In 2004, Internet service provider Net263 made a splashy announcement about its intent to enter the Internet telephony business. Since then, it has grown its VoIP services fast by marketing them nationwide as agents. Nowadays, however, due to the deteriorating market environment caused by traditional telecom service providers as well as price wars triggered by a growing number of virtual network operators (VNOs), Net263 is finding it very hard to make a profit from the Internet telephony business.


Heaven Cao, chief operating officer of Spider Info, isn’t surprised by all the obstacles encountered by Net263. In an interview with Knowledge at Wharton, Cao noted that “the kind of users VNOs have grabbed are mainly low-end customers and that market has pretty much matured. However, the majority of VNOs are losing money due to disorderly competition in the marketplace.”


According to Yu Hui, chief operating officer of CBCOM, a VNO in Beijing, “currently, more than 90% of the Internet telephony providers are illegal. They have no formal relationships with the traditional telecom service providers and offer low-quality services at a very low price. The disorder caused by them has harmed companies that have formal relationships with the traditional telecom service providers, like us.”


VNO’s Dilemma


VNOs don’t own any telecom infrastructure. They lease the infrastructure from telecom service providers and market their telecom or value-added services under their own brands. According to the announcement made by the Ministry of Information Industry in February 2003, Internet telephony belongs to the basic telecom service category, and only six basic telecom service providers are allowed to provide the VoIP services to the public. They are China Telecom, China Netcom, China Mobile, China Unicom, China Railcom and China Statcom.


Fang Meiqin, lead analyst on the telecom industry at consulting firm BDA, explained “there are three reasons why the Ministry of Information views the web phone services as basic telecom services. First, there is no way to guarantee the quality of web phone services, so it would be irresponsible to open up the market right now. Secondly, it’s in the name of protecting traditional telecom service providers. Web phones are low-cost and easy to use, representing a big threat to traditional telecom service providers. At the same time, those traditional providers just spent a lot building up their infrastructure and are not ready to provide such cheap services. Third, the government can’t monitor web phone calls, leading to national security concerns.”


As a result, Fang Meiqin added, “all of the web phone service providers have to find a way to cooperate with traditional telecom service providers. Otherwise, it would be difficult to have PC-to-phone services. Some of the cooperation is through unofficial channels or Chinese-foreign joint ventures like TOM-Skype.”


CBCOM’s Yu Hui noted that “currently, we cooperate with the six basic telecom service providers mainly through marketing their services as reseller or agent. Our main customers right now are enterprise users, though we have a few family users, too. At our company, enterprise users account for 70% to 80% of our customers. We charge them 0.15 yuan/per minute for domestic long-distant calls, and between 0.3 yuan/per minute and 0.5 yuan/per minute for international calls. Such a rate can save our enterprise users more than 70% in telephone bills.”


Spider Info’s Heaven Cao added that “almost all VNOs claim they are the agents for certain basic telecom service provider. In reality, they are pushing the envelope, and the regulators have kept a blind eye to such practices.”


When it comes to the development bottleneck of the VNOs, CBCOM’s Yu suggests that VNOs overseas can resort to different payment methods – such as charging by credit card – to develop Internet telephony, but due to policy differences, those methods are not applicable in China, causing constraints on the industry’s further growth. I’ve seen that some companies spent tens of millions of dollars yet still ended up failing. But policy differences are not the only factor. Telecom service carriers often disagree over fees and sometimes even undercut each other. In other words, VNOs can’t provide services beyond their own areas.”


Conflicted Traditional Telecom Carriers


In July 2005, the Ministry of Information Industry announced new rules that only allow China Telecom and China Netcom to test PC-to-phone services in certain areas, including the cities of Shenzhen and Shangrao for China Telecom and the cities of Changchun and Taian for China Netcom. Feeling threatened, traditional telecom carriers tried to curb the growth of web phones. But now why are they testing the services themselves? And why would VNOs market their web phone services in the name of the traditional telecom carriers?


At present, says CBCOM’s Yu Hui, “big telecom carriers such as China Netcom in the North, China Telecom in the South and China Mobile are not very interested in developing web phone services. Only those non-mainstream carriers are interested in cooperating with VNOs to provide the web phone services. Because of VNOs’ existing technology and service platforms, once those telecom carriers start to team up with them, they can begin to garner the online access fees.”


