Can't anyone make Internet phones pay?

The huge writedown for Skype is not the only disappointment in the Internet telephony world.

By Yi-Wyn Yen, Fortune reporter

SAN FRANCICSO (Fortune) -- Skype never emerged as the cash cow eBay (Charts, Fortune 500) had hoped for when it paid a jaw-dropping $2.6 billion to acquire the Internet phone startup in 2005. Now eBay's announcement Monday that it will write off $1.4 billion in charges related to Skype has analysts and investors questioning whether the Internet phone business - known as voice over Internet Protocol (VoIP) - has any commercial potential at all.

Consider: Vonage (Charts), the largest independent VoIP company with 2.5 million customers in the United States, and Skype with 220 million subscribers worldwide, have struggled to make money and compete with traditional telcos like AT&T (Charts, Fortune 500) and Verizon (Charts, Fortune 500). In July, VoIP provider SunRocket announced it was shutting down operations, leaving some 200,000 customers without service.

One big hurdle has been consumer confusion over just what voice over Internet Protocol service is and how it works. Five weeks ago eBay attempted to bring VoIP to the masses by introducing Skype headsets at 1,800 Wal-Mart stores. "If you're at Wal-Mart and you don't know what Skype is, why would you get it?" asks Sally Cohen, a Forrester Research analyst. "People may have heard of the acronym VoIP, but they don't know what it is. Awareness has to grow before adoption takes off."

Internet phone usage has grown steadily, but consumers are less willing to pay for the service. The number of people paying to use Internet phone services in the U.S. has nearly quadrupled to 16.3 million since 2005, but revenue per subscriber has dropped from $42 a month to $29, according to research firm IDC. Despite its large customer base, a mere fraction of Skype's 220 million users spend money on its service. That meant Skype's $90 million in second-quarter revenue accounted for just 5 percent of eBay's total.

Skype provides a free service to call from one Skype user's computer to another, and charges people by the minute when they dial a phone line. The problem is that it's hard to make money off the free users. "There's a lot of pressure on Skype to charge per minute, which, ironically is the way telephone companies do it," says Daniel Berninger, CEO of Net phone company FWD. "Skype will need to navigate a more successful business model."

Vonage has had its own troubles, including losing critical patent suits to Verizon and Sprint Nextel. The company reported a loss of $34 million in its second quarter and its stock has tanked since its May 2006 debut; it now trades at under $1 a share. Vonage gets customers to pay, but it has a tough time keeping them because they're skeptical about the service's reliability. "Vonage is at the mercy of a consumer's broadband service. When a VoIP service goes out, people don't associate that with a broadband connection problem. They'll just blame Vonage," Cohen says.

Skype's 30-hour outage in August certainly hasn't helped build consumer confidence in Internet phone calling. Says Cohen: "This market isn't going away, but providers will need to do more to provide a compelling experience to move consumers away from the traditional idea of a phone."  Top of page