Skype goes for the gold

Can new paid services put the Net phone upstart on the path to profits?

Networking
Net phone phenom Skype is preparing to expand its menu of paid services, hastening its efforts to evolve from a free provider of niche services into a profitable company that could give industry giants a run for their money.

The Luxembourg-based upstart has so far signed up 29 million registered users for its free Net phone calling software--a unique version of voice over Internet Protocol, or VoIP--making it one of the fastest-growing services on the Net. Now it's aiming to milk profits from its swelling ranks of freeloaders with paid services that promise to make its Net-only product significantly more useful to consumers--and potentially more lethal to traditional phone providers.

Last July, Skype launched a paid service called SkypeOut that lets subscribers make calls from the Internet to the traditional phone network. It has signed up 1 million customers so far, the company said last week.

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What's new:
Internet telephony provider Skype still has problems with quality, it has had a recent fiasco with billing, and it gives its core service away for free. How can it survive with that business model?

Bottom line:
Skype maintains that the fraction of its million (and climbing) free users that buys add-on services will keep it and its free service in the black. But the Dutch company has a long road ahead.

More stories on Skype

Also last week, Skype quietly unveiled test versions of two new paid products--voice mail and a service dubbed SkypeIn that lets subscribers obtain ordinary telephone numbers. SkypeIn represents a potential watershed, since it will enable Skype subscribers for the first time to receive incoming calls from the hundreds of millions of people who still use traditional phone services.

Finally, Skype is working with equipment makers to develop hardware that will connect conventional phones to its free software and paid services. German giant Siemens, for one, has already released a Skype adapter for cordless phones in Europe. New devices are expected soon in the United States, from companies including Vtech and iMate, that will let people make Skype calls using an ordinary handset, rather than a PC.

Analysts said Skype's efforts to bridge the Internet and the traditional phone network could pose a major headache for traditional phone companies and other VoIP upstarts alike--if it can continue to undercut rivals on price.

"Skype is going from a glorified (instant messaging) client that led VoIP to something that has broader implications, especially when you can do things like get a phone number assigned," said Jupiter Research analyst Michael Gartenberg. "A lot depends on how lean they can keep it, and how low they can keep prices as they expand."

Skype and host of rivals are turning the telecom industry on its head using Internet technology to offer more calling features for less.

Skype is going from a glorified IM client that led VoIP to something that has broader implications.
--Michael Gartenberg, analyst, Jupiter Research

In this topsy-turvy world, Skype represents the competitive extreme, wielding a weapon that few others are willing or able to match: Using peer-to-peer architecture, it claims it can offer its software service for free to tens of millions of people, and still make boatloads of profits by persuading only a fraction of its users to upgrade to paid premium services.

In order to make a big impact, however, Skype needs to get its service off of the Internet and PCs and onto familiar phone equipment via the traditional phone network that most people still use.

Skype's new services bring the company a long way in this direction. Taken together, SkypeIn and SkypeOut will dramatically expand Skype's usefulness and reach, offering users everything they need to talk to people who don't use the service. While that will cost subscribers money, it is considered a key step to making Skype palatable to mainstream users. Skype's core service, while free, requires that both caller and called use Skype's software over a broadband connection.

Looking forward to payday
Skype's tests for new paid services throw a spotlight on the company's audacious plans to transform itself from a largely free service into a commercial dynamo. The company, which claims to be among the fastest-growing services on the Web with some 155,000 new registered users each day, may nevertheless be hearing some footsteps coming up behind. Web giant AOL recently , joining cable powerhouses such as Cablevision, long-distance provider AT&T and a slew of start-ups bent on transforming the once stodgy telephone industry, seemingly overnight.

In an interview with CNET News.com, Skype co-founder Niklas Zennström said the company does not plan to charge for its Skype software. Rather, he said, Skype's costs are so low that the company can afford to give its core product away to hundreds of millions of people and still make money selling ancillary services, such as SkypeOut, SkypeIn and voice mail.

