Qwest's Upgrade Journey Buoys Lucent

A deal breathes life into a new switch project. Plus, the Denver telco's regulatory burden is heavy.
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The voice-over-the-Net crowd was whooping and hollering Wednesday after

Qwest

(Q)

rolled out some bold new upgrade plans.

The troubled Denver telco posted a

third-quarter profit, helped along by a big gain on the sale of its directories business. But what investors were really excited about was the company's decision to roll out a new generation of phone switches.

Two facts make Wednesday's plunge into voice over Internet protocol, or VoIP, particularly noteworthy. Most important, Qwest's decision will resuscitate

Lucent's

(LU)

so-called softswitch, a highly regarded piece of technology that looked dead in the water when the big gearmaker had its hands full slashing unprofitable businesses. Also intriguing, the move will probably register with some telecom watchers as a protest by Qwest execs champing once more at the regulatory bit.

First things first. The choice of Lucent to head up Qwest's network modernization program is a major win for the misstepping Murray Hill, N.J., gearmaker. Lucent has failed miserably in previous attempts to make a new generation of local phone switches to build on its success with the nearly ubiquitous older model, the so-called 5E. The new equipment that Qwest has agreed to buy is called the 5E-XC and is Lucent's first win on the local switch migration front.

"This is a significant development for Lucent," says Legg Mason analyst Timm Bechter. "This has been a big glaring hole in their product portfolio, and they've done a poor job of upgrading the 5E switches to softswitches."

Rival

Nortel

(NT)

, for example, beat Lucent on a huge

Sprint

(FON)

contract, which caused Lucent to largely

shelve the softswitch effort as it was wracked by cost cuts.

"Lucent's late to the party, but at least they are now at the party," says Bechter, who has a hold rating on the stock. Legg Mason has no underwriting ties to Lucent.

The VoIP gala has been fashionable indeed this year. Given the dramatically lower operating costs of VoIP gear and the pricing advantages over conventional phone service, investors have been rushing to equipment makers like

Sonus

(SONS)

, which specializes in softswitch gear.

Sonus shares have more than quadrupled as investment momentum got behind VoIP. Notably, Sonus was down 4% to $8.61 in midday trading as Wall Street mulled Lucent's return to the playing field. Lucent rose 1% to $3.07, and Qwest added 7% to $3.63.

Like so many developments in telecom, though, the VoIP push hasn't been entirely organic. The movement grew in part out of Washington's regulatory framework, which holds that phone service over the Net isn't subject to the same rules as conventional phone service. That means VoIP service is subject to no taxes, no mandatory contributions to universal service funds, no line charges -- the sort of fees that represent about 25% of a total monthly phone bill.

This

loophole was preserved in recent federal price rulings. To some investors, that development spelled a great opportunity for IP networking gearmakers to sell to Bells like

Verizon

(VZ) - Get Report

,

SBC

(SBC)

and

BellSouth

(BLS)

. Thus the rise of Sonus.

Now, by buying gear that will allow it to use the Net, Qwest intends to demonstrate that it too can play the avoid-regulations-and-tariffs game.

The scale is small, for now. The local phone giant is initially targeting a "select group of customers in Minnesota" for its service. All things told, the Lucent project will take something on the order of three years.

But then, that's where all the big telcos are headed. And as Legg Mason's Bechter points out, now it's up to Lucent to prove its new switch is more than "just a press release."