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The comeback of the mobile Internet

J. William Gurley writes that the cellular phone is starting to prove its worth as a launchpad for interactive entertainment services.

Things are going great, and they're only getting better
I'm doing all right, getting good grades
The future's so bright, I gotta wear shades
--Timbuk 3, "The Future's So Bright"

It seems like just yesterday that the worldwide cellular industry was under attack from all sides. As the bubble burst, the outrageous sums that were coughed up for 3G licenses, coupled with the equally large cost of 3G implementation, stood out like two elephants crammed into a fish bowl.

If swallowing 3G costs weren't enough, the media and analysts (including yours truly) began to espouse the benefits of open-standard, unlicensed spectrum radios--also known as 802.11 or Wi-Fi. Not only that, but everywhere you turned someone wanted to discuss Wi-Fi's disruptive effect. It's hard to play offense when you are always on defense.

However, against this grim backdrop, something extremely exciting is emerging in the cellular world. In the past twelve months, the cellular phone began to prove what many of its hard-core supporters have voiced for years--that the cell phone can be a leading springboard for interactive entertainment services. What's more, it could be much bigger than you realize, perhaps even bigger than the PC industry.

Recent events
While these statements may seem like old news to Europeans, where SMS (Short Message Service) has been the bastion of electronic communication for years, success with non-voice applications on cell phones is a new phenomenon in the United States.

Since the fourth quarter of 2002, U.S.-based carriers have begun to see a measurable increase in the usage of revenue-generating interactive services. In early June, Verizon Wireless announced that its interactive service, Get It Now, had achieved close to 12 million downloads of entertainment content since its launch in September of last year. Its phenomenal growth is accelerating. May downloads averaged 2.3 million, which equates to an annual run rate of more than 27 million applications.

More importantly, in April, Verizon announced that active Get It Now customers showed a $7.50 increase in Average Revenue Per User (ARPU). With ARPU declining steadily across the industry, any product or service that can increase ARPU is the nirvana of the cellular business model. Sprint and AT&T Wireless have announced increased download and ARPU traction as well.

The key trend contributing to the recent blossoming of alternate cellular applications in the United States is the release of next-generation cell phones. These "fat" phones come complete with huge color screens, large processors, plenty of memory and sometimes even cameras. These phones, which began shipping in volume in the fourth quarter of 2002, are flying off the shelves, many at prices under $100. No longer is the experience limited to text-based interfaces such as the much-derided WAP interface.

The key trend contributing to the recent blossoming of alternate cellular applications in the U.S. is the release of next-generation cell phones.

Qualcomm's BREW (Binary Runtime Environment for Wireless) operating system and Sun's J2ME are at the core of these next-generation phones, enabling numerous user-interface, development and implementation improvements. Two other contenders hoping to take market share are Microsoft's Windows-based Smartphone, and Nokia's Symbian-based Series 60--including the much-ballyhooed NGage product, which is as much Game Boy as cell phone. If history is a guide, given natural replacement rates and attractive price points, it should not be long before these "fat" phones represent the majority of new phones being sold in the United States.

Platform advantage
As an alternative to other potential interactive technologies (game consoles, PCs, Game Boy), cell phones have some unique advantages. First and foremost, they are pervasive. The installed base of cell phones worldwide is around 1.3 billion. Second, most people carry them wherever they go--this is a real plus for interactive games as well as communication-oriented features. Cell phone games can entertain during "stolen moments"--time that would otherwise be wasted.

Additionally, cell phone carriers have been much more adept than say Internet portals in introducing billing or "wallet"-like features. You can "buy on a click" much easier on your phone than you can on the Internet--an example of the carrier using its previously existing billing relationship. Lastly, because all current cell phones have both a global phone number and an Internet Protocol (IP) address (with your carrier acting as the ISP), you already have a directory-enabling structure that allows any phone to easily link to another.

