Avoid the VoIP Value Trap

Sure, I dig the technology, and love the cheap service it enables. But as an investment, I've got to admit: I hate VoIP.

I didn't just draw this conclusion from Vonage's (NYSE: VG  ) recent woes. Every Internet telephony company I can think still sits below its IPO price. Perhaps some of these companies had "overly successful" IPOs, but I believe their collective slump owes more to these companies' futile struggles to create significant shareholder value from a disruptive technology.

Destroying value
I remember chatting with Foolish colleague Tom Taulli more than a decade ago about making phone calls over the Internet -- now widely known as voice over Internet protocol (VoIP). The technology was still being developed at the time, and quality was poor, but we knew it would cause a sea change in global communication. Today, companies such as Vonage, eBay's (Nasdaq: EBAY  ) Skype, and Comcast use broadband data networks to deliver digital voice services to millions of consumers.

So why would I pooh-pooh this cool technology rocking the telecom world? As flashy and fancy as it sounds, VoIP offers no new killer applications or buzzworthy innovations. It's the same thing you've always used -- just cheaper.

You win some, you lose some
Consumers benefit most from this efficiency, because they get to yak longer for fewer pennies. The big losers are the incumbent telecoms -- including Verizon (NYSE: VZ  ) , Qwest, and AT&T (NYSE: T  ) -- that find it difficult to charge consumers higher fees without losing them altogether.

Vonage estimates that its subscribers could save more than $300 per year by switching from an incumbent's voice service plan to its unlimited VoIP service. Assuming that's true, Vonage, with more than 2.2 million subscribers, is draining $660 million annually from rivals' revenue. And that's only a fraction of the estimated 10 million people who have switched to Internet telephone services. No wonder VoIP companies face a huge uphill battle against the established powers in telecom.

VoIP may cost the incumbents money, but I still can't see how any company could actually make money from it. Low barriers to entry and high levels of existing competition will stifle growth before the service goes mainstream. Even companies that provide the "picks and shovels," like Sonus Networks (Nasdaq: SONS  ) and AudioCodes, sell to highly cost-conscious carriers, squeezing their margins. All of these factors point to poor investments that tend to burn more cash than they bring in.

Investors have already seen plenty of companies pushing disruptive products or services that conveniently excluded "value" from their business models. Some of these familiar flameouts went up against the status quo with shaky assumptions, burning through wads of shareholders' cash:

Company

Investor Money Spent

Current Status

Iridium

>$6 billion

Sold off after bankruptcy

Pets.com

 >$146 million

Bankrupt

Webvan

$830 million

Bankrupt

Growing ecosystems
Conversely, when I look at some of the greatest investments, I see companies that develop products and services that create value where none existed before. These companies foster valuable ecosystems around their products; sometimes, they even go on to create entire industries.

Think of Intel and Microsoft (Nasdaq: MSFT  ) , back in the early days of the personal computer. These companies developed and controlled key portions of a platform for which a massive ecosystem of software, hardware and ancillary services has now developed. My mind boggles at the trillions of dollars generated in this area, and the subsequent value brought not only to investors, but consumers and businesses around the world.

A more recent example could be Apple (Nasdaq: AAPL  ) . The company created a personal music player platform that has literally drawn nearly every technology company into an ecosystem of products and services centered on the wildly successful iPod. The iPod integrates with already-established media value chains for music, books, and video. And while some companies -- such as record labels -- are crying about lost revenue, producers of everything from home electronics to outdoor accessories to footwear are profiting from the platform.

Where's the value?
Internet telephony is a novel application that leverages existing infrastructure to deliver comparable services at lower prices. Technological developments like this can help companies improve margins and offer better value to consumers, but they don't necessarily create substantial new value worthy of investment. Investors looking for that next home run stock -- the next Microsoft, Intel, or Apple -- likely won't find it in Internet telephony. Companies whose creations nurture thriving ecosystems are far more likely to produce exceptional returns in the long run.

Call on related Foolishness:

If you're looking for disruptive products and services that do translate into profitable investments, check out a 30-day free trial to the Motley Fool Rule Breakers newsletter service.

Fool contributor Dave Mock gets his giggles by doing disruptive things that are of little value all the time. He owns shares of Intel. eBay is a Stock Advisor recommendation. Microsoft and Intel are Inside Value recommendations. Dave is the author of The Qualcomm Equation. The Fool has a disclosure policy.


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