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Shifting markets, patent litigation spell trouble for VoIP providers

Once heralded as disruptive technologies, VOIP providers Vonage and Skype are ceding ground to traditional telecom providers for consumer voice services.

As Vonage Holdings Corp.'s two recent patent settlements show, VoIP's days of first-mover advantage are over, and traditional telecom providers are ready to fight for their turf.

Just two years ago, the market view seemed relatively rosy for independent providers of Internet telephony: Skype was sold to eBay Inc. for a hefty $2.6 billion, Vonage had just signed its millionth paying customer, and their biggest obstacle was the technical problem of properly routing 911 calls over IP.

Since then, business has taken a turn for the worse on almost every front but 911 routing, and even that remains a touchy subject.

Earlier this month, eBay admitted overpaying by $1 billion for Skype, as the once-darling of the VoIP industry caused eBay to post its first loss ever as a public company. One analyst estimated that the average Skype user pays only 12 or 13 cents per month, largely bypassing the pay features in favor of free Skype-to-Skype calling.

Vonage, while having a much larger customer base paying a much higher average monthly charge, could be facing even harder times. This month alone, it has settled with Sprint Nextel Corp. for $80 million and Klausner Technologies, a patent-holding company, for an undisclosed sum while fighting $58 million in damages awarded to Verizon Communications Inc. in March, in another patent case.

Bleak future for independent VoIP providers?

Analyst Scott Sleek at market research firm Pike & Fischer said Vonage and many of its fellow independent VoIP providers are not long for this world.

"We've been pretty skeptical of Vonage's future ever since they went public a little over a year ago," he said. "I really look for them to be acquired at some point in the next year or two."

Sleek said patent litigation was only one of the problems these independent providers would face in the coming years, and few chips were stacked in their corner. Instead, Sleek said, the providers that own their own pipes will be the ones that ultimately succeed, which points to the traditional telecom service and cable providers entering the consumer VoIP market.

Indeed, for independent VoIP providers, some of the same market forces that worked for them early on -- cheap deployment, use of the public Internet for call throughput -- are now working against them. Customer demands for low-cost solutions have triggered a "race to the bottom" in terms of pricing, slashing thin profit margins as even more providers spread out the already thin customer base.

So intense is the competition that Vonage has reportedly begun giving a year of free service away to keep customers from leaving.

Customer calls for quality

But while customers still demand low pricing tiers, consumer demands for VoIP call quality have started to increase, and this is one element with which Sleek says Vonage, Skype and other companies dependent on major providers will not be able to compete.

"If you're a company like Vonage or Skype … you are basically relying on someone else's network to get your service delivered," he said. "There's always that concern that you may get lost in the traffic and not get there as fast, compared to other services that are trying to ride on that network."

In other words, a neighbor's late-night downloading habits might cause subpar voice quality, or worse, dropped calls when trying to talk to grandmother. Internet service providers, on the other hand, have a much greater ability to regulate service quality and make sure that latency-sensitive information, such as voice and video, take precedence over downloading or other less time-sensitive transmissions.

Already, these providers have been making inroads. Comcast Corp. recently became the No. 1 VoIP provider over longtime leader Vonage, and triple- and quadruple-play offerings that bundle voice, data and television offerings are able to better compete on price while having a higher level of reliability and quality.

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