Net2Phone shift raises warning flags for industry

Internet telephony pioneer Net2Phone is shifting strategic gears, a sign that the price pressures pummeling the long-distance calling industry also are being felt in the young Net calling sector.

John Borland Staff Writer, CNET News.com
John Borland
covers the intersection of digital entertainment and broadband.
John Borland
4 min read
Internet telephony pioneer Net2Phone is shifting strategic gears, a sign that the price pressures pummeling the long-distance calling industry also are being felt in the young Net calling sector.

As expected, Net2Phone said today it would start a new joint venture, with a minority investment from Cisco Systems, aimed at selling Internet phone-system software similar to what it uses for its own service.

The company, which is among the most high-profile Net phone firms, hopes to move away from relying on service charges for connecting calls to sustain its business. Call charges now make up about 95 percent of the company's revenue, but the company hopes that the new software venture will make up about 50 percent of its revenue stream in just two years.

Net2Phone says it is trying to "diversify" its revenue streams in the face of a market where profit margins are falling rapidly as a result of new competition and telecommunications deregulation.

Analysts say the industry as a whole has to look at falling per-minute charges with some concern, taking the near-crisis in the traditional long-distance telephone business as a warning. But that point hasn't yet come, they add.

"Being a tollbooth is still a great business," said Mark Winther, a telecommunications analyst with International Data Corp. "Net2Phone has a pretty solid balance sheet and cash flow."

The Net calling business, which languished for years as the province of hobbyists and early adopters, finally has begun approaching something like a mainstream business in the past year.

Net2Phone itself has served as the most dramatic example of this trend. The company counts Yahoo and America Online among its investors, and recently giant AT&T took its own stake, snagging nearly a third of the company.

Another recent deal, with Microsoft, saw the company's service packaged into a free-calling feature in Microsoft's instant messaging software.

But it is exactly these types of deals that have helped put a quick squeeze on the industry's profit margins. A host of companies like PhoneFree or Dialpad have sprung up that offer free, ad-supported calling over the Net, at least within the United States. This has quickly instilled the idea among many consumers that calling online should be free--making it harder to make a profit.

"We believe a tremendous differentiating factor between Net2Phone and other players in the voice-over-IP services business is the underlying platforms and technologies that power our networks and services," Net2Phone chief executive Howie Balter said in a conference call today. "We've announced today a process of 'productizing' that technology."

Spinning out gold?
Net2Phone still charges for its international calls, where considerable money can be made by undercutting the high prices charged by traditional telephone companies. Analysts say this will be a profitable market until international telecommunications deregulation flattens the traditional calling prices.

But Net2Phone also is in a unique situation among Net phone providers. The technology it uses internally is strong and could be applied to other networks, analysts say. Its decision to spin this software out as a separate subsidiary likely marks as much of an attempt to gain revenue from this asset as a genuine shift in business.

"I'm not sure that this is a result of weakness in the service business. It may be more of the other way around," said Ofer Gneezy, chief executive of iBasis, an international business-oriented IP telephony company. "Their minute business is very strong."

Moreover, by partnering with Cisco, Net2Phone gains one of the most valuable distribution tools available, because Cisco is among the most powerful suppliers of Internet equipment in the business.

"We're not giving up any piece of the business by a long shot," said Sarah Hofstetter, Net2Phone's spokeswoman. "But with AT&T, AOL and Microsoft using our software...we have a good chance of being the de facto standard for voice-over-IP in the industry."

The companies aren't saying how much of the new venture each party will own. But Cisco is a minority partner, and Net2Phone says it expects 50 percent of its revenues to come from this software sector two years out.

On the service side, companies including Net2Phone must struggle to find a way to support the free-calling model they've developed in the past year. Advertising is helping, but all of them are moving into additional services, hoping to tap into subscribers' wallets by offering things like voice mail, one-stop in-boxes and other services.

"I think (Net2Phone) had trouble revising their business model due to the fact that these services are being offered for free in a lot of cases," said Jan Horsfall, chief executive officer at PhoneFree, a competing consumer Net-based long-distance provider. "You've got to take that mass of users and up-sell them to other opportunities...If you're an advertising-only model you've got problems."

Horsfall said PhoneFree, Net2Phone and the others are looking for new ways to generate revenue, which could be reflective of Net2Phone's new spinoff.

"The real opportunity isn't to make a fraction of a penny on a call," he said. "The opportunity is to use the low-cost structure of the Internet and reformat your revenue streams."

Gneezy agreed. "There's tremendous growth on the free, advertising-supported long-distance services. But at some point that growth will stop when the level of advertising-based revenue slows. They'll all branch out into unified messaging and other premium full-featured services. They'll move up the food chain to create more revenue sources."