Heaven Cao agreed. “Because Internet telephony charges at a much lower price than traditional telecom services, mainstream telecom carriers are not inclined to expand Internet telephony within their own areas,” Cao said. “But there is more than one telecom carrier in China, and those non-mainstream carriers are all willing to grow their Internet telephony services. At the same time, mainstream carriers also would choose to grow their Internet telephony capabilities in areas other than their own. For instance, China Telecom would provide the services in the North, an area that is traditionally dominated by China Netcom, while China Netcom would provide the services in the South, where China Telecom dominates. I think that would eventually lead the mainstream carriers to develop their own Internet telephony services.”


According to Yu Hui, “it takes at least two to three painful years for big carriers to convert to the web phone model. On one hand, web phone services will threaten their basic telecom services; on the other hand, without offering web phone services, they would be in a competitive disadvantage. During the transition, carriers will need partners like us.”


Instant Messaging Vs. Telecom


In January, Tencent was reported to be secretly testing PC-to-phone calls. Although right now regulators don’t limit PC-to-phone services offered by Internet service providers, they certainly won’t ignore this sector. Instant Messaging providers led by QQ, MSN Messenger, Yahoo! Messenger, UC and POPO have signed up hundred of millions of users, and the majority of the instant messaging providers also offer PC-to-PC calls. According to Tencent’s first-quarter report, more than 531.5 million users have signed up for its instant messaging services, branded as QQ, and 220.5 billion of them are active users.


In the case of the cooperation project between Tom Online and Skype, Tom Online is responsible for marketing and Skype is responsible for technology. The co-project’s Lu Feng told Knowledge at Wharton that “Skype now has 13 million registered users in China and 70% of them are active users of its VoIP services. Skype is the world’s second largest VoIP service provider in terms of the number of active users. Although Skype currently doesn’t offer PC-to-phone services, named as Skype Out, to the Chinese customers, they can access such services at Skype’s web sites overseas and use Skype Out to call their friends overseas.”


Because Chinese users have to rely on foreign servers to access the Skype Out services, they often experience low voice quality and sometimes can’t even get through to a lot of foreign places. And the current regulations in China don’t allow Skype Out to be used to make calls to China from abroad. In the event of policy changes in the future that would open the web phone market up to both traditional carriers and ISP providers, who would be more likely to become the mainstream in this market.


In the future, says BDA’s Fang Meiqin, “I think that the biggest winner would still be telecom service carriers because of their customer base and their ability to attract users with services ranging from Internet, video to audio. In addition, the kind of services they are able to provide is beyond the reach of ISP providers. In contrast, ISP providers’ advantages lie in the variety of value-added services they can provide, such as gaming, searching and entertainment. They can make money by targeting specific groups of customers such as small-business owners and younger customers. But they have to rely on telecom carriers for their services.”


Heaven Cao doesn’t believe that ISP providers can compete with traditional carriers in the short term. “At the beginning, traditional carriers are bound to have certain advantages, including their infrastructure and vast operating experience,” he said. “Web phone services may add hundred of millions of yuan to ISP providers’ income, which is quite significant based on their current earnings. But for someone like China Telecom, which earns thousand of millions of yuan a year, the amount is not that significant at all. So there is no competition between the traditional carriers and the ISP providers.”


Looking Ahead


Fang Meiqin thinks that the current PC-to-phone market in China remains small. “At the end of 2005, this was a 500 million yuan market and it of course will grow fast,” she said. “I think that it may take more than two years for the policy to change so that the market will be fully opened up. Chinese companies would be the first to be granted the right to enter the market, but I’m not sure about when foreign companies will get the right.”


In terms of the impact of Internet telephony on long-distance, local and mobile calls, Fang said “Internet telephony wouldn’t divert customers away from long-distance carriers but would force them to lower prices. And it would have very limited impact on local calls because they are already very cheap. In addition, it may take a very long time for Internet telephony to have an impact on mobile calls because it takes at least three to five years for the technology to be in place so that people can make web phone calls with their mobile phones.”


Adds Heaven Cao: “Currently, Internet telephony is only a supplement to traditional telecom services and its main users are those low-end customers who don’t mind call quality that much but just want to save money. In the next 10 to 20 years, Internet telephony shouldn’t replace traditional telecom services because with the traditional services, the quality and security of the call are usually guaranteed.”


CBCOM’s Yu Hui notes that “at present, Internet telephony mainly targets enterprise users partly because they boast higher average revenue per users. On the other hand, it may be too costly for individual users to spend between 300 yuan and 400 yuan on the equipment. Individual customers won’t become the target audience for such services until in the future.”