U.S. Wholesale VoIP Models: Domestic vs. International

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1 Market Analysis U.S. Wholesale VoIP Models: Domestic vs. International Abstract: Besides the better-defined international wholesale VoIP model that cuts rates on highcost routes, some U.S. NextGen carriers use their networks to provide domestic wholesale VoIP, whose near-term appeal is less clear. By Steve Koppman Strategic Market Statements The international model using the Internet, despite talk of its inevitable demise, is likely to continue to grow in the near future more rapidly and reliably than the domestic model. Services that don't require their customers to make their own IP investments are likely to be more rapidly successful in the near and medium term, especially given the current economic outlook. Carriers seeking to promote wholesale VoIP would do well to clarify the technology's relative costs and benefits for customers. Although VoIP conversion will be a long slog during the next five to 10 years in the absence of urgent reasons for adoption, economic revival whenever it comes will increase network investment that will move the market faster in that direction. Publication Date:November 5, 2002

2 2 U.S. Wholesale VoIP Models: Domestic vs. International Introduction: Tale of Two Models While a major, relatively longstanding, wholesale voice over Internet Protocol (VoIP) model involves niche players using the Internet to offer lower-priced calling on high-cost international routes, another, less widely known and slower to catch on wholesale model is a primarily domestic one used by U.S.-based NextGen players with national and international Internet Protocol (IP) networks they use for voice as well as data traffic. While the growth curve for both these models has slowed, international North American-originated wholesale VoIP sales will approach $400 million in 2002 (with nearly $300 million attributable to two dominant but relatively small players, ITXC and ibasis), while the harder to measure and define U.S. domestic wholesale VoIP market will remain well under $100 million. Ambiguity in definition is particularly problematic in this market, because services are typically not identified as VoIP (nor circuit-switched) and the share of voice traffic carried internally by carriers as IP but not advertised as such to customers continues to rise. The Anti-Regulatory VoIP "Tradition" and Beyond VoIP has historically taken root by finding ways around market "choke points" where regulation has raised prices, primarily international settlement rates. But domestically too, for example, an international wholesale VoIP player has provided Florida intrastate service to a major carrier wanting to avoid that state's high intrastate access charges and claims to save it 60 percent despite having to trunk the traffic back and forth some thousand miles to its New York location. But VoIP is gradually moving beyond its earlier role getting around regulation, or primarily international "arbitrage" as it is pejoratively called. That business is also one whose appeal seems likely to decline over time as settlement rates and international prices decline worldwide, and a variety of lower-cost modalities for international calling develop, though the international VoIP players note their costs are declining too in a continuing environment of excess capacity. Domestic Strategy: Using What You Have In contrast with this international wholesale business, VoIP is much smaller as a proportion of domestic wholesale minutes and revenue, and often even less clearly identifiable as VoIP, paced in the United States by such carriers as Level Three and Genuity which, having built their own IPbased networks, try to leverage their advantages for voice as well as data. The domestically focused businesses of these NextGen IP-oriented companies, by contrast with the international strategy, use private domestic IP carrier networks already in place rather than the Internet. Most of these players (Global Crossing being the exception) have most of their assets in the United States and have been simply trying to get the most out of them. Level Three pulled back from international overextension to recover financially in Genuity grew out of

3 incumbent local exchange carrier (ILEC) GTE, although it does have some international assets. Clearly, none of these players is in top financial shape: One is emerging from bankruptcy, another is considered at risk after being abandoned by its founding company, and a third recently received big new investments that took it off Wall Street's suspected critical list. The Two Markets In both international and domestic wholesale models, the key players are relatively small and vulnerable. The international model continues to grow rapidly, despite reasons for its demise, sustained by its low-cost model. The domestic model meanwhile is largely an artifact of a few networks already in place. Clear reasons for adoption are neither well established nor clearly articulated. More profound market development will await some combination of actions by larger carriers and a more compelling rationale. IP on the QT As elsewhere, U.S. buyers and suppliers have generally de-emphasized VoIP's identity because of its reputation for inferior quality and wellknown lower cost, the latter stoking carriers' fears that acknowledgment of its use will bring retail customer demands for further price reductions while wholesale margins are already hard-pressed. Out of the Closet, Into the Router: "Native" Service But the NextGen players are now moving toward more explicit introduction of "native" wholesale VoIP services requiring service provider customer use of IP equipment in contrast with most current services. Genuity Genuity is relatively alone among its peers in already providing explicitly VoIP-based wholesale service to which customers can connect over the Internet. Genuity has focused on the wholesale service the longest, since 1999, and offers market-leading prices, in some cases less than a penny a minute. (Its stability has, however, been in question since Verizon stepped back from its key role in the company.) Level Three Level Three, which has been providing its standard wholesale voice serving only a handful of customers, including WorldCom on a VoIP platform transparent to customers, is planning 2003 introduction of two new explicitly VoIP services, "3 voice" inbound and a two-way (inbound and outbound) service to follow. Level Three's strategy is heavily based on taking advantage of the extensive local network it has developed for its primary dial-up Internet access business. This enables it to offer inexpensive service, even to "the house next door" without returning to the long-distance network and paying access charges, its distributed build-out already having been paid for by its managed modem business and requiring only modest upgrades at the edge to support VoIP. With its new 3

