Thanks to this year's most talked-about new technology, the cable man will be ringing doorbells to pitch a new offering: telephone service. But getting a foot in the door may prove trickier than investors expect.

The phenomenon that threatens to crash the gates of telephone companies is known as voice over Internet protocol, or VoIP. Proponents have proclaimed that this development will remake the landscape, giving big cable TV companies such as Comcast ( CMCSA), Cox ( COX) and Time Warner ( TWX) the final leg of a triple threat -- the ability to offer consumers television, Internet and now telephone service together, cheaply and reliably.

The cable companies are racing to show investors that they're riding the VoIP wave. Comcast says it hopes to be selling phone service to 40 million customers in 2006. Time Warner says that just this month, it extended its own offering to a 10th city, Houston.

And just this week, Cablevision ( CVC) rang a few bells by announcing it would offer new customers cable, Internet and phone service for $90 a month. The one-year promotional price effectively charges standard prices for TV and cable modem service and throws in phone services for free.

Wall Street has been swept up in the frenzy, viewing the march of cable as another stake in the heart of the regional Bell phone companies. The cable sector's expansion plans are unmistakably aimed at a market dominated by local phone titans Verizon ( VZ), SBC ( SBC) and BellSouth ( BLS). Some observers have gone so far as to compare VoIP to the early days of cell phones, which continue to be the paramount threat to the Bells' livelihoods.

But beyond the screaming headlines, some hard facts suggest that the so-called VoIP revolution is a long way from victory. The number of actual VoIP users remains minuscule, despite strong growth this year. (See charts on the next page.) Service quality falls far short of the phone industry standard, reducing its appeal. The cost advantage could be fleeting as cash-strapped states consider new tax measures.

Most strikingly, even VoIP's much-ballyhooed technological advantage is a slippery subject. For now, most of the cable industry's phone offerings rely on the very same century-old copper-wire system that they are reputed to make obsolete. Nearly all Net calls at some point must hitch a ride on the phone networks to make a connection.

Indeed, while the perceived threat of VoIP has cast some shadows over the Bells, it hasn't done much to lift the shares of cable operators. For the year, the Bells are down an average of 8%, but big cable outfits Comcast, Cox and Cablevision are down about twice as much. According to a recent Smith Barney report, the cable sector's stock performance this year has lagged the S&P 500 by 10%.

No one doubts that Net calling will some day be a fixture in a fair-sized slice of American households. But that day could yet be years off -- making a big bet on the cable companies a risky one, observers say.

"You have to keep this in perspective," says CIBC analyst Tim Horan. "People have been worrying about cable telephony for a decade." Horan has a buy rating on Verizon, SBC and BellSouth, and CIBC has no underwriting ties to the Bells.

Even as the cable companies sharpen their VoIP attack, the Bells' vulnerability is limited by the stark fact that cable modems are in just a few Bell customers' homes. "About 15% to 20% of the Bells' customers are at risk" right now, Horan concludes.

Waiting for a Repeat

VoIP's potential -- as well as its pitfalls -- lies in how it works.

Unlike ordinary phone calls, which require a dedicated circuit all the way from the caller's phone to the person on the other end, VoIP calls are sent in what's known as electronic packets. These envelopes of computer coding contain bits of conversation stamped with "from" and "to" addresses. Packets enter the stream of the public Internet where bits of email and Web images and mp3 files are coursing around the world. These small segments of VoIP conversations get routed over the Net, on to a phone network, and, if the other caller has VoIP, back over the Net, where they usually arrive in sequence.

Theoretically, the system offers the prospect of great flexibility and lower costs by using the ubiquity of the Internet to bypass the phone networks and the attendant access charges. The cable operators have made strides in adapting their offerings to consumers' needs. Systems such as Cablevision's ( CVC) Optimum Voice enable users to plug standard phones into a cable modem or a service-enabled wall jack.

That said, at this early stage in the medium's development, the process is far from trouble-free.

VoIP is a little like sticking a letter in a mailbox and expecting flawless same-day delivery. Some packets can get mangled or lost at various network bottlenecks. Early VoIP efforts were marred by poor service quality. The advent of fast Net connections and a greater reliance on telco pathways have helped improve the service, but a gap still yawns between gold-standard regular phone service and VoIP.

Even VoIP phenom Vonage, which sells unlimited broadband calling for about $30 a month, relies on several telco partners to connect its customers' calls.

