December 28, 1998
Amid the Delirium Over Internet Auctions,
Investors Turn Deaf Ear to Telephony Over the
Web
By Bill Alpert
Investors were going mad last week for Internet flea markets like uBid, whose
shares jumped 104 points in two days, to an intraday delirium of 189 before
plunging 68 1/2 Thursday to 121 5/8 . But Wall Street could hardly care less
about Internet telephony. VocalTec and NetSpeak, firms whose shares once
saw the far side of $30, have floundered this year, falling to the single digits.
But the industry is starting to put serious money on technologies that place
phone calls across the Internet instead of through traditional phone circuits.
"This thing is moving from tire-kicking and dabbling to very important business
initiatives," says Michael R. Rich, who left AT&T last month to become
president of NetSpeak, a Boca Raton, Florida-based rival of VocalTec. At the
Western Cable Show earlier this month, says Rich, nearly every cable television
operator presented plans for phone service. Traditional phone suppliers like
Northern Telecom's Nortel Networks and Motorola are putting their first
Internet stuff in the field. Giant startups like Level 3 Communications and
Qwest Communications International are spending tens of billions of dollars to
create "new generation" phone networks based on Internet technology.
Conventional phone networks set up a circuit from one end of a call to the
other, with that call hogging the line even during conversational lulls. Internet
arrangements slice a caller's speech into packets of data, which individually find
their way to the listener, where the packets are reassembled in proper order.
Unfortunately, some of the conversational packets get delayed or lost, giving
many Internet calls the quality of a bad cellular connection.
Quality Problems
Although VocalTec turned the world on to 'Net telephony in 1995,
voice-quality problems have limited its popularity to folks making calls into
countries with high international phone tariffs. Most nations, including the U.S.,
currently define Internet calls as "data," not "telephony," allowing 'Net callers to
bypass regulatory tollbooths. An Internet caller can duck the nickel-a-minute
access charge imposed on long-distance users by local phone firms in the U.S.
And a 'Net call to China costs only about 25 cents a minute.
This advantage could vanish with the stroke of a regulator's pen, of course, but
the packet-style transmission of phone calls still offers compelling economic
advantages. During pauses in speech, for instance, the phone network could
transport packets from other conversations or from communicating computers.
Jim Crowe, chief executive of Level 3 in Louisville, Colorado, has claimed that
such efficiencies could make transport costs on his Internet-style network some
27 times cheaper than those on conventional phone networks. Packet-switched
technology also will allow new services -- like enabling people to talk while they
collaborate on a spreadsheet or compete in a computer game -- creating new
revenue opportunities for phone outfits.
Spinoff Ahead?
While investors seem eager to bid up shares of still-unprofitable business
concepts like Internet auctioneering, the stock market seemingly has lost
patience with pioneering 'Net phone networks.
One such company, Hackensack, New Jersey's IDT, is considering the spinoff
or sale of its Net2Phone subsidiary, which offers long-distance calls for a nickel
a minute between 62 cities. Net2Phone had $5.3 million in revenues in its first
fiscal '99 quarter, ended October 31. The total was a third higher than it
reported in the preceding three months. However, the IDT subsidiary is still in
the red.
One problem, admits IDT's David Greenblatt, is that traditional phone firms
offer deals as cheap as eight cents a minute. So the firm is refocusing its
business on prepaid phone cards, which brought IDT $67 million in revenues in
the first fiscal '99 quarter, and allowed the corporation to earn $4.9 million, or 14
cents a share. With IDT shares trading at 15 7/8, Greenblatt argues that
investors are placing no value on IDT's Internet phone business.
Internet Phone Stocks
Not much to speak of, in profits, but Internet telephony will be huge. Isn't that
enough today?
Suppliers
Recent
price
Enterprise
capitalization
(millions)
Est. 1999
cash flow
per share
Est. 2000
cash flow
per share
VocalTec
$12
$137
$1.30
NA
NetSpeak
10
126
-1.00
-$0.80
Carriers
Level 3 Commun.
40
14,280
-1.00
-$1.50
Qwest
44
16,184
1.60
NA
Note: "Enterprise capitalization" includes stock market value plus debt. "Cash
flow" includes earnings before interest, taxes and depreciation charges.
