Vonage: Gasping for Air

With a ban on new subscribers looming, the ailing telecom is under pressure to find creative new ways of doing business

Vonage attorney Roger Warin didn't exactly inspire confidence when he responded to a judge's ruling that bars the company from signing up new customers: "It's the difference of cutting off oxygen as opposed to the bullet in the head," Warin said on Apr. 6, after U.S. District Court Judge Claude Hilton for the Eastern District of Virginia signed the injunction, effective Apr. 12.

The ruling came about a month after a jury said Vonage infringed on Internet calling patents held by Verizon Communications (VZ); Vonage appealed the Apr. 6 decision. But just as living things don't last long without air, Vonage (VG) won't achieve much growth without new subscribers. So that same day, another judge of the same court granted Vonage an emergency, temporary stay to sign up new customers pending a hearing for a permanent stay. "In terms of our business there is no change," says Vonage spokesperson Brooke Schulz.

That hearing hasn't been scheduled but is likely to happen in the next month. A decision to uphold Hilton's ruling, however, would only step up pressure on Vonage to find a way to keep operating without using Verizon's technology, through a so-called work-around. "This will be a challenge in light of the fact that the judge construed the scope of Verizon's patents broadly," analysts at Stifel Nicolaus wrote in an Apr. 6 research note.

One possible work-around: an acquisition. Analyst Jon Arnold of J. Arnold & Associates believes Vonage may simply purchase a company like VoIP Inc. (VOII), which operates its own telecommunications network and holds a slew of patents, some of which might help Vonage sidestep Verizon's patents. Neither VoIP nor Vonage would comment on the buyout speculation (see BusinessWeek.com, 3/9/07, "What the Verizon Verdict Means for Vonage").

Subscriber Churn

As Vonage tries to find a work-around, results in the meantime are bound to suffer. The company was expected to sign up 100,000 to 120,000 new users per quarter this year, according to estimates by Charles Gerlach, an analyst with consultancy In-Stat. That's down from an unimpressive 166,000 new users in the fourth quarter. But if the courts second Hilton's decision, Vonage could end up with no new users at all. Indeed, the company is all but certain to lose its crown as the No. 1 Web-calling services provider to Comcast (CMCSA).

And for telecom services providers that rely on new subscribers to offset the portion of subscribers lost each month through churn, zero new subscribers would strike a big blow. If Vonage's fourth-quarter churn rate of 2.3% is any guide, the company could lose more than a quarter of its customer base this year. "Vonage is by far the service that has been dropped the most often," says Gerlach, citing users' dissatisfaction with Vonage's customer care as one of the reasons. If that churn rate holds, and if Vonage is unable to sign up more users after the new legal review, it would be reasonable to expect Vonage's revenues, which reached $607 million in 2006, to drop this year as well.

In anticipation of the decision, Vonage shares tumbled 6.9% to $3.37 the day before Hilton issued his ruling, which he did on a day when stock markets were closed. Shares may slide more when markets reopen in coming days, says Clay Moran, an analyst with Stanford Group.

Making Lemonade

A focus on better customer retention would be key to Vonage's well-being no matter what the future holds. "I am almost wondering if it's a blessing in disguise," says Arnold. "Maybe this will force them to be more disciplined in the use of their money." Specifically, he says, Hilton's decision might force Vonage to beef up its customer care and to start offering more new, innovative services to retain its existing customers and attract new ones. For instance, if Vonage were to start offering a wireless service, as planned, new wireless customers wouldn't be affected by the court rulings, which apply to Web calling (see BusinessWeek.com, 2/20/07, "Coming Up: Vonage Wireless?").

There's also one potential silver lining to the dark cloud hanging over Vonage. If Vonage turns out to be unable to recruit new customers, it may be able to cut back on its marketing budget, which was $365 million last year. Lower marketing spending could prop up margins even as sales decline. And given that the company has some $500 million in cash, it's going to be able to keep paying its bills for the time being.

Still, even a well-funded organism can't last long without oxygen, and Vonage's air is in short supply.

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