The New Lords of the Ring Tone

Why Americans are hanging up on the Baby Bells.

Click on illustration to enlarge. Illustration by Robert Neubecker.

In the 1990s, tech gurus like George “Infinite Bandwidth” Gilder rhapsodized that with the roll-out of fiber-optic cable, the price of making phone calls and sending e-mails would fall inexorably to zero. The investment thesis: Go long the New Economy start-ups like Global Crossing and short the incumbent Baby Bells. After all, Verizon, BellSouth, and their sad siblings were under assault from all directions. Portable wireless phones were going to displace land lines. Juggernauts like Worldcom/MCI would eat the Baby Bells’ lunch in long-distance. Cable companies would use their fat pipes to deliver high-speed voice and data to the home. And these legacy companies, with their large bureaucracies and unionized workforces, wouldn’t be able to respond.

Gilder’s promise of infinite bandwidth was more like infinite jest. Companies like PSINet, Global Crossing, and 360 Networks piled on debt to build out telecom infrastructure and lay millions of miles of fiber-optic cable. But in a cycle reminiscent of the boom and busts that surrounded the telegraph and railroad, we got a glut of cable and vicious price competition. By late 2001, just 5 percent of the U.S. fiber-optic capacity was in use. Bankruptcy and consolidation quickly followed.

While the Baby Bells have suffered, as this five-year chart of the stocks of Verizon, SBC, BellSouth, and Qwest shows, they survived the meltdown. Consumers and businesses continued to pay their phone bills, and the companies (Qwest excepted) continued to pay their dividends. And they’ve been leading the consolidation. So far this year, as Forbes notes, SBC has agreed to buy AT&T, and Verizon bought MCI. And all the Baby Bells are furiously marketing DSL high-speed Internet connections. Collectively, the four companies are worth close to $190 billion.

But just as it was too soon to declare the Baby Bells dead in the 1990s, it may be too soon to declare them the victors in this decade. The price of making phone calls or accessing the Internet may not be going to zero. But a slew of developments in recent weeks suggests that it will be getting closer to zero than the erstwhile Baby Bells would like. And if current trends escalate, it won’t be too long before kids regard telephone jacks the way us thirtysomethings used to look at the giant console radios in our grandparents’ basements.

The one telecom sector Baby Bells dominate is the land-line business—the phone in your home. But despite spotty service and dead zones, cell phones may slowly be displacing land lines. Today’s twentysomethings have come of age talking on portable wireless handsets. Why bother with the expense and hassle of a Verizon installation if you’re going to move in a year? The Wall Street Journal yesterday noted that a Manhattan landlord who owns a few dozen buildings didn’t even bother to install standard phone jacks when he renovated many of his apartments.

For a growing number of people, the personal computer is becoming the telephone. Until a few weeks ago, 3-year-old Skype was another one of those quirky Scandinavian tech stories and a great example of a viral marketing. Some 54 million people had downloaded the software that allows users to speak to one another free of charge via the Internet. But in September, when eBay, another valuable business built on the wreckage of the 1990s fiber-optic infrastructure boom, decided to cough up $2.6 billion in cash and stock for Skype, the company became a serious player. If just a fraction of eBay buyers and sellers start using Skype instead of their local phone company, it would be a huge blow to the Baby Bells.

Last month, Vonage, the venture-capital-fueled Voice Over Internet Protocol company that, like Skype, is turning fiber-optics into a cheap telephone network, announced it had added its millionth line. That’s rapid growth, considering it had just 400,000 subscribers in January. And there’s likely more to come. In August, the Daily Deal and others reported that Vonage was preparing an initial public offering of between $400 million and $600 million. Oh, and big cable companies like Time Warner and Cablevision have made slower (but still notable) headway at signing up customers for VoIP telephone service.

Taken together, the numbers of VoIP phone customers aren’t huge. But this is a zero-sum game. Every customer added by Time Warner, Skype, or Vonage is one lost by Verizon or SBC. And although none of these services is close to free—even with Skype, you have to pay for services that allow you to make calls out of the network—these services don’t have to be free to hurt the Baby Bells badly. The start-ups can undercut them on price because they don’t have the same infrastructure costs—pensions and buildings, wires and switching stations.

The Baby Bells have tried to combat potential shrinkage of the land-line business by diversifying into wireless, DSL, and Internet service. But these areas are problematic, too. Cable modems are significantly more popular than DSL service. And the emerging area of wireless Internet access isn’t shaping up as a growth area for the Baby Bells either. Building citywide wi-fi networks is a capital-intensive business, and the returns are uncertain. So, the Baby Bells haven’t exactly been rushing to build wi-fi networks on spec. Which means they’ve left a vacuum for others. And here again, the new entrants are driving the price down. Earlier this week, Philadelphia hired Earthlink to build its wi-fi network, which should be completed late next year. The service won’t be free: Poor people will pay $10 per month and others will pay $20 per month. And the news flow just keeps getting worse. Last week, it was reported that Google is interested in building a free wi-fi network that would cover all of San Francisco. With a cash hoard of $7.1 billion (and rising), Google has the ability to build free wi-fi networks wherever it wishes.

The rampant innovation and investment in cheap and potentially free voice and data services have left the Baby Bells on the defensive. They’re left lobbying state legislatures to forbid the construction of municipal wi-fi networks, as SBC did in Texas (the effort failed), and pushing yesterday’s technologies at ever-lower prices.

When eBay announced its acquisition of Skype, many analysts wondered how it could be that a company with 2004 revenues of only $7 million could be worth $2.6 billion. More analysts should wonder how Verizon can be worth $86 billion.