Firms at the forefront of the telecoms revolution

The promise of dirt-cheap phone calls to anywhere heralds a "revolution in telecoms", says Paul Durman in The Sunday Times. Calls over the internet using voice over internet protocol' VoIP are set to make phone calls charged by the minute from traditional providers such as BT "a thing of the past". When you make a VoIP call, the voice signal is broken up into "packets of data" and sent over the internet to be reassembled at other end. This is a more efficient way of making a call than using traditional technology and calls are typically free, or very cheap. Disadvantages are few, although users do have to have broadband access and a special handset.

Privately owned Skype has long been the company to watch, says Maija Palmer in the FT. Not yet two years old, it already has more than 51 million users of its free VoIP software. Good news for its two founders, Niklas Zennstrom and Janus Friis, who were also behind Kazaa, a now-outlawed service that let users download songs from the web. But these two mustn't take anything for granted, says Fiona Maharg-Bravo on Breakingviews.com. Rupert Murdoch's NewsCorp recently offered to buy Skype for a rumoured $3bn, but that kind of valuation makes all kinds of optimistic assumptions about conversion rates and revenue growth. Equally, Skype has a growing number of strong competitors. Last week Google, the world's largest internet search firm, launched its own online voice calling service called Google Talk, says Katherine Griffiths in The Independent. Yahoo! already offers the service. But the largest player in the field is Vonage, with a market share of 37.5% in the US and with plans to raise up to $600m (£333m) in an initial public offering. Vonage provides low-cost phone services to 800,000US households and is now marketing the service here for £9.99 a month.

The fixed-line industry has begun to respond, with BT moving fastest, says The Economist. And not before time: research firm TeleGeography estimates VoIP subscriptions will grow from 1.8 million at the start of this year to four million by the end of December in America alone; by 2010, it sees over 17 million US subscribers. That's why BT is migrating its "circuit-switched" networks to new internet-based ones, essentially trying to beat the VoIP providers at their own game. It's also why SBC America's second-largest Baby Bell', or regional operator is working on a project called Lightspeed, which aims to deliver telephone services, TV and movies to customers via IPTV hugely enhanced broadband connections that use internet protocol.

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The big players are right to be worried, says Durman: they have billions of annual revenues "ripe for pillaging". So far, small firms such as Vonage have only started to eat away at the giants' dominance, but VoIP is poised to "devastate" their traditional business. Of the new players, Google looks well placed: it has brand power, resources and reputation. Its entry demonstrates the internet telephony revolution is "for real".

The best four stocks in the sector

So far, many investors have shunned companies that offer VoIP because they are small and have to compete against the telecom establishment, says Paul La Monica on CNNMoney.com. Most lose money initially and will do so for a while. Even so, their shares having fallen such a long way that some of the VoIP plays are beginning to look "absurdly cheap". Since early January, shares of Net2Phone, 8X8 and Trinsic have all slumped. The only VoIP stock that has done reasonably well recently is Deltathree, up about 10%.

The upcoming Vonage initial public offering will be crucial for the sector as a whole, says La Monica; the market is waiting to see how it does on listing. But the time for canny investors to try to cash in could be now, when sentiment is weak not when the stocks have already "taken off". Take Net2Phone (NTOP, $1.71). The firm's market cap is about $125m, but it has nearly $90m in cash on its balance sheet and just $17.8m in long-term debt. Deltathree (DDDC, $2.73) and 8X8 (EGHT, $1.98) also look good value.

Here in the UK, Matrix Communications (MXC, 156p) bought out five firms last year and has taken over another three in the past six months, says Investors Chronicle. High-growth areas include VoIP and network security integration. The firm's acquisitions have underpinned turnover growth and enabled it to build a leading position in network services, which would have taken at least five years to develop organically. Brokers Daniel Stewart expect sales of £54.7m for the full year, which would mean adjusted pre-tax profits of £6m (£1.6m last year) and earnings per share of 12.3p (5.2p), putting it on a 2006 forecast p/e of under 14.