Net Phone Calls, Free -- And Clear

Skype's radical technology and marketing threaten the very foundations of telecom

Eriksen Translations Inc. is a small business with a big footprint. The Brooklyn (N.Y.) company relies on 5,000 freelancers scattered around the world to help translate business documents into 75 languages for U.S. clients. That means phone bills of about $1,000 a month. So when business development manager Claudia Waitman heard about a new company called Skype Technologies that offers free voice calls over the Internet to other Skype users anywhere in the world, she jumped. Six months after signing up, Eriksen's phone costs already have fallen 10%. Even better, its employees and freelancers confer more often, allowing them to work faster and more efficiently. "It has changed the whole way we work," Waitman says.

Stories like this are popping up all over these days. More than 12 million Web surfers have downloaded the free Skype software and registered as users since the program appeared 14 months ago. The software turns a PC equipped with a microphone, speakers, and broadband connection into a 21st century telephone. Placing a call to another Skype user is as easy as clicking on a name in a pop-up window. Up to five people can pile into a free conference call, and the sound quality is often better than that of conventional phones. Skype's growth is accelerating as subscribers urge their friends to come aboard. The number of new registered users is now 70,000 a day, up from 30,000 in May. "Skype is leading the charge into Internet telephony," says analyst Katja Ruud of market researcher Gartner (IT ) Inc.


Skype is the brainchild of two notorious iconoclasts. It was invented by Niklas Zennström, a 39-year-old Swede, and Janus Friis, a 28-year-old Dane -- the same duo who infuriated the recording industry when they created the popular KaZaA music-downloading service in 2000. Now they're doing it again.

With operations in London and Tallinn, Estonia, Skype is such a radical departure from any previous phone company that it threatens the very foundations of the trillion-dollar-a-year telecom industry. It has no phone lines or pricey switching equipment of its own, instead using subscribers' PCs and the public Internet to run its network. And rather than spending millions on marketing, the 70-employee company relies entirely on word-of-mouth. The result is a cost structure major phone companies can't touch. "Nobody else has a business model as good as ours," says Zennström.

While many outsiders think of Skype as a gimmicky way to get free calls, the Scandinavian pair are serious about turning it into a real business. The strategy: Accumulate as many subscribers as possible and then start selling them services such as voice mail, call waiting, and follow-me calls. Zennström compares Skype to Yahoo (YHOO )! and Google (GOOG ), which also started out free and now rake in money by marketing to millions of loyal customers. Two months ago, Skype launched its first revenue-generating service, called SkypeOut, which lets subscribers place calls from their PCs to regular phones for about 2 cents a minute. The company won't say how much SkypeOut is pulling in, but 230,000 people have signed up, buying a minimum of 10 euros, or $12.40, in prepaid calling time. That's at least $2.8 million in revenues.

Next up is a push to attract more corporate customers. On Oct. 6, Zennström announced plans to roll out services next year aimed at small businesses, such as larger conference calls, group billing, and software tools to tie Skype user lists into company phone directories.

To fuel its ambitions, Skype has raised $20 million in venture funding. Among its backers: Draper Fisher Jurvetson, the firm that funded the free e-mail service Hotmail and then sold it to Microsoft (MSFT ) Corp. for $395 million. The explosive success of Hotmail made venture capitalist Timothy C. Draper a believer in so-called "viral marketing," where word of mouth can turn startups into major players virtually overnight. He sees the same principle working for Skype in Net telephony. "There's no question in my mind that Skype will become a $1 billion company," Draper says.

Already, that ambition is drawing rivals' fire. AT&T points out that Skype doesn't control its own network, so it can't provide the dependability required by most corporations. "Our customers demand quality and reliability most of all," says William Archer, president of AT&T's European unit.

Others, including SBC Communications (SBC ) Inc., accuse Skype of freeloading by using established companies' networks to provide services. SBC, for one, is asking regulators to make Skype pay for access to local networks."I was brought up believing if someone uses something, they should pay for it," says CEO Edward E. Whitacre Jr. Skype retorts that its users are paying for broadband -- and that carrying voice over the Net is no different than sending e-mail or streaming audio.

The impact on the Old Guard could get worse. Gartner figures the number of minutes of voice calls on conventional fixed-line networks will fall 10% this year worldwide. The majority of that is due to a shift from fixed to mobile calls and replacement of dial-up Net connections with broadband. But 15% of the decline is from calls sent over the Net. All told, London researcher Ovum forecasts that worldwide local and long-distance revenues will plunge by $15 billion, to $94.4 billion, by 2007. At the same time, revenues from Internet phone calls will top $8.9 billion.

To be sure, Skype isn't the only company offering phone calls over the Net. The first such services emerged a decade ago amidst much hoopla, but they foundered because the technology was immature. Now, thanks to growing penetration of broadband connections that boost the quality of Net telephony, startups such as U.S.-based Vonage Holdings Corp. are signing up hundreds of thousands of users for so-called Voice-over-Internet Protocol (VoIP) service. Some telecom giants, such as AT&T and Britain's BT Group PLC, (BTY ) have jumped into the field. And cable companies such as Comcast Corp. (CMCSA ) are offering VoIP services over their networks to compete with local phone companies.

What sets Skype apart from rivals is its unique technology. Zennström and Friis are apostles of so-called peer-to-peer networking, which does away with expensive centralized computers. Instead, Skype weaves together a distributed network from millions of connected PCs, radically lowering its costs. In essence, the company has reduced telephony to a piece of PC software that operates just like e-mail or chat. That means the network can expand indefinitely -- at almost no cost to Skype. It costs Skype less than 1 cents to add a new user, vs. hundreds of dollars for a traditional VoIP provider.

Although Zennström won't discuss Skype's profitability, the company's low costs mean that, with a large enough base of customers, it ought to be able to make money even if only a small fraction of them pay for extras. The most compelling question, though, is how quickly Skype's technology and business model will begin to reshape the rest of the telecom business. It won't happen overnight, but an inexorable shift away from the old way has already begun. Just ask the folks at Eriksen Translations.

By Andy Reinhardt in Paris

    Before it's here, it's on the Bloomberg Terminal.