Voices across the Internet

IP carrier iBasis moves beyond rate arbitrage Incumbent carriers still cling to the billions invested in the circuit-switched telephone network, but they are taking furtive glances at lower-cost means of transport. And that's good news for iBasis, a wholesale carrier that provides IP voice and fax service to global Tier 1 carriers and other service providers worldwide. By 2004, according to Insight Research, voice-over-packet revenue is expected to hit $33.9 billion, or 10% of all North American voice revenue.

But providing a cheap means of transport does not a long-term, profitable business plan make, so iBasis and other carriers like it must branch out into higher-margin services.

Currently, iBasis uses the Internet to carry traffic for 70 carriers, including 11 of the top 12 U.S. international carriers. The company's "assured quality routing" technology sends IP calls to the traditional switched network when the Internet is particularly congested, or about 10% of the time.

Traffic on the iBasis network predominantly originates in North America, and the carrier's largest markets for call termination are China and Mexico. iBasis also started rolling out points of presence (POPs) in Europe so it can handle calls going from Europe to Asia and Latin America, said Ofer Gneezy, president, CEO and co-founder of iBasis.

iBasis derives a large majority of its revenues from the call completion fees collected from the volume of voice and fax traffic carried over its network. For the third quarter, iBasis' usage rose to 168 million minutes, an increase of 40.7% over second quarter volume. Third quarter revenue was $17.21 million, a sequential increase of 26.5% over the second quarter.

As the volume of minutes increase, however, so do the expenses. These come in the form of termination fees (paid to local service providers to terminate calls received from the iBasis network), purchased minutes (fees paid to other carriers for completing calls over the public network to destinations outside the iBasis network), Internet access charges for the company's branch offices, charges for the dedicated international private line circuits the company uses, and equipment expenses.

In the third quarter, this expense bucket bulged to $17.3 million, or 101% of total revenue. That was up from 99% during the second quarter, and that's before R&D, sales and marketing and general and administrative costs.

But according to iBasis, the rapid buildout of its network masks the underlying positive margin in its core business. Once the carrier achieves network capacity in the 20% to 25% range, incremental adds to capital expenditures and hits to cost of goods sold will no longer significantly impact gross margins said John Quirk, director of investor relations for iBasis. The network's capacity for the third quarter was about 13%.

"We continue to increase the size of the network to get more POPs to lower our costs and provide voice access with a local call in more and more points," Gneezy said. iBasis also expects to reduce the "overhaul" traffic - the percentage sent to the public network because of congestion - to about 5%.

But having to pay termination fees to U.S. local exchange carriers could make it difficult for IP carriers such as iBasis to eke out a profit, said Robert Rosenberg, president of Insight Research. "The retail price of calling drops, but on a wholesale basis, you don't see a concomitant drop - the local carriers have been very good in forestalling that," Rosenberg said.

The longer-term profitability picture for iBasis depends on the company's ability to move beyond mere rate arbitrage to providing enhanced Web services such as hosted unified messaging. "The price arbitrage game is still a viable market, but it won't be for long," said Megan Gurley, research analyst for The Yankee Group. "You have to provide more than cheap pricing."

iBasis announced two services it expects will push the company into profitability in two years. The first is a unified messaging solution called VoCore, which combines storage hardware from EMC, directory services from Software.com and a unified messaging application from Cisco Systems. By year-end 2000, iBasis will have spent about $35 million to $40 million to develop the solution.

"Unified messaging is an application in search of broad acceptance," Gurley said. "Before you have it, you don't realize you can't live without it." Unfortunately, service providers have done a terrible job driving home the marketing message to end users, she said.

The advantage to iBasis' unified messaging offering is that it is modular, so service providers can pick the applications best-suited to their target markets. Sales assistance from Cisco is another strength of the solution, Gurley said.

The second product is what iBasis calls "Internet telephony hosting" - providing voice application service providers and portals a network with worldwide access points. iBasis expects this to become a lucrative product as content distribution and e-commerce services become voice-enabled. The service will be provided through iBasis' 11 Internet central offices (COs) worldwide. The company expects to have 20 Internet COs operational by the end of 2000.

"They're hoping to be the infrastructure component to a new market - a much smaller and newer market that requires a lot more education and will grow less quickly," Gurley said.

With the help of these new products and increased network usage, iBasis aims to achieve sustainable positive gross margins beginning in the first quarter of 2001 and be profitable in the fourth quarter of 2002. Wall Street is not yet differentiating between the legacy service providers and the new networks that are inherently lower cost, but it eventually will, Gneezy said.

iBasis could even benefit from the organizational divides being implemented by the interexchange carriers, Gneezy said. "Once consumer long-distance stands on its own, there's no particular reason to use the carrier's legacy network," Gneezy said. "They're more likely to use Internet telephony networks to carry more of the traffic."