Vonage's Iffy IPO

Sure, the VoIP provider has half of the North American market. But it also faces plenty of fresh competition and rising costs

On Feb. 8, Vonage made official what the telecom world had long expected. The Web-calling leader finally filed with regulators a plan to raise as much as $250 million by selling shares. Speculation over an IPO erupted last year after online-auction powerhouse eBay (EBAY) scooped up Vonage rival Skype for $2.6 billion.

The IPO, underwritten by Citigroup (C), Deutsche Bank Securities, and UBS Investment Bank, is expected to be priced later this year -- likely sooner rather than later.


  And Vonage is wasting no time getting its house in order. Vonage said Michael Snyder, formerly of ADT Security Services, will become chief executive. He takes over from co-founder Jeffrey Citron, who will become chairman. Citron is the founder of broker-dealer Datek Online Holdings, the subject of a Securities & Exchange Commission investigation of alleged improper use of the Nasdaq Stock Market's Small Order Execution System. Datek settled with the SEC in 2003.

But it's going to take a lot more than management changes to gird Vonage for the challenges it's facing as it prepares to go public. Vonage, with more than half the North American market for the so-called Voice over Internet Protocol (VoIP) calling market, is going public in an environment fraught with accelerating competition and regulatory uncertainty. And a first glimpse at the telco's finances shows costs are headed in the wrong direction -- fast.

Lately, some have likened Vonage's IPO to that of digital video-recorder pioneer TiVo (TIVO). The latter went public to much fanfare in 1999, only to see bigger rivals eat into its market share. Even though it's been around since 1997, TiVo is still booking losses. At $5.64 (at the market close on Feb. 8), its stock is trading 81% below its IPO levels.


  For Vonage, profitability looks far-removed as well. While sales in the first nine months of 2005 more than doubled from all of 2004, its losses are mounting. Since its inception in 2001, Vonage has lost $310 million. In the nine months ended Sept. 30 alone, it lost $189.6 million on sales of $174 million.

Problem is, on a per-line basis, Vonage's sales are falling, while costs-per-subscriber are rising. According to the IPO filing with the SEC, Vonage spent $213.77 per subscriber on marketing in the first three quarters of 2005, compared with $137.70 in 2004. At the same time, average revenue per line has dropped to $26.63, from $30.99. If a customer has just one line (and most do), it would take more than eight months to recoup marketing expenses alone.

Other expenses are headed in the wrong direction, too. The per-line cost of providing service has increased every quarter of 2005 -- and it's expected to rise again this year as Vonage enables emergency 911 calling.


  Price pressure abounds, as new players jumped into providing VoIP service with service packages that cost as little as $19.95 a month. These new, smaller players will erode Vonage's share this year, says Michael Arden, an analyst with tech consultancy ABI Research.

One of the bigger threats: Web-calling company Packet8, which in December began selling its service to customers of BellSouth (BLS). This is the first instance of a major telco teaming up with a VoIP player on service (see BW Online, 1/11/06, "Putting a Face to the Voice").

But the most vigorous assault may come from cable companies, which offer customers attractively priced packages of TV, Internet access, and Web-calling. As the number of residential VoIP subscribers in North America rises from 2.7 million in 2005 to more than 5 million people at the end of this year, Vonage's overall market share is expected to drop from 52% to 40%, figures Arden.

Moreover, some time this year, Vonage will stop being the largest provider of Web calls in North America, giving way to cable company Time Warner Cable (TWX), says Andrei Jezierski, co-founder of management consultancy i2 Partners in New York.


  Vonage will also need to defend its ground against Internet companies Google (GOOG), Yahoo (YHOO), Microsoft's (MSFT) MSN, and Skype. All these companies will launch advanced VoIP capabilities this year. MSN will allow users to call friends by clicking a button in their Hotmail address book.

Google is expected to launch its VoIP service Google Talk soon, and it's trialing VoIP technology from a company called VoIP. Skype has integrated VoIP with applications such as customer-relationship management software from Salesforce.com (CRM) (see BW Online, 2/01/06, "Voice over Microsoft Protocol?").

All of these rivals have deeper pockets than Vonage -- even if it does raise the $250 million through its IPO. In the past two months, Vonage has already sold $249.9 million of senior unsecured convertible notes, due in 2010, to private-investment funds in a private placement.


  Vonage's expenses could rise further depending on regulatory changes. A U.S. Senate committee is currently debating whether to allow telcos such as Verizon (VZ) and BellSouth, which carry calls on behalf of providers like Vonage, to charge extra fees to ensure that traffic goes through glitch-free. Should such tolls be imposed, "then, it's going to be another cost of doing business they are going to have to bear," says Jon Arnold, principal at VoIP consultancy J. Arnold & Associates.

Sum up all these trends, and "it can only go one way for Vonage," says Arnold, who believes Vonage's operating margins will fall. "It's a company on the way down."

Vonage may need to use its new source of funding to reinvent the way it does business. If the network-neutrality debate does turn against the company, Vonage might have to come up with new pathways for traffic -- for instance, over wireless lines. Perhaps Vonage could acquire a wireless service provider or an Internet Service Provider (ISP) over whose lines it could offer service and bypass telcos' fees, says Arnold. Or, it could share costs of priority network use with an operator of Wi-Fi (wireless fidelity) hotspots in cafes and airports.


  Snyder, who will assume his CEO duties on Feb. 27, faces a daunting task. He might be up to it: Before joining Vonage, Snyder had been the president of ADT, where he started as a salesman in 1977. Since becoming ADT's president in 1997, Snyder managed to grow that company's revenues sixfold. His consumer-marketing savvy could come in handy.

Still, Snyder is relatively unknown in the VoIP world. VoIP entrepreneur Jeff Pulver says he would have expected someone like former AT&T President David Dorman or MCI’s Michael Capellas.

Vonage's IPO will act as a litmus test for the VoIP industry. Today, there are two-dozen VoIP companies wanting to go public that will take their cues from Vonage's experience, according to Pulver. Judging from the outlook now, the first cues may not be encouraging.

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