Digital disconnect

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NEW YORK — Nate Williams hardly noticed when his phone company vanished.

Mr. Williams, a freelance illustrator from Seattle living in Argentina, had signed up two years earlier with the Internet calling company SunRocket Inc. so he could maintain a U.S. number and make cheap calls back home.

He said the service was great when it worked, but it was so unreliable that it took a while for it to sink in when SunRocket, the second-largest stand-alone Internet phone provider, suddenly collapsed last month and abandoned more than 200,000 customers.

Mr. Williams and many others had paid about $200 in advance for a year of service.

SunRocket was a bad situation,” Mr. Williams said by phone from Buenos Aires, his voice sounding hollow as he used EBay Inc.’s Skype phone service. “Small companies are going to have a tough time in lots of industries, especially technical ones.”

Times have grown especially tough for independent Internet calling companies as they face mounting competition from big corporations, legal challenges and new regulatory costs that erode their cheap pricing and hurt the bottom line.

With big economic trends against them, some companies are finding that once-promising business strategies have disconnected from financial reality.

“Many of the small service providers are going to go out of business. It’s not just SunRocket,” said Jeff Kagan, an independent telecommunications analyst based in Atlanta.

Consumers are increasingly embracing big bundles of services from cable and phone companies that include television, Internet access and both wired and wireless voice calling, Mr. Kagan said. He said that leaves little room for voice-only providers, which are likely to merge, be acquired or follow SunRocket into oblivion.

“That’s the chance the customer takes when they do business with a small company,” he said. “You don’t know until you try to make a phone call and it’s not there.”

Internet calling, also known as VoIP or Voice over Internet Protocol, shook up the telecommunications industry several years ago as independent start-ups offered telephone service over high-speed Internet connections instead of copper wires.

The products, with sound quality ranging from great to lousy, often allow calls to and from regular phones and include unlimited long distance and many calling features at cheaper prices.

Big corporations, initially slow to catch on, have since roared ahead, with cable providers now dominating the industry and stealing customers away from traditional phone companies.

At the end of 2006, 6.5 million homes had Internet calling service through a cable provider and 2.7 million with an independent company, said Jupiter Research analyst Doug Williams.

He said cable’s dominance is expected to continue with more than 20 million phone customers by 2012, compared to less than 5 million with the stand-alones.

Cable companies have an advantage by controlling the networks that carry their voice services, unlike independent providers that “piggyback” on existing broadband connections, Mr. Williams said.

Independents “have little or no control over service quality,” he said. “It’s delivered as a best effort.”

Vonage Holdings Corp. led the charge to provide Internet phone service in 2002.

While the Holmdel, N.J., company remains the stand-alone industry leader with more than 2.4 million subscribers, its future is uncertain as it endures a financial and legal pummeling.

Vonage stock never recovered after a disastrous initial public offering last year, with shares tumbling from an opening price of $17 to around $2.20 today. The Vonage chief executive who took charge soon before the IPO resigned in April.

Earlier this year, a jury found that Vonage infringed on technology patents related to Internet calling and awarded millions and future royalties to New York-based Verizon Communications Inc.

Vonage’s appeal is pending.

Vonage and SunRocket went down the route of simply being cheaper,” said Blair Levin, an analyst with the Stifel, Nicolaus & Co. investment firm. He said Vonage is a historically important company but it does not have a “defensible asset.”

“If the Bells and cable decide to lower the price for voice, which is now just part of the bundle they are offering, it’s going to be difficult for these independent voice folks to really make a go of it,” Mr. Levin said.

Mr. Williams of Jupiter Research said there is little hope for independent providers because by competing on price “they have driven the margins down so far that there is very little there to work with.”

Vonage said in April that it would cut back on marketing costs. It had been spending $275 for each new subscriber.

Vonage might be sold or go out of business, but because it is a public company and much larger than SunRocket, its millions of customers are not likely to be suddenly cut off without time to switch, Mr. Kagan said.

Despite the industry’s troubles, new players still emerge.

Soon after SunRocket’s demise, Silicon Valley start-up Ooma Inc. began offering a $399 gadget that promises free Internet calling via regular phones with no subscription fees.

The company, which has $27 million in venture capital backing, is using a technology similar to peer-to-peer computing networks, with customer Ooma boxes playing a role in routing calls across the country.

One independent Internet phone provider that knows it must evolve or die is 8x8 Inc., the Santa Clara, Calif., company behind the Packet8 phone service.

It is the No. 2 stand-alone provider since SunRocket’s demise. The company has about 185,000 residential and business customers, including about 19,000 SunRocket refugees.

Seeing Vonage’s failed IPO and the strength of the cable companies, 8x8 chose to focus on small business customers instead of the volatile residential market, CEO Bryan Martin said.

He said cable firms often bypass small businesses, which tend to use phone company Internet connections.

The company 8x8 said in its quarterly earnings report Thursday that it was the “first major pure play VoIP service provider to generate positive cash from operating activities.”

The company said more than 8,000 U.S. businesses have subscribed to its phone service, representing 44 percent of its revenue.

“We see it as a nice defensive niche against the cable companies in particular and to the extent Vonage ever decides to play in this space,” Mr. Martin said.

Mr. Martin said Vonage’s model has been to pour money into growing at any cost and SunRocket was a “carbon copy of Vonage” with offers that made little sense. He said 8x8 rebuffed a SunRocket request for an alliance as its end approached.

SunRocket is not unique, and I think over the next couple of months you’re going to see a couple of other players exit the space, hopefully in a more controlled fashion in regard to their customers,” Mr. Martin said. “We believe we could be one of the last players standing.”

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