Testimony of John Hodulik, CFA

Managing Director, UBS Investment Research

FCC VOIP Forum

Washington, DC

December 1, 2003

My name is John Hodulik and I am the Wireline Telecommunications Analyst
at UBS Securities LLC. Thank you for the opportunity to address the
Commission this morning. I hope to bring a bit of a financial
perspective to the forum and explain how investors view the emergence of
VoIP.

I think we need to begin today's discussion by defining the topic. Voice
over IP specifies both a technology and a service. The technology is
Internet protocol. The service is voice transmission. I believe VoIP
exists in three main forms: VoIP in carrier networks, VoIP in private
networks, and VoIP in the public Internet. This last form exists in both
server-based models and through peer-to-peer networking. Sometimes the
lines delineating these forms from one another are not clear.

IP technology has been increasingly employed by the public switched
telephone network ("PSTN") in carrier networks to transmit telephone
calls, predominantly deployed on long haul routes to improve bandwidth
efficiency. Meanwhile, large corporations have been placing more and
more of their voice traffic on their own private networks via IP. UBS,
as an example, recently completed a layer-3 switch upgrade enabling it
to bypass the PSTN in many instances and to significantly reduce its
telecommunications costs. Now, the benefits of VoIP are making their way
into the consumer and small business markets. Small entrepreneurial
companies and cable providers are driving this acceleration in the
consumer market while the Bells largely focus their VoIP strategies on
the business market.

VoIP presents the Regional Bell Operating Companies with their greatest
challenge yet. While they stand to benefit from VoIP as an insurgent
technology in the business market, their dominant share of the consumer
market will erode at a faster rate as this technology is deployed. A
significant amount of voice traffic is already moving to alternative
platforms. Wireless substitution and electronic messaging are already
having a profound impact on minutes of use. The effects of falling
volumes are compounded by the aggressive price points of these competing
technologies. VoIP services, either from cable or edge-agnostic
providers, have the potential to become a much larger factor than either
of these.

Due to the open standards of the Internet and IP technology, a company
no longer needs to control the transport infrastructure to provide the
application. This has "de-coupled" terrestrial voice service, a \$200
billion market, from the underlying telecommunications networks.
Ownership of this network has always been one of the Bells largest
advantages. This "de-coupling" dramatically lowers barriers to entry for
new competitors and turns on its head the relationship between
profitability and investment intensity in the telecom sector. IP
technology also creates another deflationary factor for the industry and
largely lifts the constraints that have protected local voice service
from the effects of Moore's Law.

Open standards should also lead to the development of new, IP-based
services provided by third party developers. These services will include
unified messaging, video-conferencing, entertainment services, and many
others that are not voice related. New, higher value services will be
introduced as funding flows into the developer community once the user
base has reached critical mass. Large established software companies
will also attempt to add value as they push for greater control of the
IP device.

As a result, the pace of change in the market for "voice" services will
accelerate, becoming more similar to that of web-based services than the
traditional PSTN. Eventually, these new services will become the main
driver for the acceptance of VoIP and it will become increasingly more
difficult to determine what is a traditional "phone call." Importantly,
it should also lead to the commoditization of enhanced services
currently offered by local service carriers such as call waiting, caller
ID and voicemail. These services contribute a significant portion of the
ILECs' profits in the consumer market.

As a result, operating cash flow margins in the sector will fall as
local service revenues contract. Local voice and switched access
revenues generate approximately 60-65% of Bell wireline revenues and at
least 75% of the profits based on our estimates. However, these revenues
are declining at a rate of over 8% per year. Rural carriers have even
greater reliance on access revenues, which will continue to diminish as
VoIP becomes pervasive. We believe it will be extremely difficult for
the carriers to replace these profits through sales of new services such
as DSL and long distance as these products typically produce lower
margins.

Currently, the Bells generate operating cash flow margins of roughly 40%
of sales before pension effects. Without effective costs controls and
job reductions, we believe margins could fall significantly for the
group over the next five years as traffic continues to migrate to new
platforms. This has significant ramifications for investment in
telecommunications infrastructure. The Bells constitute the vast
majority of spending on wireline carrier network infrastructure in the
United States, at approximately 70% of the total. As VoIP-based
providers take on the roll of the ILECs, investment by the large
incumbents should remain highly constrained.

Ironically, the existing regulatory framework is promoting the adoption
of VoIP as well as any focused strategy could reasonably be expected to
do. When VoIP providers say they worry that regulators could slow the
acceptance of the technology and their growth, they are acknowledging
the underlying regulatory benefits they have relative to the traditional
telcos.

If the regulatory imbalance remains, the incentive for incumbent
carriers to shift traffic to IP-based platforms will remain strong. The
Bells have made it clear with recent announcements regarding VoIP that
they will follow the path of least resistance. Over time, this will put
undue stress on the existing regulatory framework, making the existing
intercarrier compensation regime and Universal Service funding
mechanisms untenable.

From a network standpoint, voice and IP services can be commingled
relatively easily. However, this marriage pits the micro-managed
regulatory world of voice, where returns are almost guaranteed, with the
hands-off, market driven world of IP where companies are left to sink or
swim on their own. From a capital market's standpoint, much of the
uncertainty is because there appears to be a regulatory void when it
comes to VoIP. The FCC needs to take a leadership position, creating one
set of rules that distinguish between the different types of VOIP. Until
this is completed, investors will remain wary about funding new ventures
that provide the service.

I cannot stress enough the importance of creating a regulatory framework
that will stand the test of time, allowing investors to anticipate the
winners and losers based on strategy and execution rather than
unforeseeable changes in Washington. A patchwork of differing state
regulations does nothing to provide clarity and, frankly, makes no sense
considering the lack of geographic distinction on the Internet where
there are no LATAs or state boundaries. While there is certainly a role
for the states regarding public policy aspects of VoIP based telephony
service, I believe this is an issue that requires a national standard,
which is something that only you can develop.

In sum, I believe VoIP has created not just the need but also the
opportunity for regulators to rethink the traditional framework that
governs telephony in the United States. I believe this forum should be
as much about creating parity as it is about fostering the growth of
VoIP. Regulating VoIP similar to the traditional telephone network is
not the answer. The answer is to fundamentally reassess regulation of
the traditional telephone network before the value-creating portion of
that infrastructure and the regulatory framework that governs it,
becomes obsolete.