The victors
Who will be the winners of this long-expected revolution? Certainly the carriers will reap rewards. Verizon has been particularly aggressive promoting these features in the United States, with Sprint and AT&T Wireless following suit. New features like gaming and ring tones can spur people to upgrade their phones, and hopefully their rate plans, helping carriers retain customers.

Since carriers don't actually make any content, they rely on independent publishers to produce interesting applications for subscribers. In order to encourage content development for cell phones, carriers share revenue from downloads. One critical element of carrier strategy is determining the optimal share. While a more carrier-friendly split may be good for the carrier's bottom line, it could drive content providers to more generous carriers, rendering the greedy carriers' products less attractive to customers. Interestingly, one of the most successful content platforms, Japan's NTT DoCoMo service, is built around an extremely generous 91 percent to 9 percent split, which is more favorable than all U.S. and European carriers' current deals. The carriers are all walking a fine line between driving revenue and creating a viable ecosystem to encourage publishers to invest in content.

Handset companies could benefit from these new services, as they now have more opportunity to differentiate their various phones. This is offset by the operating system companies who are seeking to create some form of cross-phone standardization and move as much of the value-add to software as possible. The most interesting development here is likely Qualcomm's BREW initiative. BREW, which integrates a handset OS with a unified billing and provisioning system, was at first easy to ridicule as overly ambitious, but is doing amazingly well. Verizon, once again, is reaping the benefit as the only U.S. carrier to fully commit to CDMA (Code Division Multiple Access) and BREW.

Publishers are also establishing a critical role in the marketplace. The cell phone "platform" is, in reality, a complex patchwork of operating systems and carrier networks. The matrix is quite mind numbing, easily rocketing into hundreds of permutations. It is also difficult for cellular carriers to manage relationships with the thousands of small developers that hope to deliver applications for this new medium. The group that simultaneously solves these two difficult problems is the publishers. While some publishers from existing platforms are sticking their toes in the water (like interactive software company THQ), many of the publishers for this new platform are new companies. Leading the group is Jamdat, a young company out of Southern California. Out of Europe, Gameloft also has a compelling offer and a strong partnership with Ubi Soft Entertainment.

The punch line to this story is the law of large numbers--in this case the enormous numbers of cell phones launched around the world. Consider this: Analysts peg the worldwide installed base of active PCs to be between 500 million and 750 million. However, the active installed base of cellular phone users is, once again, approximately 1.3 billion. Looking forward, this gap is likely to increase. The IDC-reported number for annual PC sales is approximately 150 million. The current estimate for worldwide cellular sales is more than 400 million. Turn your eye to developing countries and the gap is even larger. In China, the installed base of cell phones, at 200 million, is already 10 times the size of the installed base of PCs.

It is likely that these mind-blowing user numbers are the key drivers behind Microsoft and Intel's bold commitment to 802.11.

It is likely that these mind-blowing user numbers are the key drivers behind Microsoft and Intel's bold commitment to 802.11. Widely available 802.11 signals bode well for PCs and PC-variant systems (such as Pocket PC). On the other hand, if the cell phone infrastructure (including the physical plant, operating systems, handset characteristics and more) matures ahead of broad scale 802.11 implementations, the cell phone industry could reap incremental rewards. The PC industry aims to make the Internet experience mobile, through products such as Centrino-powered laptops and Wi-Fi-enabled Pocket PCs. The cellular industry aims to make its voice-based platform more interactive, by driving next-generation phones, as well as 2.5G support deep into the installed base.

The potential "competition" between the PC platform and the cell phone platform are not lost on PC industry executives. In a July 14 New York Times article, Craig Barrett, Intel's CEO, noted that "there are now about 40 million Wi-Fi users, and new access points are selling at the rate of about 15,000 a day, which makes Wi-Fi a much faster growing technology than cellular telephony." The cellular phone is clearly emerging as an interactive springboard that deserves attention--perhaps everyone's attention.

To join Gurley's "Above the Crowd" distribution list, visit Benchmark Capital's Web site .. The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete, and its accuracy cannot be guaranteed. Any opinions expressed herein are subject to change without notice.