Bleaker future for Net-phone pioneer

Analysis: Vonage can survive, but investors won't thrive

WASHINGTON (MarketWatch) -- Vonage Holding Corp. helped make Internet-based phone calling respectable, but the company has become yet another pioneer that has failed to reap the rewards of its trailblazing ways.

The company's most pressing concern is a patent dispute with Verizon Communications Inc. that threatens to cut off Vonage's ability to sign up customers. Just as worrisome is Vonage's high cost of doing business and diminishing success in attracting subscribers.

Unless Vonage fixes those problems, the company's stock will never come close to seeing $17 again - the price at which Vonage launched an ill-fated initial public offering in May 2006. Vonage
VG, -1.36%
now trades at $3.35, and it recently fell to as low as $2.88.

"Regardless of what happens with Verizon, they are definitely swimming upstream," said Jon Arnold of J Arnold & Associates, an independent analyst of Internet-based communications.

Citron immediately unveiled plans to cut costs by $140 million in 2007 as part of a broader restructuring. He also insisted the company could still prevail in its battle with Verizon.

In March, a federal jury ruled that Vonage violated three of its larger rival's patents and the company was ordered to pay $58 million in damages as well as future royalties of 5.5%.

Last week, the U.S. district court judge overseeing the case in Alexandria, Va., issued an injunction barring Vonage from signing up new customers. A federal appeals court, however, agreed to hear Vonage's appeal on April 24.

Holmdel, N.J.-based Vonage, with 2.4 million customers, is the leading independent supplier of phone service that uses the Internet to transmit calls. Because the technology is cheaper, Vonage can offer subscribers unlimited local and long-distance calling for as little as $25 a month, including a number of features such as caller ID.

Even if a federal appeals court ultimately sides with Vonage -- many analysts are skeptical -- the company's future looks far bleaker than it did one year ago. Vonage is still burning up cash quickly, losing lots of money, and it could run out of funds within a few years.

What's more, investors are unlikely to supply a major cash infusion without first seeing signs of significant progress and a "white knight," or a potential acquirer, is nowhere in sight.

In many ways, Vonage has adopted the failed tactics of independent local-phone companies spawned by the high-tech boom in the late 1990s. The company owns few proprietary assets and relies heavily on existing networks owned by other carriers to deliver its service.

Big spending

More of "a marketing company rather than a technology company" -- as analysts at Citigroup put it in a recent report -- Vonage also raised ample funds from deep-pocketed venture capitalists. And it's spent the cash quickly to build its business even as the losses piled up.

In 2006, for example, Vonage lost $286 million on the way to recording revenue of $607.4 million. The year before, the company lost $261 million while generating $269 million in revenue.

"This is 1999 redux. The 'smart' money is starting to look stupid," said Paul Wright, a longtime telecom analyst at the mutual-funds giant Loomis & Sayles. "The reseller model just doesn't work."

The hope of many early investors was that Vonage would grow quickly, threaten the established order and thus elicit a generous buyout offer.

Vonage has certainly succeeded in the first two aims. The company gained 2.4 million customers in just a few years and the established order -- in this case Verizon -- certainly has felt threatened. Verizon estimates it's lost as many as 600,000 subscribers to Vonage.

Instead of making an acquisition proposal, Verizon responded with a patent lawsuit in an effort to drive Vonage out of business. Defeat in the legal battle with Verizon, however, isn't enough to send Vonage to an early grave. The company has enough money to last until late 2008 and should be able to fund any payout to Verizon.

"I am not worried about them shutting off my service anytime soon, but it will be tough for them to get rich," said Stephan Beckert, research director of the telecom-consulting firm TeleGeography, who uses Vonage service at home.

Wiser use

For the foreseeable future, Vonage will remain under heavy pressure to slash costs and the company will have to stay on a strict cash diet to survive. Critics say the company spent too much too fast to market its service, mostly on clever TV ads.

Consider the company's gross margin - the money leftover after Vonage subtracts the actual cost of providing phone service. In 2006, Vonage generated a healthy gross margin of 61%. A 5.5% royalty payment to Verizon would only put a small dent in Vonage's margin.

Yet the company's high gross margin is misleading since heavy marketing expenses are the lifeblood of phone companies. They have to spend lots of cash to sign up customers.

If Vonage's marketing expenses are factored in, the company's gross margin was a meager 1.2% in 2006. Recognizing that concern, Vonage said Thursday it will slash marking expenses by $110 million in 2007 to $310 million.

Citron also said Vonage would shy away signing up "marginal" customers in an effort to reduce churn, or the percentage of subscribers who cancel service. Churn totaled a relatively high 2.4% in the first quarter, meaning Vonage loses about 50,000 users a month.

Taking those steps, however, means the company won't add as many net subscribers as Vonage has targeted -- as many as 900,000 in 2007. And if Vonage trims spending on customer service, subscriber growth and retention could be further undermined.

The irony is this: Internet-phone service is here to stay regardless of what happens to Vonage. The industry pioneer proved that the technology works and made millions of Americans aware of so-called Voice over Internet service via its funny ads and marketing deals with big chain stores such as Best Buy.

Indeed, millions of Americans actually use "VOIP" even if they don't know it. More than 6 million cable customers subscribe to "digital" phone plans that operate just like Vonage's service, according to an estimate by researchers at TeleGeography.

"There is no question that voice as an application can be delivered over the Internet," Beckert said. "At some point in the future all calls will go over the Internet backbone."

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