Vonage: Away from the Edge, for Now

The Web-calling service provider can seek subscribers until its appeal hearing on the patent infringement case brought against it by Verizon

That Vonage man dressed in a lobster costume will remain stuck in a revolving door a bit longer: On Apr. 24, the U.S. Court of Appeals for the Federal Circuit granted Vonage a permanent stay to a prior injunction. The troubled Web-calling service provider is once again allowed to recruit customers, effectively giving it a new lease on life. Last week, Vonage warned in a regulatory filing that if it were unable to sign up new subscribers, the company could face bankruptcy.

On Apr. 24, the court said that Vonage (VG) should get an expedited hearing of its appeal of an Apr. 6 lower-court decision on a patent infringement case brought by telecommunications giant Verizon (VZ). Both Vonage and Verizon have to file briefs by May 30 (Vonage's first brief is due May 9), with an oral argument set for June 25.

Tricky Nitty-Gritty

Vonage's shares, beaten down over the past several months, rallied 30.8%, to $3.78, on the news that the company will be able to sign up new subscribers, at least for now. That's critical considering nearly 29% of Vonage's customer base turns over every year. "The decision allows them to step back from the edge of the cliff," says Will Stofega, an analyst with IDC.

But Vonage isn't all that far from the edge. While the stay means Vonage has a chance to overturn the Apr. 6 ruling, the decision does not signal an inclination on the judges' part to side with Vonage on appeal. The same judges who ruled on Apr. 24 will be hearing the appeal on June 25 (see BusinessWeek.com, 4/6/07, "Vonage: Gasping for Air"). "It's a mistake to take too much away from this decision," says Nolan Goldberg, a lawyer at law firm Proskauer Rose in New York in assessing the court's Apr. 24 action. "I don't think the court wanted to sign a death warrant on Vonage."

The judges spent much of the two-hour proceeding—unusually long, according to lawyers—trying to understand the potential impact of an order to stop recruiting new customers. They also seemed to struggle to understand the claims and the arguments made in the case, delving into the nitty-gritty of voice-compression technology, servers' role in providing service, and figuring out which types of phones a decision may cover.

"It's very hard to tell from the briefs what's going on here," Chief Judge Paul Michel told a Vonage lawyer during the hearing. "Your motion papers don't explain the context and significance of the injunction and claims."

Uncertain Outcome

The unusual length of the hearing "is an indication that the judges didn't have their hands around this case as much as they would like," says James Shalek, partner at Proskauer Rose. "They were trying to understand the merits and didn't lean one way or another."

Vonage's lawyers offer a different interpretation: "This particular court has a lot of patent expertise and experience, and they wanted to grill into the issues," says Scott Doyle, partner at law firm Steptoe & Johnson, which is representing Vonage in the case. "You can never tell [which way judges are leaning] based on questioning. Sometimes, the most aggressive judge can, at the end, be on your side."

The fact that the appeal has been expedited may or may not be good news for Vonage, which had expected the legal wrangling with Verizon to go on for up to two years. That might have given Vonage time to develop a work-around technology that would come in handy if the patent infringement verdict isn't overturned.

But the expedited appeal by no means guarantees that a resolution will be reached in June. In one of the best-case scenarios for Vonage, the appeals court could change definitions of certain terms, redefining how broad Verizon's patents are and to what they apply. If so, the case would be sent back to the district court for a retrial. Plus, in the fall, Vonage may start fighting another patent infringement battle, this one involving Sprint Nextel (S).

Uneasy Customers

As these legal wranglings continue, Vonage vows to stay focused. "It's business as usual for us," said Jeffrey Citron, Vonage's interim chief executive officer, in a statement. "We will continue providing reliable, quality digital phone service at the best value in the market and connecting thousands of phone calls every day. We remain focused on growing and strengthening our business and driving toward profitability."

But keeping this promise may be tough, given the legal fees and royalties the company has to pay. Until the case is decided, Vonage will deposit 5.5% of certain service revenues into a special account to be payable as royalties if Verizon wins the case. While Vonage had previously said it expected to turn operationally profitable in the first quarter of 2008, it is no longer offering such assurance.

The company also has had operational problems of late. In the past week, its customers were struck with a service outage, and users have been reporting technical problems to the vonage-forum.com message board for the past month. Plus, some customers, worried Vonage could go under, have been shopping around for other service options.

Comcast Footsteps

"They need to reassure existing customers," says Jon Arnold, principal at telecom consultancy J. Arnold & Associates. "Ultimately, this Verizon thing is just a huge wake-up call. There are a lot of things wrong with their business model."

Now may be the time for Vonage to invest in new features, such as a wireless offering, which would differentiate its service from that of cable companies like Comcast (CMCSA). Comcast is poised to overtake Vonage as the nation's No. 1 Web-calling provider (see BusinessWeek.com, 2/20/07, "Coming Up: Vonage Wireless?").

Vonage's ad campaign may not be working, either, judging by its slowing subscriber growth: its 166,000 new subscribers in fourth-quarter 2006 were nearly 20% fewer than the year-ago period. Clearly, Vonage has its work cut out for it, even if it's no longer at the edge of a cliff.

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