"Our business model relies on providing Skype for free, and then upgrading a fraction of our users to some sort of paid service or product," said Zennström, speaking from London using Skype over a wireless LAN connection that cut out from time to time. "Once we get a lot of people using Skype for free, some will buy value-added services, some will buy value-added products--cordless phones, headsets and so on. We don't count on all our users being paying customers, we count on only a few being paying customers."

SkypeOut's 1 million paying customers represent a bit less than 4 percent of current registered users for its free Skype service. Customers buy SkypeOut accounts up front, and are assessed per-minute usage charges--generally pennies for most calls. The company does not disclose its take on these deals.

SkypeIn reverses the equation. Customers pay a flat fee for phone numbers chosen among available area codes. A 12-month subscription costs 30 euros ($40), and 3 months is 10 euros ($13.40), with a free voice mail account thrown in, according to information posted on Skype's Web site. Normal long-distance charges apply, but calls are free for people who call in from the same area code. Subscribers can choose any area code, regardless of where they live, potentially eliminating some long-distance charges.

Skype has acquired only 10,000 phone numbers so far for test purposes, in the United States, Hong Kong, France and the United Kingdom. Once SkypeIn is ready for prime time, Skype promises to greatly expand its number pool, and eventually offer choices from every area code around the globe.

One big growth area in future is on mobile phones.
--Niklas Zennström, co-founder, Skype

Rival VoIP providers such as Vonage and Packet8 charge flat monthly fees for unlimited calling within limited geographical regions, and a per-minute charge for most international calls. Rates run from about $15 and up, depending on the plan. That can make them significantly cheaper than some traditional phone plans. But they are still more expensive than Skype.

Skype's voice mail beta is also offered at a flat rate, with 12 months costing 15 euros ($20.11) and 3 months at 5 euros ($6.70). If no one is available to answer the phone, callers can record a message that is stored on Skype's servers and then downloaded when the subscriber logs in, much like e-mail.

Although rates are low, Zennström said he's confident Skype will generate huge profits, given its low cost structure and massive user base.

"Typical customer acquisition costs in the phone industry is several hundred dollars," he said. "We believe in zero."

On the cheap
Skype's costs are low because it relies on peer-to-peer network architecture to complete calls over the public Internet, with no need for expensive equipment or infrastructure on the back end, Zennström said. That contrasts with the business plans of the phone companies, which rely on owning the network. The "Baby Bell" local phone providers, for one, are building out new fiber and high-speed Internet networks at a cost of billions of dollars each.

Skype's costs are bound up almost entirely in payroll--currently, for about 100 employees--and related expenses such as travel, Zennström said.

Ultimately, Zennström said, there will be only one network--the Internet--making SkypeIn and SkypeOut superfluous. But that could take years to come, giving Skype plenty of time to develop new paid services. He said the company is working on offering a video-calling feature, but declined to comment on when it would be available, or whether it would be a free or paid service.

"One big growth area in future is on mobile phones," he added. "Mobile phones are changing, becoming more powerful computers with open software, and open to more radio networks, including Wi-Fi."

One area where Skype is facing escalating costs is customer service. The company has been hit recently with an unusually high number of complaints over billing and credit-card-related errors, Zennström said. In response, Skype last week ended its contract with an outsourced customer service provider and moved the function in-house.

"Outsourcing was a mistake," Zennström said. "We now have better controls, and tracking to make sure complaints are addressed and followed up...We take customer service very seriously, and I believe we have taken the necessary steps to improve."

Zennström said he does not believe customer service costs will create a major drag on margins, thanks in part to availability of online self-help tools.

Jupiter's Gartenberg said Skype's biggest problem may not be escalating costs or customer service issues, but ease of use.

Skype has released versions of its software for phones running Microsoft's PocketPC software, and has announced a deal to put its software on a Motorola phone. But the vast majority of its users remain tethered to the PC, Gartenberg said. Unless Skype can break onto more familiar telephone devices, it could find itself locked in a niche category, he said.

"The mass market wants to use telephones," Gartenberg said. "VoIP has been around for years, but it wasn't until (VoIP pioneer) Vonage plugged it into a regular phone that the service started to take off. The Motorola deal is a good step in the right direction, but the key is continuing that momentum forward to become a mainstream product."

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