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Net2Phone's Call to Investors

Investors who believe that 2004 is the year that placing phone calls over the Internet finally arrives as a technology and a business -- and signs certainly point that way -- have found a place to put their money. Many are suddenly taking a lot of interest in Net2Phone (NTOP), the most established stock in the voice-over-Internet protocol (VoIP) business. In 2003, the shares climbed more than 70%, from $4 to $7, and it kicked off 2004 with a bang, jumping 15% on Jan. 5 to close at $7.67.

Net2Phone debuted in 1995 with a cheap service that allowed customers to call friends from their personal computers. Now it boasts by far the longest track record, the most revenues, and the largest market capitalization of any public company in the VoIP business. "If you want to make a bet on VoIP," says Ari Moses, an analyst with Blaylock & Partners, a brokerage firm that helped underwrite Net2Phone's recent $52 million secondary offering, "Net2Phone is the best pure play."

That isn't saying as much as it might seem. Even though Net2Phone deserves credit for its hard-won survivor status, it's still a very speculative stock. Investors are bidding up the shares not only because they think Net2Phone's traditional business of facilitating Internet calls for consumers and small businesses will pay off (analysts say that business has delivered some attractive growth and positive cash flow lately after years of losses). They're also betting that Net2Phone will score big with a two-year initiative to persuade cable companies to outsource their VoIP business to it.

"IDEAL FIT." The plan -- and it's far from a slam dunk -- is to get small cable companies to either license that chunk of business over to Net2Phone or agree to share some of the revenues on Internet calls with Net2Phone. In return, they could tap into Net2Phone's expertise and capital (it has a $140 million war chest) to build and run VoIP services.

Time Warner's (TWX) cable unit recently announced plans to build its own VoIP service, as other cable giants are doing. By contrast, "we're an ideal fit for a cable operator that doesn't have the operational skill, technology, and capital to roll out telephone service in 2004," says Bryan Wiener, president of Net2Phone's traditional Internet phone calling division.

Persuading cable companies to come aboard is slow going, however. So far, Net2Phone has signed up only Liberty Cablevision of Puerto Rico, which is a subsidiary of Net2Phone's part-owner and strategic partner, Liberty Media (L). "It's hard to think of that deal as a precursor," says Richard Klugman, an analyst with Jefferies & Co., which also helped with Net2Phone's recent secondary offering. Net2Phone has another deal in the works with Cebridge Connections, the 12th-largest cable operator in the U.S., to deploy VoIP service in select markets in Texas and Missouri.

"It's still unclear at this point whether cable companies will sign up and under what conditions they will sign up," says Klugman, who rates the stock a hold.

ROOM TO CLIMB? Analysts who are more bullish on the stock have rather modest expectations for subscriber growth in the cable-outsourcing business. And they concede that Net2Phone is likely to lose money for at least the next 18 months (and even longer if the outsourcing business really catches on, since it will then have to spend more capital building out the services). Still, they see room for the stock to climb.

Moses figures that Net2Phone should have 20,000 cable subscribers by the end of July (the end of its 2004 fiscal year) and around 1 million by 2007, reaching 20% of the customers in its target market. At that point, he believes it will generate $400 million in sales (59% from the cable side of the business) and be profitable on an EBITDA (earnings before interest, taxes, depreciation, and amortization) basis for the year. He has an $8 price target on the stock.

Vivian Mamelak at Natexis Bleichroeder believes Net2Phone's subscriber base will be slower to ramp up. But she nonetheless initiated coverage of it on Jan. 5 with a $9.50 price target. She projects that Net2Phone's revenues from its traditional business will grow at a compound rate of 9% over the next five years, and that its cable-telephony business will grow at nearly 200% a year, for aggregate revenue growth of 18.6%. That would bring sales from $91.7 million in fiscal 2003 to $215 million in fiscal 2008.

GLUE STICK. Dan Berninger, an independent analyst in Washington, D.C., who has been involved in several VoIP startups, believes the end game for Net2Phone isn't just accumulating subscribers but rather linking phone calls between cable providers (which then wouldn't have to pay access fees to the traditional phone companies).

"There needs to be somebody that helps glue all the cable companies together," Berninger says. He points out that Liberty Media Chairman John Malone tried something similar by linking up cable-broadband Internet access providers with AtHome. That company ultimately failed, but "whatever lessons he learned from that process he can now apply here," says Berninger.

"That's going to be an opportunity down the road," agrees Wiener. But for now, he says, Net2Phone has its hands full with its current goals of signing up cable customers as well as improving the performance of its traditional Internet calling business. In that side of the company, Net2Phone is both exiting unprofitable businesses, such as selling disposable international calling cards, and entering more profitable, newly deregulated emerging markets, such as India and Turkey.

PRECARIOUS POSITION. Wiener concedes that the more cable companies Net2Phone signs up, the more money it will lose in the near term. He says it takes about three years in each market for the service to become profitable. "The more short-term losses increase, the more long-term returns will grow," he argues.

For now, Net2Phone adds up to a big opportunity that still comes with plenty of risks -- even though the viability of VoIP no longer appears to be chief among them. As its price rises, the stock is increasingly vulnerable to a setback if the company fails to sign up new cable customers fast enough. Likewise, some surprisingly good news could take it to new heights.

"There's a lot of headline opportunity, but some of it's already built into the stock price," says Klugman. For investors, Net2Phone has delivered plenty of excitement lately. Now it just has to deliver the goods. By Amey Stone, senior writer for BusinessWeek Online in New York

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