Vonage on the Line

Potential investors in the Net calling outfit's IPO would do well to remember that it has yet to make money and it faces tough competition

Investors who want a slice of Vonage Holdings get their chance this week. Vonage, a pioneer of Internet-based phone services, is expected to set the price for its initial public offering on May 23. According to filings with the Securities & Exchange Commission, some 31.25 million shares will go for $16 to $18 apiece. So the IPO could raise $500 million to $562.5 million. At least one report on May 22 said that investors had oversubscribed for the IPO, requesting more shares than would be available.

That could bode well for share performance right out of the gate, but anyone considering Vonage stock has to think about the company's longer-term prospects. No question Vonage is growing fast. Sales zoomed from $16.9 million in 2003 to $269.2 million last year. The number of subscribers hit 1.6 million at the end of March, from 857,000 at the end of 2003. Vonage is harnessing the popularity of what's known as Voice over Internet Protocol (VoIP), which lets people make voice calls with the same technology that's used to move data over the Internet.

Despite that breakneck growth, the company has yet to make money. Losses have swelled steadily with revenue, to the point where Vonage lost $261.3 million last year on sales of $269.2 million. Worse, a company long at the forefront of Net phone calls is now facing an onslaught of competition, from upstarts like eBay's Skype (EBAY) to giants such as Verizon Communications (VZ) and AT&T (T). "They used to have an open field, but they don't anymore," says Scott Cleland, founder and president of Precursor, a research and consulting firm based in McLean, Va. "Everybody else is catching up."


  And the competition is accelerating in time to steal some of Vonage's IPO thunder. Just a week ago, Skype said that it would allow its users to call any phone in the U.S., wired or wireless, for free (see BW Online, 05/16/06, "Skype Goes For Broke"). In the past, Skype has charged 2 cents a minute for such calls. That came on the heels of a decision by Verizon to drop the price of its own VoIP service right down to the $25-a-month level that Vonage charges (see BW Online, 05/05/06, "Verizon's VoIP Offensive"). Without a price advantage, Vonage will struggle to lure customers from established phone companies, especially since those phone companies offering other services like wireless and broadband that Vonage can't.

Then there are cable companies eager to pick off phone customers wherever they can. After a slow start, Time Warner (TWX), Cablevision (CVC), Comcast (CMCSA), and others are aggressively offering their own VoIP services. Time Warner Cable has passed the 1 million customer mark. Cablevision has one of the highest acceptance rates among its customers, with 900,000, or 20%, of customers taking its phone service.

Cable providers may end up being Vonage's most serious rivals. They tend to attract a similar kind of customer: people who want less expensive phone service and are willing to try an alternative to the traditional phone company. And cable companies have some distinct advantages over Vonage. For one, they offer phone service over their own networks, giving them control over call quality. Vonage relies on the networks run by cable and phone providers.


  Moreover, cable companies have multiple opportunities to market to their own customers, making it cheaper for them to win subscribers than it is for Vonage. Cablevision, Time Warner, and others can stuff fliers into monthly bills, offer phone service when they field service calls, and put their own ads into television programming. "It gives them an enormous amount of effectively free advertising," says Craig Moffett, senior analyst at Sanford C. Bernstein.

There are plenty of bulls on Vonage. The company's top executives are barred from making their own case right now because of SEC rules governing IPOs. But many customers are fanatical about the service, especially because they've been able to save so much money vs. what they would have paid their traditional telecom provider. Many have flooded online discussion groups with their positive experiences with the company. Vonage has also offered customers the opportunity to buy shares in its IPO.

And some experts believe the company will be able to grow its way to profitability. James DeStefano, analyst with Renaissance Capital in Greenwich, Conn., compares Vonage to Sirius Satellite Radio (SIRI) and XM Satellite Radio (XMSR). "They're like the hyper-growth satellite radio companies," he says. "We think people are going to value the company based on revenue per subscriber. And we think Vonage could command a bit of a premium because their revenue per subscriber is roughly double that of the satellite companies." He estimates that the revenue per customer at Vonage is about $26, compared with $12 for the satellite companies.


  But Vonage financial filings offer little reason to expect the company to start making money anytime soon, if at all. As competition has increased, marketing expenses have soared. In 2005, it spent $221 in marketing for each new customer it added, up from $129 in 2003. "They're facing tougher sledding because they face real competition for the first time," says Moffett. Under the risk discussion in its IPO filing, Vonage says, "We may continue to generate net losses for the foreseeable future."

The company seems to be gaining little benefit from greater economies of scale. In the first quarter of this year, revenues hit $118.9 million, slightly less than triple the figure a year earlier. Over the same period, the amount of cash used in operating activities increased even more rapidly. It hit $74.6 million, more than triple the figure in the year-earlier quarter (see BW Online, 05/16/06, "Can Anyone Tell Me Why Vonage Isn't Toast?").

Perhaps the biggest risk for Vonage lies with possible changes in the way Internet phone service is regulated. Now, Vonage and cable providers enjoy a cost advantage because they're not subject to some of the taxes and other fees as Verizon and AT&T. For example, Vonage and its customers don't contribute to the Universal Service Fund, used to subsidize the cost of phone service to poor and rural residents.


  Many experts believe this loophole won't remain open much longer. "If you bet on Vonage, you're betting against the lobbying power of AT&T in Washington," says one expert. "I think you're taking your life into your own hands."

One hope of Vonage supporters is that the company could end up being acquired after the IPO. The argument is that any company with millions of customers should make an attractive target. As evidence, they cite eBay's decision to buy Skype for $2.6 billion. A likely scenario? Some experts doubt it. "I think the reason that they're having an IPO is that nobody would buy them," says Cleland. "They need cash to keep going so they're going to the public to get it."

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