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Can telecoms wring profit from enterprise IP?

AT&T and MCI say new IP services are growing like crazy, but they may have trouble making money from them.

This is an era of mixed blessings for two of the nation's biggest phone companies.

AT&T and MCI not only are grappling with the mix of promise and regulatory issues associated with their respective acquisitions by SBC and Verizon, they are finding it difficult to make money off some of their fastest-growing IP services.

At the heart of the problem are the relatively thin profit margins on the telcos' sales of enterprise-data IP services such as Internet protocol virtual private networks (IP VPNs). The remedy, experts say, is fairly straightforward but not necessarily easy to implement: The phone companies need to develop and sell more add-on IP VPN products and services to boost their returns.

News.context

What's new:
Business customers are shifting data-service spending to IP VPN services.

Bottom line:
SBC and Verizon, which plan to acquire AT&T and MCI, will still be challenged to make money from the new and growing services.

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"IP VPNs are crucial to the future of the AT&T and MCI networks," said Frank Dzubeck, CEO of Communications Network Architects, a telecommunications consultancy in Washington, D.C. "But the trick will be moving the enterprise data business away from being a commodity market into selling more advanced services over the new network."

On the plus side for the telcos, the market for IP VPNs is increasingly robust.

When United Communications Group, a provider of business publications, wanted to add bandwidth and new locations to its network, it faced a hefty increase in monthly service-provider fees, said Mitchell Barlow, chief technology officer of UCG.

So, rather than adding more point-to-point lines to the Rockville, Md., firm's network, Barlow looked at alternatives offered by AT&T and Sprint. UCG opted for AT&T's IP VPN service, which uses a signal-enhancing technology called multiprotocol label switching (MPLS).

The switch to an IP VPN has saved the company about 10 percent to 15 percent over what it would have paid to continue using its private-line service, Barlow estimates. In addition to the cost savings, the new service offers better redundancy and more flexibility for adding locations to the network.

"It just made sense for us," Barlow said. "We have a lot of communications between our Maine and Florida sites, and all of that had to come through Rockville because our point-to-point network was designed in a hub-and-spoke configuration. It was very inefficient use of our network. Now each of our locations can communicate with each other as if they are all on the same local area network."

UCG isn't the only company that is making the switch to IP VPNs, according to AT&T and MCI, which have both been marketing their services aggressively over the past year. These carriers claim that many of their customers are ditching their traditional data services for new IP VPN services because they are easier to manage and set up.

IP VPNs, whose MPLS technology tags traffic to create a defined path through the network for individual users, are the fastest growing services in AT&T's and MCI's business portfolios, the companies say.

These new services will play a key role in the strategy of the new telecom companies that will emerge after SBC Communications completes its proposed acquisition of AT&T and Verizon gets closer to closing a merger deal with MCI. MCI's board recently approved the merger with Verizon, although the deal still could fall through, as some MCI shareholders have threatened to block the purchase if a better offer comes along. Qwest Communications, which outbid Verizon for the MCI assets, could get back in the race, some MCI shareholders have said.

Experts warn that even with new, growing applications such as IP VPN, SBC and whoever ends up with MCI's assets still face many challenges as they develop their enterprise business.

Cannibalizing the legacy business
Just as the shift to IP in the consumer market has hurt SBC's and Verizon's existing consumer voice businesses, the same thing is happening in the enterprise market as customers deploy their own voice over Internet protocol (VoIP) networks and abandon traditional private-line--or frame-relay--services for IP VPNs.

AT&T says it is prepared to handle the shift in the marketplace, since it has been investing in its IP MPLS network for several years.

"We are not at all worried about cannibalizing our legacy business," said Michael Antieri, group executive of AT&T's product management team. "We might have worried about that kind of thing 10 years ago, but not now. We're not in denial. We know the technology is enabling convergence, and we are committed to IP."

The problem is that since profit margins are actually smaller on IP VPN services than they are for traditional frame-relay services, experts say, carriers need to layer value-added services such as managed security or managed VoIP services on top of the IP MPLS network.

"AT&T and MCI might make it sound like the switch to IP VPNs is no big deal," said Sean Hackett, a senior analyst with The Yankee Group. "But it's going to be painful. They are only doing it because they have to. Otherwise their customers would go somewhere else. The margins on IP VPNs are going to be much smaller, but I'm sure they'd rather have small margins than no margins."

So far, the strategy of up-selling value-added services has not materialized, added Hackett. Customers have been unwilling in large numbers to outsource critical functions such as security.

"I could have signed up for the managed firewall service," said UCG's Barlow. "But I'm not ready to give that up yet. I need to have full control."

Making it work
Making IP VPN services profitable is critical for anyone selling data services to large companies, and it will be a key aspect of SBC's and Verizon's strategies.

The local phone giants, after all, are acquiring AT&T and MCI for their enterprise businesses, which they hope will help them scale their overall business beyond that of their arch rivals, the cable companies. Today, the enterprise market is one of the only areas in which the telcos do not compete head-to-head with cable.

Right now cable operators are eating away at the phone companies' traditional consumer voice and data businesses. SBC and Verizon are taking aggressive steps to upgrade their networks to add higher-speed data services and also TV service to compete with the cable companies. But this transition isn't going to be easy, since the phone companies will have to spend billions of dollars to roll out new services.

Additional revenue from enterprise sales and the savings they will get from consolidating networks with the long distance carriers could help offset the expense of building the new consumer networks. It also could provide opportunities for SBC and Verizon to cross-sell services, such as wireless and local voice calling, into the business market.

"The challenge for SBC and Verizon is keeping their focus while managing the merger, while at the same time rolling out ambitious plans on the consumer side," said Jim Penhune, an analyst at market researcher Strategy Analytics.

AT&T's customers do in fact worry about the company's ability to stay focused on service while the merger progresses.

"As far as I was concerned nothing was broken," said Barlow. "And now they are going to fix it with this merger. My gut reaction is that going through this integration process is going to be torture. Just getting the bills to come out to zero every month will probably be a challenge."

Todd Willinger, vice president of infrastructure engineering for Service Master, another AT&T customer, said he agrees.

"My experience with mergers is that they are messy," he said. "I know SBC's goal is to take as much cost out of the business as possible. I just hope they do it from the right places."

Antieri of AT&T said he knows the transition may be bumpy, but he believes the strategies of both companies are complimentary. For example, he sees SBC's large DSL footprint as a perfect way to reach more customers' branch offices.

"We're really excited about the merger, but it's still a long way off," he said. "There are regulatory issues to work through, so for now we remain focused on rolling out our new IP services and meeting customer demand."