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New tech eats into traditional telecom

Don't blame the economy, analysts say. Blame the "cannibalization" effect, when a new technology chews away at a company's older business.

Telecom companies aren't going to recover along with the global economy, because the much-blamed macroeconomic conditions were never really the problem, analysts say.

New technologies, which often aren't as profitable as the old ones, are the real culprits.

"While the economic slowdown is a cause of the global telecom slowdown, it may only be a secondary one," Merrill Lynch analyst Adam Quinton said during a conference call hosted by the investment bank on Thursday.

The "cannibalization" effect, when a new technology eats away at a company's older business, is more to blame, according to a new report from Merill Lynch. Cannibalization is an age-old problem for technology companies, but according to Merrill Lynch's study, the problem is worse than expected in the telecommunications sector as broadband, cable telephony, wireless and VoIP (Voice over IP) technologies have all ganged up to erode traditional voice services.

U.S. carriers also suffer more because of the strength of the cable and DSL (digital subscriber line) businesses in the United States, according to the company's research.

The final twist of the screw is that several of these new technologies are less profitable than the old ones.

Upstarts in the telecommunications field have long predicted new, Internet-based technologies would replace traditional communications.

"My grandchildren will say to me, 'What is a dial tone?'" said Bill Ingram, CEO of VoIP company Nuera Communications.

But the effect on telecom companies on a global scale has surprised even the most bearish analysts, Merrill Lynch said. SBC Communications, BellSouth, Verizon Communications and non-U.S. companies such as BCE, a Canadian communications company; Telstra, an Australian company; and Telefonos de Mexico, have gone from year-over-year revenue growth in the high teens in early 2001 to flat or declining revenue in early 2002, according to Merrill Lynch research.

Broadband threat
The main threat broadband services pose to incumbent local carriers like Verizon and BellSouth is that customers with high-speed Internet access are no longer in need of a second phone line. Verizon's installation of fixed lines has gone from around 1 percent growth in March 2001 to a decline of almost 3 percent in March 2002; BellSouth's have gone from zero percent growth to 2 percent declines; and SBC's have gone from 7 percent growth to close to zero growth over the same time frame, according to Merrill Lynch.

While all those companies have DSL businesses that they rely on to offset loss from their traditional businesses, the net effect is negative because DSL has a lower profitability than basic local services and has even lower margins compared with a second-line business, which has been even more profitable for companies.

"Ironically, broadband has been, and continues to be, hailed as a major source of potential future growth for incumbent local carriers," Quinton wrote in the report. The situation is even worse in the United States than overseas, he added, because business in second lines had been high, and cable eats away at traditional business. European carriers and telecom companies in emerging markets like Latin America are better off, according to Quinton, because cable is less of a threat, and several of those companies own cable assets anyway.

Wireless cutters
Wireless services are also cutting into the fixed-line businesses, as competition has driven prices so low that its often cheaper to make wireless calls. Competitive pricing has helped wireless companies stem declines during tough economic times, despite a delay in upgrading their services.

SBC's wireless revenue has gone from 15 percent to around 7 percent in March 2002, while Verizon's has remained almost flat. And analysts say things are bound to improve when wireless providers get over delays in introducing their next generation of services.

The much-ballyhooed "third generation" has yet to take off; Verizon became the first provider to launch the services--which are expected to boost revenue in the future--in a limited capacity in January.

VoIP gaining ground
As Internet telephony, or VoIP technology, gains acceptance, carriers are also suffering.

While traditional phone companies work to integrate IP technology into their existing networks by installing gateways to turn voice into data "packets" which operate over certain legs of their networks, VoIP is gaining ground in business settings in a way that could shut telecom companies out of the picture entirely. By running voice in packets of data over their internal networks, employees can make calls without ever touching copper wire.

"While there is limited statistical information to quantify this trend, it is interesting to note that Merrill Lynch already employs VoIP for roughly 50 percent of its telephone lines in the U.S.," Quinton said in a report. He added that the shift to VoIP technology has been a substantial cost savings for the company and "represents an unrecoverable revenue loss" to traditional voice providers.

Most Internet telephony service providers (ITSPs), like all young companies, aren't as profitable as the incumbent players.

The six ITSPs tracked by equity research firm Kaufman Brothers have gross margins ranging from 12 percent to 23 percent, while the seven ILECs tracked have gross margins ranging from 40 percent to 81 percent.

But VoIP can be extremely profitable for some companies. Net2Phone, one of the bigger companies providing Internet telephony, has the strongest margins, according to Kaufman Brothers.

"The margins are ridiculous in this business. Our margins are 46 percent. AT&T has been in this business for 120 years, and their margins are only 13 to 15 percent," said Sarah Hofstetter, senior vice president of communications at Net2Phone, which had the strongest margins, according to Kaufman Brothers' research.