Vonage's Troubles Aren't Over

Operating results have improved and Vonage has settled its patent lawsuits, but it now faces a debt-refinancing crunch

The news has rarely been better for Vonage after a nightmarish year of lost patent battles and weakening growth that left the Internet phone company drifting toward bankruptcy. In its third-quarter update on Nov. 8, Vonage reported that operations turned cash-flow positive for the first time.

Even better, Vonage (VG) announced the end of all current patent litigation, which had threatened to shut down its phone service since March (BusinessWeek.com, 9/27/07). Just weeks after settling patent suits brought by Verizon (VZ) and Sprint (S), Vonage said it also had reached a deal to resolve a new charge of patent infringement filed in October by AT&T (T).

Stock Surges on Settlement

Details are still being ironed out, but Vonage says it will likely pay AT&T $39 million over five years. "With litigation behind us, we are happy to refocus on our business," acting Chief Executive Jeffrey Citron said during the company's earnings call.

In a rare spurt of enthusiasm, investors pushed Vonage's battered stock nearly 14% higher, to $2.49 a share, after the report. The stock has recovered sharply from an all-time low of 96¢ reached Oct. 1, yet remains 85% below the $17 price of Vonage's initial public offering in May, 2006.

Overall, the company lost $161 million in its latest quarter, up from a $62 million loss in the same period last year. But excluding litigation-related royalty payments and restructuring charges, Vonage's operating loss narrowed to $1 million, down from $53 million in the third quarter of 2006. The company ended the quarter with 2.52 million customer phone lines, a net gain of 78,000. While well below the 204,000 added in the same period last year, that gain marked an improvement over the 56,000 lines Vonage added in the second quarter.

Losing Customers Fast

But one day of relatively good news does not a recovery make. The company has yet to stem a flood of customer defections. During each month of the third quarter, 3% of Vonage's customers closed their accounts, spiking from the second-quarter churn rate of 2.5% per month. And in a troubling sign, Vonage acknowledges about 70% of those who leave are unhappy with customer care.

Vonage says it is already pursuing several measures to address this problem—and seeing results. The company has begun rolling out new software for its customer call centers and plans to put out a new adapter by yearend to make it easier to connect a phone to a customer's Internet modem. Already, Citron tells BusinessWeek.com, the time a customer waits for Vonage to answer a service call is down.

Looming Debt Crisis

But even if those efforts succeed, there's another problem that may be harder to overcome. Vonage still faces a debt-refinancing crisis, a situation made more difficult by the mounting leeriness of lenders after the collapse of the subprime credit market. In December, 2008, some $250 million of Vonage's debt will come due for repayment. While the owners of those convertible notes can exchange them for stock, Vonage's share price has plummeted so far since the debt was issued it's highly unlikely the lenders will accept anything but cash.

Unfortunately, cash is not one of Vonage's strong suits. Despite the positive turn in its operating cash flows, the company's stores of currency are being depleted fast. At the end of September, Vonage had $355 million in cash and equivalents. But since then, the company has agreed to pay $80 million to $120 million in the Verizon settlement, with the exact amount dependent on the outcome of a pending court appeal.

Then it agreed to pay $80 million to Sprint and the as-yet unfinalized $39 million to AT&T.

While the exact timing of all these payments is not set, the settlements are likely to seriously deplete Vonage's coffers before next year's loan repayments. Chris Roberts, an analyst with Tejas Securities Group, notes that with an expected upswing in marketing during the holidays, Vonage may burn through another $100 million of its cash reserves. In a year, he says, Vonage will not have enough cash to pay back the debt.

Alternatives to Refinancing

It's no wonder then that Citron, talking with BusinessWeek.com, called debt refinancing his No. 1 priority. But again, due to the subprime lending turmoil, even the best-performing companies are finding it hard to refinance their obligations.

There are a few alternatives, though none very certain. If they want to avoid bankruptcy, Vonage's existing bondholders may have to agree to extend the term of their notes by one or two more years, Roberts says.

Vonage also might try to raise more cash by selling additional shares. But the amount of money required at the current stock price would dilute the value of Vonage's existing shares by as much as 50%, further punishing Vonage's weary stockholders. In fact, it's not so certain institutional investors would risk much money on a new Vonage offering given the beating they took on the IPO (BusinessWeek.com, 2/9/06).

Time to Sell?

With all the uncertainty, the prospect of being forced to sell out to an acquirer persists. Analyst Frederic Ruffy of Optionetics, a provider of tools for portfolio management and trading, estimates a potential buyer could pick up Vonage and its 2.5 million customers for $400 million to $450 million, a 20% premium on the company's current $341 million market value.

Potential acquirers include Sprint, which unlike AT&T and Verizon, lacks a residential phone business, says Jon Arnold, principal at telecom consultancy J. Arnold & Associates. However, Sprint also is struggling financially, and since no replacement has been found for ousted CEO Gary Forsee, the company's strategic direction is uncertain.

Other possible acquirers might include a satellite TV company like DirecTV (DTV) or EchoStar (DISH), which could see a benefit in bundling their own phone service with video. They've already packaged their TV services with phone and Internet services from AT&T and Verizon, but those partners are fast becoming rivals, rolling out their own cable offerings.

Citron would not comment on whether Vonage has been approached by potential acquirers or held any talks. "The company will always evaluate all available options," he says.

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