MAKING THE CASE FOR IP TELEPHONY

While IP telephony has long been one of the most promising technologies for the cable industry's incursion into the telco market, it has so far remained hopelessly stuck on the drawing board. But the story of the little technology that couldn't may take a more tangible form in the next 12 months, because the business case finally makes sense.

Although few in the industry predict a wholesale move by large telcos into the cable business because the cost structure is still too high — and some believe the same applies to cable operators encroaching on local telephone service — the economics of the two are radically different. While the Bell companies have shown no appetite to approach Wall Street for the massive amounts of cash it would take to build out video networks, cable operators don't necessarily need to jump in with both feet to make a splash in telephony.

The coagulation of CableLabs' PacketCable specification helps give cable operators a standard set of equipment to choose from, but the entry of multiple system operators into IP telephony is being driven by a confluence of economic factors that have nothing to do with the certification waves in Louisville, Colo.

“There's this kind of critical mass that has formed that a few months ago wasn't there,” said David Russell, director of business development for ADC's IP cable business unit.

Ironically, that critical mass comes at a time when the cable operators that are deploying circuit-switched services a few years ago are starting to make a noticeable dent in incumbent telco market shares. At the same time, cable telephony competition that was once welcomed by the Bell companies as corroborating evidence that they should be allowed into the long-distance market is becoming more of an annoyance.

In its year-end 2002 report, Cox Communications reportedly added 67,190 telephone subscribers in the fourth quarter to end the year with 718,420 customers. What's more, the company generated more than $100 million in quarterly revenue from circuit-switched voice customers.

Meanwhile, Comcast — which suddenly found itself king of cable telephony with its acquisition of AT&T Broadband — has already said it would not push forward with the circuit-switched voice service launched by AT&T but instead would deploy voice over IP. Despite its reluctance, Comcast has ownership of 1.3 million telephone customers, which makes it the 10th largest telco in the U.S., just behind Puerto Rico Tel and just ahead of Broadwing's local group.

Perhaps Comcast is sticking to its philosophical belief that cable telephony only works in an IP environment, or perhaps it's because the company doesn't own any Class 5 switches and buying them would kill its economic model. However, it's a happy coincidence for cable that just as the Comcasts of the world are starting to test voice over IP, the business case has begun adding up.

The key to making that VoIP model work has been a reduction in capital expenses, particularly on the equipment needed inside the home.

“It was difficult for them to talk about this very aggressively until they had PacketCable-qualified customer premises devices,” Russell said. “You'll soon have Packet Cable qualified call management servers. The fact that Cisco is now on the Packet Cable bandwagon also helps.”

Cisco Systems and Terayon were the first to receive PacketCable certification for the their cable modem termination systems; Arris and Toshiba were the first to win certification for the customer premises equipment.

Mapping out the business case for IP telephony over cable starts with cost. In two different models developed by Nortel Networks — one for primary voice customers and one for a package of services including data — the largest category of capital expense is in the customer premises equipment.

In both cases, Nortel made the assumption that the cable operator would provide lifeline voice service and deploy a multimedia terminal adapter (MTA) in the home.

“A year and a half ago, the cable MSOs were looking at secondary line [services], but the economics didn't prove in,” said Elaine Smiles, director of cable marketing for Nortel, which inked a deal with Cox Communications in November to provide VoIP equipment.

Primary-line power, one of IP telephony's technical issues that many operators feared most, turns out to be a relatively small percentage of the overall capital investment. Instead, the MTA, which acts as a home gateway by routing both data and voice, costs out at about $150 per unit in Nortel's model.

Given the dramatic drop in prices of cable modem manufacturing costs, with some going as low as $50, even that cost may be high. Ironically, MTA costs likely won't follow the same path as cable modems, Russell said.

“Instead of commoditization occurring before the volumes, we're getting something different,” he said. “[Cable operators] know how much cable modems cost, and they know what the part costs are for the incremental part of an MTA over a cable modem.”

Even at $150, though, Smiles said cable operators would provide some form of subsidy to offset the cost to the user.

On the operating expense side, selling, general and administrative (SG&A) costs simply can't be avoided. While the model Nortel has been presenting to MSOs makes the assumption that the cable operator would wholesale long-distance service, it's the human elements of the systems — including customers care reps — that cost the most.

Currently, however, SG&A on existing cable services run at about 30% of the total operating expense. For IP voice, that cost will be a little higher, but not significantly enough to throw the model off balance, Smiles said.

“In launching any new service, you need to weigh your SG&A up front, particularly in year one and year two,” she said. “[Public network] connectivity may come as a surprise, but consistently through the business cases, it's always SG&A that is the biggest element.”

On the revenue side of the ledger, Nortel makes the assumption that cable operators will start with relatively low penetration rates, though it does forecast what some may consider an aggressive 8% of current cable modem users picking up IP voice service in the first year. By year five, that number increases to 27%, a figure that Smiles insists is reasonable.

“We've been talking to MSOs about multimedia opportunities, but what they really wanted help with was understanding price points and penetration rates,” Nortel's Smiles said.

Using a series of research methods, including focus groups among current broadband users, Nortel's average revenue per user for primary voice comes to $55 per month. At that level, MSOs could expect a payback time of about 30 months. In addition, Nortel's “Advanced Communicator” model — which relies on packages of Internet voice, call management features, long-distance and multimedia collaboration — shows operators bringing in $25 per month per user but with a payback period of only 15 months.

“We found there are heavy broadband users who will pay for broadband voice, almost regardless of price,” Smiles said. “However there aren't that many, so it's hard to make money. We found the highest take rate was on the Advance Communicator-type package.”

Within that packaging, cable operators reach their peak revenue by pricing service at $19 per month. In the home office market, though, Nortel's research shows a little less price sensitivity, with peak revenue reached at $21 per month for an Advanced Communicator package.

However, not every vendor is quite as aggressive in its VoIP cost analysis, and there is some disagreement on the details of revenue projections. ADC, for one, is slightly more conservative and isn't convinced that second line revenue will be much higher for cable operators than for telcos — despite the fact that current circuit switched users have shown a great propensity for ordering multiple lines.

“We actually think second line will be lower in the IP voice environment than in the circuit-switched world,” ADC's Russell said. “We think there's less of a need for second lines because you're building on top of a cable modem.”

Still, many believe the cable VoIP model makes sense given the ever-lowering costs of deployment. Siemens, for instance, is playing up the margins that cable operators are already getting on circuit-switched voice.

“We've looked at what Cox has done,” said Graham Howard, solution marketing manager for voice over cable for Siemens. “They're already running at EBITDA margin of forty percent. It should be even better with packet voice. If you look at any other business, reaching forty percent of EBITDA margin within two years is a pretty good proposition.”

Even if the IP telephony cost analysis makes sense, the issue of cable carriers competing against incumbent telephone companies on their home turf brings up some ticklish political questions, according to Blair Levin, managing director of regulatory strategy for Legg Mason and former chief of staff for Federal Communications Commission Chairman Reed Hundt.

“It's not quite clear that cable and telcos want to compete with each other,” Levin said in a presentation just before the SCTE Emerging Technologies show held last month. “The cable guys know that if they delve into telephony in a big way, the telcos will come right after them.”

And there are many who believe cable operators won't spend sizable amounts in the next 12 months given the state of the overall economy.

“If you hear about what the cable operators are saying to Wall Street, it's all about success based capital,” said Geoff Tudor, CEO of Advent Networks, which is concentrating on cable data access in the small business market. “We think the timing of that the first step is to go in with a pipe and displace the existing T-1. That's a four- or five-month payback. After that you go in and try to get their voice services on top of that.”