Adopting internet protocol may be the only way ahead for many telecommunications companies.

The newer, alternative telecoms operators who built capacity for new-fangled services faster than they built their business models, have suffered the most. They invested heavily in fibre-optic networks or hosting centres that optimised Internet Protocol (IP) technologies. IP moves information around in data packets, which is much more cost-effective – up to 30 per cent cheaper – than using older, circuit-switched networks designed for voice calls. Two years ago the companies building all this new capacity were a dime a dozen on the conference circuits, all equipped with power-point presentations showing fantastic growth projections. What they forgot to watch was the revenue side, which wasn't growing nearly as fast as their capital expenditures. The more exposed companies – those with high debt and few customers – are imploding.

For the financially stronger operators, the fallout has proved a kind of boon, allowing them to attract disaffected customers and pick up cheap assets, like web-hosting centres. And certainly the cost savings of using IP technology have not gone away. "Twenty-five years ago we saw the shift from analogue PBX systems to digital PBX systems," says Jack McMaster, CEO of alternative telecoms operator KPNQwest. "Well, you are about to see a big shift again as private corporate switched data networks go to IP VPN [virtual private networks]. At the macro level the migration from circuit-switched to IP infrastructures is continuing."

As corporate budgets have been put under pressure by the slowing economy, "companies are now asking questions about their telecommunications that they weren't asking six months ago," in the words of Duncan Black, head of corporate network strategy at Cable & Wireless. The problem for Cable & Wireless is that even though it has focused its business on IP technology, and made purchases like Digital Island to give it expertise in digital content distribution, these moves haven't had much of a positive effect yet on its bottom line. C&W has issued two profits warnings and seen its share price slide 65 per cent since the year began, and it has told analysts that revenue in its principal global business unit will fall 5 per cent this year.

Cable & Wireless is "taking some financial hits" in the short term, but company executives say the next 18 months will see a change: businesses will want and expect a "business-quality internet" and only a few carriers will be able to deliver it.

Some operators say they are better placed than others. Amsterdam-based KPNQwest, which has almost finished building a pan-European fibre network linking 50 cities, says it is delivering a business-quality internet today and doesn't fear price erosion. "Sometimes it's not so much how good you are, but what car you are driving," says Mr McMaster. "C&W is stuck in the UK between BT, Colt and Energis. Most of C&W's revenue is from legacy voice products even as [C&W chief executive] Graham Wallace tries to re-invent the company to be a pan-European data player. It's a tough competitive position. Whereas I have a fresh network with less than a 2 per cent market share. Virtually everyone out there could be my customer."

Concerns about a recession are expected to cool corporate demand for IP services and these fears have already pulled down the stock prices of big network equipment manufacturers such as Cisco Systems and Nortel as well as the telecoms companies themselves. But the internet has rung in a new set of technologies and expectations about communications, from e-mail to e-commerce and e-marketplaces. Even now, in more sober economic times, retail data traffic is expected to grow at 90 per cent a year, while wholesale growth will be closer to 200 per cent, says The Yankee Group.

KPNQwest says the appetite from corporate clients is there. It signed one corporate IP VPN contract every day for 25 days in September and counts among its clients Dell Computer and Cap Gemini. KPNQwest also believes that its up-to-date network, which allows it to "light", or turn on, new fibre-optic capacity as and when it needs to, will help it keep one step ahead of the technology change and price erosion that equity analysts such as Mark James at Nomura worry about. "I've a cost horizon that goes down with each generation of optical technology," says Mr McMaster. "So the punch-line is my margins don't get worse, they get better. After all, I am not a commodity."

Businesses have already begun to log on to this new IP technology and it's not just the big firms. Although some are wary that IP is still less robust than more conventional transmission technologies like ATM (asynchronous transfer mode) or frame relay, all are attracted by the potential cost savings. Research by consultancy Ovum, commissioned by IP services provider Netscalibur, shows mid-size companies of under 1,000 staff in the UK, Germany and Italy have made savings of $25bn (£17bn) in the last year by using IP to drive out costs. In the UK alone, savings reached £3.95bn, a figure that will jump to £8.15bn by 2006.

Netscalibur takes the more unconventional view that it can build a business delivering IP services like messaging and remote working applications, without owning any network at all. "The winner is who gets the customers, not who has the networks," says Francesco Caio, chief executive of Netscalibur. The former chief executive of Italian mobile operator Omnitel says carriers, including BT, France Telecom and Deutsche Telekom, wrongly see the IP revolution as an infrastructure play. "It's like the Hollywood industry all over again. They had the idea that you need to own your own cinemas to make money. I am building a networkless networking company."

Most analysts agree that for operators to find sustainable and on-going revenues in the IP world, they must do more than provide simple network capacity. The ability to manage applications and data and to build customer relationships will be a crucial selling point. "There have been too many companies with too many half-baked business plans," says Andy Greenman, an analyst at The Yankee Group. "Out of that will come traditional companies with high levels of service agreements."

But, although telcos like BT and France Telecom have these kind of long-standing relationships with their customers, Mr Greenman is not certain if they have the right skills for this brave new IP world. "The incumbents and companies like Cable & Wireless have the credibility, but they don't have the skills to translate this into the new business environment," he says. "We don't really know who fills that gap, but it's likely to be the systems integrators, like IBM and EDS."

Providing a full e-business infrastructure service to business customers seems to be the new mantra for network owners, be they BT or KPNQwest.

In an economic downturn companies may be more choosy about what they need and are willing to pay for, but the cost savings of IP and the importance of e-business to overall corporate strategies is winning them round. An example is a £350m contract for Cable & Wireless to provide CGNU, the UK's largest insurer, with an IP-based corporate voice and data network over the next seven years. The agreement, signed in July, took nearly a year to negotiate. "Companies want either one hand to shake or one throat to throttle," says Cable & Wireless's Mr Black.

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