4 4 U.S. Wholesale VoIP Models: Domestic vs. International inbound service designed for marketing, it hopes to leverage its strengths behind a market-leading (price-wise) offer for toll-free service. Global Crossing: Slowed to a Crawl Global Crossing, meanwhile, had its rollout of explicitly wholesale IP Origination slowed to a beta crawl (with only two test customers) by its 2002 bankruptcy reorganization and now says it plans to re-energize that service as well as bringing up complementary IP Termination in Global Crossing is at the same time dramatically increasing the share of minutes carried as VoIP within its network, which already doubled sequentially in the second quarter of 2002 into the 15 percent range, which largely reflects increasing carriage of Global Crossing's basic wholesale voice service over IP, both internationally and domestically. Qwest has also introduced a wholesale IP termination service, though efforts to interview that carrier were unsuccessful. VoIP Ambiguity: Taking the Measure Global Crossing's situation illustrates the ambiguities of VoIP revenue measurement. Global Crossing is known as an IP-based carrier, so a buyer might assume its traffic would be carried as IP, but the large majority of its voice minutes are in fact on a circuit-switched basis, although this balance is fast-changing. Its wholesale service is not explicitly labeled as circuitswitched or VoIP, and the carrier uses two separate networks. As the share of these minutes carried over IP increases, should this be credited as an increase of revenue for wholesale VoIP? The Large-Carrier Outlook Even large mainstream carriers are making tentative moves toward developing their own wholesale VoIP-based services. AT&T, though it won't comment publicly, quietly tested its own wholesale service this year, believed to be focused on international. WorldCom uses VoIP for internal traffic. Sprint has made no apparent move toward wholesale long-haul IP yet but is focused on packetizing its local networks. As carriers evolve their network technologies, however, they tend to move closer to VoIP. The question is, chiefly, how fast. Economy: Boom or Bust? The role of the economy continues to be controversial and paradoxical in its influence on this market. Promoters claim that arguments for VoIP's long-run network-consolidating lower cost are strongest in harder economic times. And the appeal of niche wholesalers is strengthened when carriers reduce their investment in expanding their own networks. But the economic climate of tight capital, along with dropping public switched telephone network (PSTN) prices, has slowed the extent to which carrier customers invest in IP equipment a setback to carriers focusing on new IP-explicit services requiring such hardware. Before the current

5 5 slowdown, VoIP adoption was viewed as arriving much faster, and carriers are still adapting their planning to a much slower-evolving marketplace. The Cost Equation Wholesalers with hard-pressed margins look to VoIP for economic advantages. The Internet-based model that avoids settlement payments and terminates international calls at low rates clearly does that. But while a new, low-cost IP transport network is an advantage, the share of wholesale costs typically coming from long-haul transmission itself is small (less than 10 percent), so cost advantages domestically on private carrier IP networks where normal access charges are paid at the PSTN end would typically be in low single digits. Potentially greater savings may result depending on how specific carriers organize their networks and services. The eroding cost advantage of international VoIP as other international rates decline meanwhile contributes to a gradual shift in discussion of the modality from international money-saving and the basic abilities of the technology to the relative efficiency of IP vs. circuit-switching and the quality of business models. Accepting the Inevitable...Whenever The Long (Slow) Slog But dramatically lowered PSTN pricing domestically along with tightly constrained capital spending suggest the argument for VoIP will not be won quickly. At best, migration to VoIP generally will be a long slog of five to 10 years or more, especially in the absence of radically lower cost or applications the customer doesn't want to do without, and in the presence of a slowed economic climate and a more skeptical view of new technologies. Even mainstream carriers seem to accept the claims of VoIP as a probable long-term requirement to remain a low-cost provider and are moving incrementally in that direction. But at the same time VoIP has a broadly conceded inevitability, it lacks urgency and will not be at the top of carrier capital priorities during a discouraging economic period. When Large Players Move Major carriers will meanwhile experiment to ensure they have worked through potential quality and other problems. Of the two large, financially relatively healthy long-haul players, AT&T appears to be positioning for leadership in this segment while Sprint focuses first on local network packetization. To a large extent, they rely on smaller carriers to test, demonstrate and so "prove out" wholesale VoIP. They can gradually increase the share of their high-cost international traffic on the technology as they see fit, while testing domestically and seeing when the Level Threes of the world come up with something that looks consequential.

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