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02/10/98- Updated 12:13 AM ET

Net could revolutionize phone service

New phone technology could be 'unstoppable'

NEW YORK - Almost a year ago, AT&T research chief David Nagle demonstrated an Internet telephone call during a two-day meeting with stock analysts.

He placed the call from a computer, not a telephone. The sound quality was terrible. The delays were annoying.

The story was far different last month when AT&T executives met once again with Wall Street analysts. President John Zeglis showed off a new kind of higher quality, phone-to-phone Internet call. And the demonstration was accompanied by a stunning announcement that AT&T would be the first major U.S. long-distance carrier to jump into the emerging market now known as Internet Protocol (IP) telephony. It is basically a cheaper, more efficient technology that could allow millions of AT&T phone calls to travel via the Internet instead of the regular phone network.

The shift at AT&T is powerful evidence of a remarkable change that has occurred in telecommunications during the past year. Telephone calls over the Internet, dismissed not long ago as a high-tech version of ham radio, are suddenly taken very seriously by the communications establishment.

That raises the prospect of lower prices and new services for consumers and major changes in the structure of the industry now dominated in the USA by AT&T, MCI, Sprint, GTE and the regional Bell phone companies. AT&T's trial begins during the second quarter. Qwest Communications and a few other carriers already allow people to make calls over the Internet for 5 cents to 7.5 cents a minute.

By 2002, the Internet could account for 11% of U.S. and international long-distance voice traffic, up from just 0.2% last year, predicts analyst Mark Winther of International Data. "Internet telephony is a reality, and telcos have surprisingly awakened to that rather early," analyst David Goodtree of Forrester Research says. "It will be the catalyst that forces the total restructuring . . . of the profits of all telcos worldwide."

Perhaps this forecast was the wakeup call: IP telephony could eliminate the profits of U.S. long-distance carriers by stealing just 6% of U.S. telephone traffic, the International Telecommunications Union warned in a report last year.

Evidence of the hastening convergence of the phone network and the Internet is overwhelming.

The same day that AT&T announced its Internet telephone plans, MCI revealed a pact with Netspeak, a company that makes computers that connect phone networks to the Internet. Bell Atlantic announced a day later that it wants to build high-speed Internet transmission lines across its local phone territory. US West announced the following day that it was forming an Internet-development alliance with equipment maker Cisco Systems.

America Online, the country's largest on-line service, is testing IP telephone service with 5,000 users. Tele-Communications Inc., the country's largest cable TV operator, said in December that it would begin offering Internet phone service in late 1999. Last month, start-up Level 3 said it would build the nation's first telephone network based entirely on Internet standards.

"Over the next few years, you will see very rapid growth in IP telephony," says Joe Nacchio, CEO of Qwest, which is constructing a 16,000-mile fiber network that uses both traditional phone switching technology and the Internet. "I think it will be unstoppable." He already offers consumers IP telephony in nine Western cities.

Humble beginnings

Internet telephony barely existed until February 1995, when an Israeli company, VocalTec, introduced a software program that allowed people to speak to each other using their PCs and a microphone.

"It was like ham radio," recalls analyst Francois de Repentigny of Frost & Sullivan, an early user. People could only talk to other personal computer users who ran the same software and happened to be logged onto the Internet at the same time.

The medium took a huge step forward in 1996, when VocalTec unveiled a "gateway" computer that connects the Internet to the phone network. That allowed people to speak to each other over the Net using regular phones instead of PCs.

The advance was a major break with tradition. The basic design of the phone network hasn't changed since AT&T invented it more than 100 years ago. It's a vast roadway where every call has its own lane, or circuit. A telephone call ties up an entire circuit, even when people pause between words or put the phone down to answer the doorbell. The Internet is much more efficient. Calls travel a short distance over copper phone lines to the nearest phone company office, where a gateway computer converts the sound of the voice into the ones and zeros of computer language and breaks it into little pieces known as packets. Compressed packets are thrust into the Internet or data network, where they share lines with other transmissions, such as e-mail.

