More sour news on the telecom farm -- or just another Chicken Little?

A widely circulating joint research report from McKinsey & Company and J.P. Morgan & Co. (Nasdaq: JPM) says a decline in the growth of Internet Protocol (IP) network traffic is partially to blame for the ongoing shakeout among telecom service providers.

The report predicts that IP traffic growth will slow from its recent 200-to-300 percent growth rate to a 60 percent annual increase by 2005, mainly due to a slowdown in the growth of Web-page traffic. This slowdown, the report predicts, will hurt backbone carriers the most, as better management at the network's edge and aggressive pricing eat into pure IP transport revenues.

While the report still sees overall IP traffic revenues growing from $13 billion in 2000 to more than $56 billion by 2005, it also predicts that network-edge traffic aggregation (through Web hosting and content delivery networks) could steal away as much as $6 billion per year in transport revenues from backbone providers by 2005.

"Industry players that were formed around what was believed to be an insatiable drive toward Web-centric traffic and revenue growth," the report claims, "will soon have to begin rewriting business plans, if they haven't already, to pivot toward enterprise customers -- a goal for which many will find themselves ill equipped."

"These findings are good news for backbone carriers with rich customer relationships," says Paul Roche, a principal at McKinsey who helped prepare the report. "But for single-use or Web-centric providers, this is trouble."

Roche says McKinsey and J.P. Morgan conducted a wide range of interviews with service providers to get the numbers for their study, which contains a number of caveats attached to its modeling and predictions.

Though some observers question some of the report's specific numerical findings, they tend to agree with its conclusion that telecom providers need to develop specialized IP services to survive the current telecom nuclear winter. For example, the report predicts that services such as virtual private networks (VPNs) are the key to survival. Similar thinking was no doubt behind Juniper Networks Inc.'s (Nasdaq: JNPR) decision this week to add more IP functionality to its routers (see Juniper Mounts Pulpit for IP Services).

"People who are only selling pipes are the ones who will die," says Faizel Lakhani, vice president of network solutions at Caspian Networks, which is building network core routers.

The report predicts that enterprise-centric traffic will account for the lion's share of IP-based revenues going forward, a trend that is already being addressed by some equipment and service providers that are focusing on providing managed services instead of pure bandwidth. The report also says that backbone providers will face "continued economic dislocation" while network edge providers will grow in importance as more IP traffic gets managed and controlled closer to the actual customer.

Several industry observers questioned the basic premises of the report, saying both that slowing growth was somewhat inevitable (since traffic levels are already high) and that some IP traffic patterns, particularly outside the U.S., are still in the formative stages.

Vint Cerf, one of the Internet's early pioneers and now a senior vice president for WorldCom Inc. (Nasdaq: WCOM), questions both the report's current and future IP traffic estimates. "I doubt traffic ever grew at 300 to 400 percent per year," says Cerf, responding via email. "I think it has been more like 80-100 percent [annual growth] which is likely to continue, especially as broadband is more readily available and more widely deployed."

Others questioned some of the data.

"It's not clear if the report takes into account Internet traffic that will come from places like India and China, which are wild cards when it comes to predictions," says Ron Westfall, a principal analyst with research house Current Analysis.

Many industry players, however, are already embracing the changes discussed in the report. Sprint Corp. (NYSE: FON), for instance, formed a separate business unit last November that is aimed at providing more managed services, on top of hosting and colocation, to enterprise customers.

Level 3 Communications Inc. (Nasdaq: LVLT), which has an established colocation business, recently announced plans to support voice-over-IP services; and earlier this week, Cable and Wireless (NYSE: CWP) snapped up content-delivery provider Digital Island (Nasdaq: ISLD) for $340 million, helping confirm the report's prediction that consolidation will be rampant as backbone players and ILECs seek to add functionality -- while the single-service players collapse.

"We expect there to be a lot more M&A as carriers try to add scope," Roche says. "And we're pretty sure that the absolute number of backbone providers is going to shrink, going forward."

Though Roche says that the backbone consolidation may also hurt network core equipment providers, Caspian's Lakhani disagrees with some of the report's traffic-decline figures, saying that his company's sources see both edge and backbone IP traffic continuing to increase.

"It seems like there's some confusion [in the report] over what's edge growth versus core traffic growth," Lakhani says, noting that because the path of IP traffic is largely unpredictable, the core capacity must increase at a multiple of the growth at the edge to handle unforeseen events like broken links or spikes in traffic.

Lakhani, who says that Caspian obtains its own network-traffic figures from its non-disclosure agreements with "19 leading ISPs," says that corporate IP traffic may be increasing even faster than the report predicts.

"Corporations are moving from T1s to T3s far more quickly than anyone has anticipated," he says. Another increase will come as pure IP services start to offer the quality-of-service attributes of current WAN services.

Though not yet available on the Web, the full 112-page report (titled "IP! -- How Changes in the Internet Are Disrupting the Telecom Services Industry") can be obtained from either McKinsey or J.P. Morgan, Roche says.

- Paul Kapustka, Editor at Large, Light Reading
http://www.lightreading.com