces cable modem installations by nearly 2 to 1. By pushing DSL -- and eventually hawking all manner of snazzy services that run on top of it, from digital voice calls to films -- carriers may be able to stave off the decline of traditional voice service. Just look at the numbers from Korea. With the world's highest penetration of residential broadband, the East Asian powerhouse shows the way. While local phone-call revenue there is expected to drop 7.4% this year, to $2.5 billion, the $2.2 billion that Korean carriers are expected to get from DSL will more than make up the difference. By 2007, predicts researcher Gartner Inc., DSL will be a $46.6 billion global industry.

Strangely enough, one service that carriers aim to provide over those DSL lines will sound mighty familiar: voice calls. But they'll be sent over the Internet. The technology has been under development for a decade but is finally coming into its own. Instead of using fixed circuits, as has been the case since the phone network was invented more than a century ago, voice traffic can be chopped up into digital chunks and shipped around in much the way e-mail messages are. In Japan, the emergence of ultracheap Net telephony services will shrink revenues from traditional voice calling by up to half over the next few years, predicts Tadashi Onodera, president of No. 2 Japanese carrier KDDI Corp. Voice-over-DSL service, meanwhile, will be worth $4.7 billion worldwide by 2007, predicts researcher Allied Business Intelligence.

The move to Internet telephony is essential for the simple reason that it holds the key to lowering costs. But DSL takes care of only the outermost edge of the phone network -- the last few hundred meters to the customer's home. To remain cost-competitive, carriers also have to reengineer the very heart of their systems, the trunk lines that carry traffic over long distances. The reason: New Internet-type equipment costs as little as one-tenth as much as the older-style gear now used in the network. Equally important, it's only half as expensive to operate. This transition will be the dominant technological issue facing the world's phone companies over the next decade. When it's finished, carriers will be able to offer customers a unified communication channel that handles voice, data, and video. "Every carrier is following the same road map," says Mark de Simone, vice-president for technology solutions at Cisco Systems Inc. in Feltham, England. "The only difference is their timetable."

Some brave operators are already moving toward this futuristic model, with startling results. The most advanced is Telecom Italia (TI ), which has completely rebuilt the core of its nationwide network around Internet equipment. Telecom Italia expects to reduce its operating costs by 60% when the technology has been fine-tuned in a year or so. That should help it hold operating margins steady at an industry-leading 44% even as fixed-line revenues drift down over the next few years, predicts Merrill Lynch & Co.

This transformation won't happen overnight. And it's going to cost a bundle. Gartner figures carriers will shell out $44.7 billion from 2003 to 2007 on Internet-type equipment for their networks, while spending on traditional phone gear will fall 12.5% annually over the same period, totaling $41.9 billion. "We're trying to replace one of the most sophisticated and evolved infrastructures in the world," cautions Tal Simchony, chief executive of Veraz Networks Inc. in San Jose, Calif., a seller of equipment for sending voice calls over the Net.

Carriers no doubt wish that technology change were their only challenge. But while reinventing the future, they also have to deal with a troubled present. The most immediate problem: holding on to customers. Thanks to deregulation, established carriers are losing market share to competing local service providers. Most fixed-line European telcos, for instance, still own and operate 90% to 100% of the phone lines in their home markets. But rivals are walking off with 30% to 50% of the minutes spent talking over those lines, as customers can now choose alternative carriers for calls, according to telecom market watcher Pyramid Research LLC in London. In Germany, giant Deutsche Telekom carried just 68% of the voice minutes in 2002, down from 74% two years earlier. Fixed-line revenues at France Télécom (FTE ) fell 2.1% in this year's first half, to $12.5 billion, while at Japan's giant NTT (NTT ), fixed-line revenues dropped 9%, to $28.2 billion, in the year ended last March.

Newcomers are profiting from the change. Europe's No. 1 competitive carrier, Stockholm's Tele2, has 20 million customers in 23 countries, vs. 10 million three years ago, and posted first-half 2003 revenues of $2.3 billion, up 18.2% from a year ago. Smaller companies, such as Germany's 3U Telecom Inc., which offers cut-rate fixed-line service in seven European countries and the U.S., are gaining even faster. And in Russia, the country's No. 1 alternative provider, Golden Telecom Inc., more than doubled its revenues in this year's first quarter, to $78 million, by concentrating on business Internet and data services.

It's not all smooth sailing for upstarts, however. The 2001 telecom crash wiped out dozens of newcomers and reduced pressure on industry giants. For the past three years, their share of international long-distance traffic has held steady at 69%, notes analyst Stephan Beckert at market researcher TeleGeography Inc. in Washington, D.C. "We have seen the empire strike back," he says. Established carriers are fighting especially hard against opening up their networks to competitive access. Tele2 CEO Lars-Johan Jarnheimer says they use every available avenue -- legal, technical, and administrative -- to slow down rivals. One telling statistic: According to the European Competitive Telecommunications Assn., a Brussels trade group, old-guard carriers on the Continent have made fewer than 7% of their local phone lines available for resale by rivals. "Regulators could be acting much more strongly," says Jarnheimer.

Many telecom giants own both wireless and wired networks, so they're not staring at the abyss. Indeed, to boost their stake in wireless, some have bought into cellular operations in developing countries to keep growing. Deutsche Telekom owns a share of three wireless operators in Eastern Europe, Spain's Telefónica (TEF ) has investments throughout Latin America, and Singapore's SingTel has minority stakes in mobile companies in the Philippines, Indonesia, and Thailand. But some carriers -- including BT and AT&T (T ) -- have spun off their wireless units in recent years. That explains such tactics as BT's move to resell wireless from another company.

Yet even those that own both wired and wireless divisions are struggling with the shift. The biggest problem is figuring out how not to lose customers in the process. Sonera has chosen to keep subscribers in the fold by encouraging their migration from one part of the business to another. But Deutsche Telekom is letting the market decide. It's pitting its huge T-Com fixed unit against the T-Mobile wireless group and vice-versa. "They are going to compete on voice," says CEO Kai-Uwe Ricke of DT. The problem with such internal rivalries is that they can distract companies from the real threat, says Katja Ruud, a telecom analyst at Gartner. "Instead of beating external competition, they're expending resources fighting themselves," she says.

A decade ago, Massachusetts Institute of Technology pundit Nicholas Negroponte observed that it was an accident of technology history that phone calls are made mostly over wires while more complex television broadcasts travel over the air. The rise of wireless phones and cable TV has borne out Negroponte's prediction that the situation would flip-flop. But along the way, the emergence of the Internet has thrown all the rules out the window. "People have written off the big telcos many times before, but they always bounce back," says Mike Quigley, the president for fixed-line communication at French equipment-maker Alcatel (ALA ). Today's turmoil will someday produce a new telecom system, with voice calls sent through the air and wired broadband available in much of the world. And the old wireline telecom firms will still be there -- battered, transformed, but mostly intact.

By Andy Reinhardt

With Jack Ewing in Frankfurt, Irene M. Kunii in Tokyo, and bureau reports

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