Heavy Toll
Competition gains ground at Bells' expense
*FCC figures as of June 2003. **Verizon, SBC, BellSouth and Qwest. ***AT&T and MCI. Source: Federal Communications Commission, Cellular Telecommunications & Internet Association

Ringing Endorsement?
Upstart technologies start to catch on
*Figures included in cable phone user count. Source: Companies, In-Stat/MDR.

Just a Sliver
Cable phone use remains but a fraction of the market
*FCC figures as of June 2003. Source: Federal Communications Commission, Cellular Telecommunications and Internet Association

And that's cable VoIP's dirty little secret.

In the heat of the communications bundle battle, cable companies have forged some odd alliances with phone companies in an effort to offer VoIP service. Outfits such as Time Warner have enlisted telcos such as MCI, Sprint ( FON) and Level 3 ( LVLT) to handle the phone service and connect the calls.

Even Cox and Comcast, which initially tried replicating the costly phone circuit-switch approach, have since decided to move toward VoIP. Neither company has said whether a telco partnership is in the cards, but industry observers say an arrangement like Time Warner's with MCI and Sprint is likely. In fact, one source familiar with the situation says MCI has been preparing a deal with at least two more cable companies.

While doing cable VoIP via the telco infrastructure solves many of the tech and quality problems, other challenges remain. Cable companies must still wrestle with 911 emergency location capabilities along with federally mandated wiretapping. A more vexing and expensive question is whether to provide an uninterrupted power supply so phones work during electric outages, as Bell lines do.

The problem with cable operators investing a lot in phone infrastructure is that they could end up in the same boat as the Bells, helplessly watching customers jump ship to cheaper services.

Cream of the Crop

Regardless of VoIP's shortcomings, the cable phone threat puts the beleaguered Bells further on the defensive. The timing doesn't help: Fresh in Wall Street's mind is how the Baby Bells got trounced by cable in the opening rounds of the broadband Internet wars -- after they helplessly watched their lucrative local phone businesses shrink at the hands of wireless service.

Since the beginning of 2000, the Bells' total access lines have dropped 14%, to 156 million from 181 million, largely because of disconnected second lines and the big flight to cell-phone services. Notably, last year marked the first time in history that total wireless subscribers exceeded the number of lines the Bells served.

The Bells now face a delicate battle to restore their indomitable image in the face of what some investors see as cable's attempt to follow the wireless example and skim off the cream of the Bells' customer lists.

"For cable, the beauty of this is that it's all gravy," says cable industry analyst Cynthia Brumfield with Broadband Intelligence, a unit of Pike & Fischer. "They already have video and high speed, so whatever they get with phone service is a boon."

Customer loyalty hasn't been one the Bells' key strengths, and the idea that cable can cherry-pick from the RBOC's core constituency could leave any shareholder reeling in horror. But along with the weaknesses of the cable calling offering, the industry's push to scoop up phone customers faces another hurdle: pricing.

For now, VoIP enjoys a tax-free, unregulated status that makes it far cheaper than the Bells' service. But Congress reopened debate this month on potential changes to the law. And four states -- Washington, Minnesota, New York and California -- have recently ruled that Net calls are, like plain old phone calls, subject to fees and taxes.

That could put VoIP's crucial price advantage in jeopardy. And make no mistake: The notion that Net calling will be cheaper than regular calling is seen as just as important a selling point as the oft-discussed bundling opportunity.

"VoIP has real price appeal, since it's about $10 to $15 lower than what people typically pay for phone service" every month, says analyst Brumfield. If that advantage is mitigated by a raft of government taxes and fees, as is the case with regular phone service, VoIP could lose some potential users.

Still, there's no question that VoIP does represent a major technological breakthrough for phone competition. Suddenly, cable companies have the valuable so-called first mile that they don't have to rent from the Bells. At long last, cable has the nails to start building the Bells' coffin, say analysts.

The "circuit switch service isn't going to die tomorrow, but clearly every customer that cable gets on VoIP is an incremental threat," says Jefferies & Co. analyst Rick Klugman, who has a neutral rating on the Bells. As Metcalfe's Law dictates, each VoIP customer increases the size and value of the VoIP network.

Or as Klugman puts it: "It's like the first fax machine, which was worthless until you had other fax machines to fax to."

But as with any new technology, the hype has a tendency to move far ahead of the results.

"History has shown that new products overpromise and underperform," says CIBC's Horan. "We've seen that happen often -- I'm sure that will be the case here."

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