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Net phone companies race clock

Internet phone companies are racing to cash in on what may become a billion-dollar industry before the government gets there first.

Internet phone companies are racing to cash in on what may become a billion-dollar industry before the government's wheels of bureaucracy can pick up speed.

Born from a start-up culture rather than the historically plodding environment of their Bell predecessors, these companies are looking beyond any potential regulatory complications that may arise from a report issued late last week by the Federal Communications Commission. Although the agency left the door open to regulation down the road, analysts do not foresee any insurmountable obstacles for the burgeoning industry--at least not yet.

In releasing its report to See related story: 
Net phone firms elude regulation Congress last Friday, the FCC sent a somewhat mixed signal to the industry. While the agency said it would be premature to impose fees on Internet telephony companies immediately, it went on to say that many of them appear to be no different from traditional analog phone carriers.

That renewed fears that the government may impose regulatory fees on companies that use Internet technology to provide long distance and other telephone services. While traditional phone companies such as AT&T and GTE must pay so-called access fees and universal service fees, Internet telephony companies have so far been exempt.

Concerns about the report have been reflected in the decline of stock prices among Net phone companies, which may have to temper the pace of their development. But analysts say the short-term decline should not deter the industry.

"There's really no reason for companies like IDT to get beaten up by this report," said Vik Grover, a senior equity analyst covering the telecommunications industry at Kaufman Brothers. "It's foolhardy for the Street to think Internet telephone companies could exist perpetually without regulation when you're talking about billions of minutes and 10 percent market share," he said, adding that he sees no reason to change the short- and long-term buy recommendations he has made for IDT and Level 3 Communications.

Grover cites a number of reasons for his continued confidence in Internet telephony companies. For one thing, he and other analysts say the real action is in the international market for Internet phone services.

For another, he said, if Internet telephony is subject to regulation, companies could avoid fees by building their own local networks, as a number of companies are in the process of doing. Finally, he said, regulation "could result in the reevaluation of what is a fair access fee" and ultimately bring fees down.

Still, the report has done some short-term damage. Before it was even formally released, the report caused several high-flying Internet telephony stocks to plunge.

Most notably, IDT dropped 25 percent early this month following rumors of the report's recommendations. The stock price of IDT, which uses traditional phone networks and the Internet to provide a broad range of telephone services, has dropped another 10 percent since the report was issued.

Other phone companies embracing Net technologies, including ICG Communications, Level 3 Communications, and Qwest Communications, also experienced dramatic drops after rumors of the report began to circulate. Qwest and Level 3 have regained some of that ground but are still well below their 52-week highs.

IDT spokeswoman Sarah Hofstetter said there was no question that the company's stock was affected by the report. Analysts who follow the Internet telephony market agree that the report has brought down the share prices.

"It won't be a huge blow, but it's definitely a setback," said Francois de Repentigny, an industry analyst with Frost & Sullivan. "It means that the prospects for rapid growth are diminished, and it will allow incumbents like AT&T and MCI Communications to have time to catch up."

He explained that the biggest reason for businesses and consumers to choose Internet phone services in the near future is the lower prices they offer over traditional services. If Internet phone companies are forced to pay regulatory fees, the price of their services will certainly rise. But de Repentigny adds that regulation will "stifle the growth of Internet telephony, but only domestically and only in the short term."

That's because the FCC regulation won't extend to the international market, where long-term growth of the industry is expected to be the highest. He added that enhanced Net telephony services--such as sophisticated messaging, faxing, and wireless features--eventually will make the technology appealing even if its prices aren't much lower than traditional phone service.

Under federal law, traditional long distance companies are required to pay access fees to the local phone carriers on each end of every call made. That means a carrier such as Sprint, when completing a call from San Francisco to New York, must pay Pacific Bell and Bell Atlantic between 2-1/2 and 3 cents per minute to each.

In addition, Sprint is required to pay into a universal service fund designed to ensure that phone service is offered even in areas such as inner cities and remote regions where the costs are high. So far, Internet phone companies have been exempt from paying fees because they are classified as "information services." The exemption would disappear if the FCC reclassifies the companies as "telecommunications services"--as it suggested it might in last Friday's report.

Internet telephony takes advantage of the so-called Internet protocol, or IP, an open standard that carries email and other traffic over the Net. Traditional phone networks require that a direct connection be established between the caller and the receiver and remain open even during breaks in conversation.

IP networks, by contrast, are much more efficient. They break up data into tiny packets and send them over numerous connections. The difference not only saves money but also makes it easier to offer enhanced features, such as videoconferencing and messaging.

As 10 percent to 25 percent of all telephone calls are projected to be made with IP within the next few years, Wall Street has taken a keen interest in Internet telephony companies. Former parent Peter Kiewit Sons spun off Level 3 amid strong demand for its private stock. And in the last year, IDT's stock has skyrocketed 430 percent, while shares of National MicroSystems have more than doubled.

In light of the FCC's report, however, companies may need to revise some of their business strategies. If regulations "are not onerous or they are delayed, we will actively pursue IP telephony," said Shelby Bryan, president and chief executive of ICG. "If we have horrible regulations, we'll go do something else for a living."

He added that the Englewood, Colorado-based company is reviewing its business plan every month and is hoping that IP telephony "will be a huge part of our business in the future."

ICG is not alone. Most other companies vying for a space in the IP telephony market provide enough other services that regulation--should it become a reality--won't stop their momentum, said Riyad Said, a senior analyst at Friedman Billings Ramsey.

Long distance and other phone services "are going to be a piece of this much bigger market, which is effectively the utilization of IP-based networks to support voice and data," Said predicted. "I don't see [the report] in any way as a death knell for these companies. These networks will continue to be a viable and great way to handle data and voice communications."