Internet phone service is becoming a game for players with far deeper pockets
than tiny IDT. The Internet telephony big league includes Qwest, Level 3 and
RCL Communications, as well as IXC Communications and the Williams Cos.
Qwest is the fiber-optic brainchild of Denver oil baron Philip Anschutz. By
mid-1999, it will have laid down 18,500 miles of high-capacity optical lines. Most
of the cost of creating this network has been defrayed by MCI WorldCom and
GTE, who've paid to run fiber alongside that of Qwest. Microsoft also bought
$200 million worth of Qwest shares this month, at $45 apiece, and announced a
venture that will let Microsoft update its customers' software over Qwest's
network.
Other deals have helped Qwest grow quickly, including the June acquisition of
long-distance carrier LCI International and a November joint venture with
Dutch firm Royal KPN, to built a 7,500-mile network across Europe. Including
LCI, Qwest's revenues for the nine months ended in September were $1.4
billion.
Although construction costs and interest on $2.5 billion in high-yield debt
probably will postpone profitability until at least next year, Merrill Lynch analyst
Daniel Reingold thinks Qwest could earn 35 cents a share in 1999. Looking at
cash flow -- which adds back interest, taxes and depreciation -- Reingold sees
Qwest producing $1.61 a share in '99. Shares in the firm have more than tripled
since Qwest's IPO last year, to a recent 44, putting a valuation on Qwest's
enterprise of $17 billion.
Equally impressive is the capitalization of Level 3, a spinoff of civil engineering
giant Peter Kiewit Sons.
Level 3 arrived on Nasdaq only in April, but its recent share price of 40 values
the company at nearly $15 billion, including debt. Before launching what's been
called the biggest startup in history, Chief Executive Jim Crowe built the
competitive local phone firm MFS Communications, which MCI WorldCom
bought for $14 billion.
Kiewit endowed Level 3 with a grab-bag of assets that include small local
phone firms and cable franchises. For the nine months ended September, Level
3 actually got more of its $300 million in revenues from mining coal than from
moving data. An ambitious plan to build a global network that, unlike Qwest, will
also include local loops to downtown office buildings, has Wall Street postponing
expectations of positive cash flow until 2002. Don't expect net profits until 2004.
By running Internet voice packets over its own carefully managed network,
Level 3 hopes to avoid the quality problems that bug calls made over the public
Internet. Traditional phone firms aren't idle. "AT&T has been doing some pretty
incredible things in the Asia-Pacific region," says Jeff Pulver, president of the
Internet phone consultancy pulver.com, in Melville, New York. "Internationally,
AT&T has been on the leading edge of implementation in [Internet] telephony."
Gateways to Success
In the U.S., AT&T is pilot-testing an Internet phone service called Connect
'N' Save, while Sprint offers a deal called Callternatives. Deutsche Telekom
bought a 21% stake in VocalTec last year, for $48 million, and promised to use
$30 million worth of VocalTec products by 1999.
The systems that allow calls to travel by Internet are called "gateways." They
are sold by publicly held firms like VocalTec, NetSpeak and tiny E-net, as well
as by a bunch of private firms like Canada's Vienna Systems and Redwood
City, California-based Clarent -- AT&T's supplier in the Far East. While
international bodies are drawing up standards, the incompatibility between
gateways has hampered the free passage of calls between Internet phone
networks.
After acquiring Cisco rival Bay Networks, Nortel Networks has an aggressive
IP telephony program. Glenn Falcao, president of Nortel's Internet product
business, says experienced phone suppliers like Nortel can bring scalability and
features that pioneer gateway vendors can't match. Nortel gateways are in the
field now, and Falcao expects at least one customer to announce a rollout next
month.
Impressive as networks like Level 3 will be, they won't serve consumers.
Robust consumer networks with packet phone service will await the availability
of fast networks from cable TV firms and local phone companies. At this
month's Western Cable Show, Motorola demonstrated the first device that
would allow consumers to plug in a phone, a PC and a TV. The gadget used
technology from NetSpeak, the gateway firm in which Motorola has an
investment. Tele-Communications Inc. and AT&T also are testing demand for
cable phone service, in Fremont, California.
interactive.wsj.com
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