VoIP Won’t Wake Telecom from the Dead –

We’ve heard a lot about voice over Internet Protocol (VoIP) lately, and many hope this exciting technology could be the beginning of the rebound for telecom. Venture dollars have begun to flow into telecom again and interest is even returning to public telecom stocks. But those who think VoIP is signaling the rebirth of telecom may be in for a rude awakening.

The telecom sector was one of the hardest hit in the loud bubble pop of 2000. Young, newly-public companies were trounced, but even long-established companies like Alcatel, Lucent and Nortel saw their fortunes slashed. Some of the reset can be attributed to the irrational exuberance that affected most of the market.

But the telecom setback seems deeper and longer than the market at large. Over the last few years, analysts and investors have taken the opportunity to rethink some of their assumptions about the market for telecom services and, in turn, telecom equipment. The conventional wisdom held that there was an insatiable appetite for bandwidth, driven largely, of course, by the Internet. As the argument went, as prices declined, the value of the services would grow in value and adoption so that price erosion would be generously compensated for by the technology savings and volume growth.

Today, we face a bandwidth glut greater than the surplus of fiber cabling. Even with the current shake-out well on its way, there are more service providers and equipment suppliers than the market can support. As companies get desperate to generate revenue any revenue at all they slash prices, with the double whammy of lower revenues AND lower margins conspiring to keep profits low or even non-existent.

In 2003, some new signs of life appeared in the telecom sector, judging by public market performance (see Table 1). In late October, the stocks of most of the big equipment players hit new highs, and almost all managed to end the year with significant gains.

One of the brightest spots in the sector has been VoIP. While the underpinnings for this technology are almost a decade old, the press has recently picked up on this technology “phenomenon” as it has begun to move into the consumer realm. The industry has for a decade demonstrated the efficiency of carrying voice in packet form, allowing carriers to more cheaply transmit telephone calls around the globe and reduce operational costs by combining their voice and data networks in a single infrastructure.

In 2003, the public market finally got excited about VoIP. A number of smaller public companies focus on this space and recently have been joined by others seeking to reposition themselves in this fashionable niche.

The results were outstanding (see Table 2). Many of these companies quadrupled in price during 2003. Packet8, which only recently began offering its consumer VoIP service, ended the year up almost 20X, with a market cap north of $150 million.

Naturally, some entrepreneurs and venture investors are betting that this kind of performance bodes well for the private players in this space. Telecom startups have taken a huge beating over the past few years, and we are all anxious for a recovery. Like public companies, the surviving startups have modified their positioning and focus to try to find something that can generate the desired returns. With the public market starting to show some support, investors have stepped back in, albeit at vastly reduced valuations from what we saw at the peak.

One of the hottest telecom niches seems to be “consumer VoIP” allowing consumers to use their DSL or cable modems to make and receive regular phone calls, usually offered with cheap and unlimited domestic long distance and deeply discounted international dialing. The list of players has grown quickly. Vonage, a venture-funded start-up, was one of the first in the game, but they’ve been joined by other private players, including VoicePulse, and a host of already-public companies, such as Packet8 and DeltaThree. Table 2 shows how Wall Street has warmed to these last two.

Unfortunately, despite the bear hugs of venture investors and mainstream press, the possibility of venture-style returns does not loom large. Consumers will weigh these new VoIP services against traditional wireline offerings from the incumbent Bell companies. While quality isn’t quite as good, a considerable price-sensitive segment of the market will adopt the service. But there is the rub: Even if VoIP technology is a cheaper way for carriers to transmit phone calls, the bandwidth glut will reduce the advantage quickly. Wireline carriers are already losing traffic to wireless networks, e-mail and instant messaging. Paul Johnson, a long-time securities analyst and now a hedge-fund manager, asks: “Can new VoIP assets really be cheaper than old, but fully depreciated assets?” The answer is, “no.” SBC and Verizon now offer unlimited long distance plans themselves, using re-priced technology from the last century. If your cost is zero, then you can afford to reduce prices significantly. VoIP players will have a hard time building the scale or margins that they need to sustain a profitable business. They’re already slashing prices to compete with each other.

Another VoIP niche is called “Session Border Controllers.” These boxes sit between private and public networks, or between disparate public networks, and they perform signaling and shaping functions that provide quality, security and interoperability to VoIP transmissions. This is a critical technology. In fact, there are at least six venture-funded startups building these boxes (see Table 3).

It’s a little hard to believe that this fairly narrow functionality could singularly sustain a public company, but one or more of these startups could be an acquisition candidate, especially as suppliers of existing “edge boxes” contemplate build-or-buy decisions on how best to add the capability to their own product lines. It is unlikely that all six of these companies will find good homes at attractive valuations. Like the game of musical chairs, there just aren’t enough places to sit, and some will end up being losers.

For many VoIP startups, the target customers are the telecom providers, wireless, wireline, and cable. As Table 4 shows, the carriers have greatly underperformed in the public markets throughout 2003. The traditional telco group is being punished for having a shrinking subscriber base, the wireless players are under margin pressure, and the cable companies seem to be gaining slightly at their expense. But with carriers under pressure, the entire group is going to keep capital budgets in check for the foreseeable future while continuing to play suppliers against each other.

Investors have to take these trends into account before imagining a telecom recovery. VoIP is a welcome development for the sector, but it’s not a sustainable business model while the glut continues. Telecom, unfortunately, is still dead.

Bart Schachter is a founder and managing partner of Blueprint Ventures and David Frankel is a technology partner at the firm. Based in San Francisco, Blueprint is an early-stage investor with 2 funds under management. Schachter focuses on communications and IT infrastructure, wireless technologies, nanoelectronics, software and semiconductors. Frankel’s interests include wireline and mobile communications, high-performance computing, and IT infrastructure.