Vonage's Prospects Dim

A pair of patent decisions darken the financial picture for the embattled Internet-calling provider and could leave the company susceptible to a takeover

A one-two punch of court decisions handed down Sept. 25 and Sept. 26 cast further doubt on Vonage's (VG) future and halved the market value of the beleaguered Internet-calling provider.

The bout got underway Sept. 25 when a jury found that Vonage infringed on six patents held by Sprint Nextel (S). The court awarded Sprint $69.5 million in damages and imposed a 5% royalty rate on future use of Sprint's technology. The next day, a different court upheld an earlier decision that found Vonage in violation of two Verizon Communications (VZ) patents and upheld a decision that bars Vonage from using Verizon technology without paying royalties.

Vonage's Cash Challenge

The upshot: Paying royalties to Sprint would diminish an already depleted cash pile, while the decision in the Verizon case steps up pressure on Vonage to prove that its alternatives to the technology in dispute don't infringe on Verizon's patents. Together, the rulings give consumers added reason to shun Vonage as a provider and may spur defections among existing users. They may also leave Vonage vulnerable to a takeover. For now, many investors are betting on the worst. In two days, Vonage shares sank 52%, to 94 cents as of the market close on Sept. 26.

Vonage has enough cash to stay in business for now and vows to keep battling on legal and technological fronts, but it's hardly fighting from a position of strength. "I don't want to be too alarmist," says Rebecca Arbogast, an analyst with Stifel Nicolaus. "I don't think these damages are going to bring Vonage down, it's a variety of factors. But things do not look very hopeful."

Here's why: Vonage is having a harder time adding subscribers, and it's burning cash. The company attracted 56,691 new customers in the second quarter, down from 255,936 a year earlier, while its cash fell to $343.5 million from $499.7 million at the end of 2006. To its credit, Vonage narrowed its second-quarter losses as sales rose. "This is absolutely not the end," says Vonage spokesman Charlie Sahner. "Vonage is here to stay."

But in what form? Vonage has already slashed staff and marketing expenses, and more cuts could be forthcoming, analysts say. In the past year, Vonage has lost its No. 1 ranking among U.S. Web-calling providers and has been surpassed by Comcast (CMCSA) and Time Warner Cable (TWC) in terms of market share, according to consultancy TeleGeography.

Threatened By Injunctions

In addition to the burden of paying royalties, Vonage is threatened by injunctions that would bar it from using Sprint's technology. One group of Sprint patents relates to how voice conversations are transmitted; the other relates to the way calls are connected. A Sprint spokesman says the company will seek such an injunction.

Verizon already won an injunction in the case of its own patents, one of which relates to how calls are processed as they move from a traditional phone network to the Web. The other pertains to the use of speakers and microphones with Web-calling service. Vonage says it has come up with so-called workarounds, or alternatives that keep it from infringing the patents in question.

That technology, too, will come under close scrutiny. "I'd expect Verizon will take a very aggressive look" at the workarounds, says Arbogast at Stifel. Intellectual property experts say that the scope of the Verizon patents is so broad that it won't be easy to replicate the services without violating patents. "These guys smell blood, and they are going to do as much as they can to hurt Vonage as much as they can," says Jon Arnold, principal at communications consultancy J Arnold & Associates. If courts find that the workarounds aslo violate the patents, Vonage could be charged with contempt of court and willful infringement, says Nolan Goldberg, a lawyer at Proskauer Rose.

Possible Sprint Target?

In one of the few silver linings for Vonage, the court in the Verizon case vacated monetary damages of $58 million, plus a 5.5% royalty rate previously awarded to Verizon and held in escrow. The court found that Vonage may not have infringed on a third Verizon patent at issue in the earlier trial, asking the lower court to review that decision. As a result, Vonage may get back part of the $84 million now held in escrow. "It's going to be helpful for our capital position," Sahner says.

There's also the prospect Vonage becomes an acquisition target for a company like Sprint, Arnold says. Sprint would benefit from acquiring Vonage's 2.44 million subscribers. Sprint might also integrate Vonage's Web-calling service with its own wireless offerings, in order to better compete with cable and telecom rivals.

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