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By Ben Charny, 28 September 2004 09:50

COMMENT Is Skype the next big thing? Or just the flavour of the month? Ben Charny looks at what's caused the dramatic growth of this voice over IP provider - and what's next.

When Sun Chun first heard of Skype and its promise of free, high-quality internet phone service, he figured the claims were mostly hype.

Chun, who generally considers himself an early adopter, had tried broadband phone services before, only to suffer lost calls and garbled conversations. So he was skeptical when reports began circulating a year ago of revolutionary peer-to-peer software that could render traditional phone companies obsolete, much as file-swapping services threatened the recording industry.

The jury is still out on whether Skype will take down the Bells. But Chun, for one, is kicking himself for waiting so long to try out the software.

"The conversations with our friends are surprisingly clear and crisp," Chun, a San Jose, California tech worker, said in an email. "Calls to my friend in Australia were also of equal crisp quality. So now, I am urging all my friends and family to install this incredible software."

Just over a year after Skype's launch, the Luxembourg-based upstart is showing signs of being the real deal. But as with early predictions about peer-to-peer technology and the music business, the expectations about an overthrow of the telephone industry remain unfulfilled.

In fact, as much as Skype presents a budding competitive challenge to the old-line companies, it's also looking for ways to cooperate with them. The start-up voices lofty goals of expanding the way people communicate but it still faces the down-to-earth demands of broadening its own sources of revenue.

And although users like Chun say they're impressed by Skype's voice quality, there are still some rough edges. Both caller and receiver must have the voice over Internet Protocol (VoIP) software installed. Calls to ordinary phone customers will still have a cost. And the software works only on PCs and a handful of niche devices - not regular phone handsets.

Sara Hofstetter, a senior vice president at Net2Phone, a VoIP provider that, unlike Skype, does not use peer-to-peer software said: "VoIP didn't become successful until it moved off the PC."

Even taking into account such pitfalls, Skype signals a major upheaval for the phone industry.

Because of its peer-to-peer architecture, Skype requires absolutely no infrastructure and only minimal capital investment compared with phone companies that own their own lines and switches. Rather, Skype's 750,000 daily users create the network on the fly, sharing computer resources to manage traffic flow and ensure call quality. Skype claims its network can grow organically without the need to add new equipment to support increased traffic demands.

This 'network free' concept is unprecedented, even for net phone providers that are already turning the century-old telephone industry on its ear. With Skype, one no longer needs a few hundred thousand dollars in start-up costs typically associated with net phone service, let alone the billions of dollars in investments to become a traditional phone company.

Federal Communications Commission Chairman Michael Powell said recently: "I knew it was over when I downloaded Skype. When inventors are distributing... a program to talk to anybody else, and the quality is fantastic, and it's free, it's over. The world will change now inevitably."

Skype has turned heads for its unique blend of technology and rapid grassroots adoption. The company claims more than 22 million downloads since the software was first made available in August 2003. It is currently signing up about 60,000 new registered users every day - numbers that draw comparisons to free software downloads that swept the internet during the late 1990s, such as the ICQ instant messaging service.

Tim Draper, managing director at Draper Fisher Jurvetson, which has invested $9m into the company, said: "Its growth rate is sky high. I don't think there's been this speed of adoption since Hotmail. We are thrilled with what Skype's been able to do. We think itÂ’s a global phenomenon that will change communication for the better."

Skype has also drawn comparisons to Kazaa, the wildly popular file-swapping software created by Jan Friis and Niklas Zennstrom - the same pair of developers behind Skype.

Like Kazaa, Skype uses peer-to-peer technology that connects PCs and turns them into a powerful, collaborative network without the need for central servers to direct traffic or otherwise administer the system.

In Kazaa's case, people can search and retrieve files stored on one other's computers - a capability that has drawn the wrath of the entertainment industry over allegations of massive copyright violations.

With Skype, people can place phone calls without touching the traditional phone network. That means callers can avoid long-distance charges, regardless of the destination, provided both caller and receiver have the Skype software.

Although other companies such as Vonage, Packet8, VoicePulse and AT&T have launched similar broadband phone services, most use centrally managed systems to handle call transfers to the traditional phone network. Most also charge a flat monthly fee.

Skype, by contrast, charges only when its users need to make a call that goes off the peer-to-peer network to a traditional telephone line, a capability made available recently through a new feature known as SkypeOut. The service charges a flat rate of about 2 cents a minute to 20 countries in North America, Western Europe and Australia. Different rates apply elsewhere.

Rivals argue that Skype's free calling network is a essentially closed one and thus won't have broad appeal to people wanting to call anyone without the software. As a result, rivals that offer flat billing rates may have wider appeal.

A Vonage representative said: "Skype might have great software but its business case and its reach is very limited. They aren't going to take over the world the way they are doing it now."

With all its momentum, it's surprising to hear that Zennstrom isn't interested in putting traditional phone companies out of business anytime soon - if ever.

Rather, he said, a major theme for the company is how VoIP and phone companies can work together.

In this relationship, Skype plays the role of lure by supplying a tempting internet application - in this case free internet calling with loads of extra features - that phone companies can use to sell broadband to their customers.

"Fax machines did not kill the post office. Email didn't kill the fax. Our objective is not to kill any telephone companies. People will be using phones of all kinds in the future," Zennstrom said. "If anything, we are there to help drive sales of broadband. What we want to do is expand how you communicate, adding on text messaging, file transfer, video. Voice is just one way to communicate."

Another priority is profits. "In a world of many, many billions, it's easy to find 10 million geeks," said Net2Phone's Hofstetter. "The real question for Skype is how are they going to make money?"

Skype's only revenue sources for now are sales of $55 "Cyber Phones" for laptops, and a number of Plantronics combination headset/microphones. In mid-2004, it significantly expanded its commercial efforts with SkypeOut, in which Skype users can call cell phones or landline phones. People create an account of $12, $30 or $62 worth of voice minutes. The accounts are charged at various rates, depending on where the call originates and which region is being called. Zennstrom wouldn't say how much the company now earns from these and other ventures.

"We are very focused now on the short term and introducing our commercial services," Zennstrom said.

Looking ahead, Skype plans to fine-tune what is already one of the best voice qualities in the business. It is testing new applications for videoconferencing, which will accompany the dozen free features Skype already offers. In addition, the company is busy making versions of its software for mobile devices, a difficult technical feat that could have a huge payoff.

The push began in early 2004, when Skype released a version of its software for Microsoft-powered personal digital assistants.

With such a combination in hand, the public venues, transportation hubs, stores, restaurants and offices with high-speed Wi-Fi wireless networks could become oversize phone booths, where Skype users can call each other for free, or reach the traditional phone network for a couple cents a minute.

The next step, said Zennstrom, is creating a version of Skype for cell phones. A Skype representative said the company is testing Skype for cell phones using a European cell phone network equipped with 3G, or third generation, wireless broadband gear that typically downloads data at the speed of a digital subscriber line connection.

But this push into phones is raising questions. Skype calls on a cell phone would rely on wireless data networks that are for now expensive to use. But Zennstrom is confident the price of such services will drop to palatable levels.

"That's definitely where we are going," Zennstrom said. "This will be a very big step for us."

Ben Charny writes for CNET News.com