The result is that Internet calls are cheaper than regular calls. "This is going to be the stake that finally drives a hole through the heart of the . . . extraneous costs associated with traditional voice communications," says Jim Courter, president of IDT, which charges 5 cents a minute for long-distance calls over the Internet. "The cost of calls is going to be dramatically reduced."

IP calls are especially cheap now, because they are exempt from fees long-distance carriers must pay local carriers for access to the local networks, where all long-distance calls begin and end. Local carriers want that to change, but IP technology would still be more efficient than a regular long-distance call.

Cable TV companies and Internet service providers entering the $80 billion long-distance business are sure to benefit. By 2002, the Internet will drain $3 billion in annual revenue from U.S. long-distance carriers, Forrester Research estimates. That's about 4% of their revenue base. About $2 billion of that will go to new long-distance providers, and about $1 billion will go directly to telephone users in the form of price cuts.

Profitable niches

Others, too, will benefit as IP phone service takes hold:

Up to 10% of the world's fax market, which generates $45 billion in telecom revenue a year, will move to the Internet in two or three years, says CEO David Friend of FaxNet, a long-distance carrier just for faxes.

"The $18 billion market for calls from the United States to foreign destinations will be the first and biggest target of Internet telephony," Forrester says. Key reason: The Internet bypasses international telephone networks, which are often outrageously expensive. USA Global Link announced plans in early 1997 to build an IP-based network just for international calls.

A company can easily slash its phone budget 35% by moving its voice traffic to the same network that handles its data transmissions, says Eric Benhamou, CEO of Internet equipment maker 3Com. A Forrester survey of 52 Fortune 1000 companies finds that more than 40% of telecom managers plan to move some voice or fax traffic to the Internet by 1999.

One major force driving the rapid growth of the Internet phone business is that the basic technology behind the Internet is available to the public for free. But today's Internet has drawbacks, too. It is dogged by traffic jams that can occur during peak usage. Even users with high-speed access can get bogged down when the network is overloaded. Newer versions of the Net will be able to assign higher priority to certain kinds of transmissions, such as phone calls.

AT&T's Nagle serves on a presidential advisory committee that is guiding the development of Internet 2, a high-speed network that will be available in several years.

Meanwhile, he says the quality and security of IP telephony on the existing Internet is rising. The implications of that are just reaching consumers.

Bruce Ravenel, TCI's senior vice president for telecommunications, says TCI's 12 million customers won't be able to tell the difference between a regular phone call and an IP call. "The technology inside the network will be IP, but the experience for the customer is that they will make a 'toll' quality phone call, just like they do today with conventional telephone networks."

John Roth, CEO of equipment maker Northern Telecom, goes even further. He sees the day when voice calls will be virtually free and video and data transmission will be the real moneymaker.

Who will dominate?

Newcomers might have an edge in the market to provide this new breed of phone service. "Give me one example of any company in any industry that has managed to deal with an economic change of this magnitude and be dominant in the next era," says James Crowe, CEO of Level 3. "There isn't one."

Even old-line phone carriers that develop a good strategy for IP telephony might run into trouble, because they will need to take huge charges to write off their old networks, says Francis McInerney, partner with North River Ventures, an investment and consulting group.

But Nagle says big phone companies already have paid off many of their network investments. And new data networks will lower costs for traditional carriers, so profit margins won't be gutted by falling prices. Finally, he notes, history shows that traffic on communications networks rises as prices fall.

Nagle says the fact that AT&T has been able to create an Internet phone offering between 1997 and 1998 is proof that it can compete.

"The industry is moving more quickly. And more important for us, we're moving a lot more quickly," he says. "We have realized the potential and importance of the Internet, and we are resolved to be leaders in that industry."

By Steve Rosenbush, USA TODAY

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