Vonage IPO Analysis

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Vonage IPO Analysis

Here is my March 2006 Publisher’s Outlook in Internet Telephony Magazine. This is a follow up to my last entry on the Vonage IPO.

If you’ve been following INTERNET TELEPHONY Magazine for a while, you have probably read how challenging it was to start this publication. The challenge wasn’t financial, mind you, but psychological. In 1997 when I attended Comdex and told many of the exhibitors about the new magazine title INTERNET TELEPHONY, I was more or less ridiculed. Of course, I believed in my heart that IP telephony was the future of telecom. It just seemed obvious to me at the time. Others, of course, couldn’t shake the ham radio perception of the technology.

I have learned since that just because something will obviously happen, it doesn’t mean it will happen the way you think it will or when you think it will. VoIP has absolutely revolutionized telecom and at the same time took a tired and old industry with small amounts of innovation and turned it upside down and inside out.

For example, just look at how Skype - a company that gives away free software - has become a telephone company overnight. Imagine having tens of millions of users so quickly and with miniscule acquisition cost per subscriber. Skype is a phone company. In 1997, if I had even suggested such a thing was possible, I would have been laughed out of Comdex for sure. And yet, it happened. More incredibly, other companies, such as VocalTec, Dialpad, and Microsoft, all had a business model similar enough to Skype that they could have been Skype. Just as many companies were dancing around Google’s business model before they came onto the scene, Skype really showed us how you become a phone company serving tens of millions with not billions of investment, but instead, mere millions.

And yet, communications and VoIP, in particular, has not led the industry up a smooth and steady path. We are now seeing the third ramp in interest in IP telephony. This time, however, companies like Skype have sold for over two billion dollars and there is so much real purchasing taking place in the VoIP market that our future looks brighter than ever.

Perhaps having lived through “the bubble” has made us more sober. The post-bubble mentality implores us to look at things more carefully and to analyze them: Not just the positives but the negatives as well. Perhaps with some analysis we can guide the VoIP market ever upward ensuring the technology continues to help billions of people and make corporations more productive. And of course in the process, help lots of companies make money.

Vonage - God bless them and Jeffrey Citron in particular - was responsible for educating the market about VoIP and what it can do. They have managed one of the best marketing campaigns of any company in recent memory and, in so doing, they woke up business customers and their competition as well. Vonage, however, has been spending on a pace not seen for a startup since Pets.com. Many bloggers and people at industry conferences have told me Vonage is spending too much money and can’t have a sustainable business model unless they change their strategy.

Others told me that that Vonage was going through customers at a rapid rate and their churn was in double digits. Negative rumor after rumor circulated throughout the Internet as well.

But recently Vonage put an end to many of the rumors by filing to go public. The company is growing so rapidly and has taken in so much capital that the success (or failure) of its IPO is important for the entire industry.

In reality, it shouldn’t be this way, as Vonage is serving but a single sector of the market - consumers. The service provider and enterprise markets will spend far more on VoIP technology and services in the short term. Still, Vonage has attracted lots of attention and, indeed, its performance will affect the industry.

Here is an overview and some analysis on the S-1 documents filed by the company when announcing they will go public. I have done my best to not bore you here but rather instruct you on the potential of Vonage to do well and the hurdles the company faces.

Vonage has 95% of their lines in the U.S., leaving tremendous growth opportunities overseas. If you have been waiting to hear how much Vonage spends on marketing, here is that number: $232.4 million was spent in 2004 and the first nine months of 2005 combined.

Of course, this spending ate into profits and revenues - although growing spectacularly - cannot mask the fact that losses are growing as well. Revenues were $18.7 million in 2003, $79.7 million in 2004, and $174.0 million for the nine months ended September 30, 2005. From the period of inception through September 30, 2005, the cumulative net loss was $310.0 million. The company’s net loss for the nine months ended September 30, 2005 was $189.6 million. During the same nine-month period, marketing expenses were $176.3 million.

Vonage goes on to talk about strengths such as a number one market position in broadband telephony. They even point to market research stating that Vonage is synonymous with the word VoIP in the minds of many consumers.

Another important point the company makes is that their churn has only been 2.11 percent for the first nine months of 2005. More amazingly, 13 percent of overall net subscriber line additions resulted from customer referrals!

Future Strategy
In order to grow, the company will roll out new services and work with chip and equipment providers to come out with unique products and services. In addition, the company will improve customer service, expand distribution, and enter new geographic markets.

Risk Factors
Vonage points out that it will continue to focus on market share first at the expense of profits. This could continue racking up losses for the foreseeable future. Other risks are from competitors that could come up with dual-mode phones using VoIP and, thus, make Vonage unnecessary.

Still other risks come from competing with cable companies and LECs that can bundle services and even offer telephony at a loss. In addition, these other companies might offer superior service levels or some other features that Vonage does not offer.

There is also competition from Internet companies such as AOL, Google, and Yahoo!, who, as the company says, could push prices lower.

E-911
There is also talk of potential problems with E-911 service and how the company may not be able to deliver emergency calls for some reason. They may also fail to deliver 911 calls to the right PSAP in the case of someone calling from a portable client such as a softphone or WiFi telephony device. In addition they may not be able to comply with the FCC and will subsequently be fined or potentially not be allowed to offer service.

Here is a paragraph on this topic lifted directly from the document itself:

Our ability to provide our service is dependent upon third-party facilities and equipment, the failure of which could cause delays or interruptions of our service, damage our reputation, cause us to lose customers and limit our growth.

Our success depends on our ability to provide quality and reliable service, which is in part dependent upon the proper functioning of facilities and equipment owned and operated by third parties and is, therefore, beyond our control. Unlike traditional wireline telephone service or wireless service, our service requires our customers to have an operative broadband Internet connection and an electrical power supply, which are provided by the customer’s Internet service provider and electric utility company, respectively, and not by us. The quality of some broadband Internet connections may be too poor for customers to use our services properly. In addition, if there is any interruption to a customer’s broadband Internet service or electrical power supply, that customer will be unable to make or receive calls, including emergency calls, using our service. We also outsource several of our network functions to third-party providers. For example, we outsource the maintenance of our regional data connection points, which are the facilities at which our network interconnects with the public switched telephone network. If our third-party service providers fail to maintain these facilities properly, or fail to respond quickly to problems, our customers may experience service interruptions. Our customers have experienced such interruptions in the past and will experience interruptions in the future. In addition, our new E-911 service is currently dependent upon several third-party providers. Interruptions in service from these vendors could cause failures in our customers’ access to E-911 services. Interruptions in our service caused by third-party facilities have in the past caused and may in the future cause us to lose customers, or cause us to offer substantial customer credits, which could adversely affect our revenue and profitability. If interruptions adversely affect the perceived reliability of our service, we may have difficulty attracting new customers and our brand, reputation and growth will be negatively impacted.

Local number portability too was cited as a potential problem as porting a customer’s telephone number can take up to 20 days or more. Other potential challenges are having access to more capital or having access to capital at favorable rates.

In addition, the company cites the potential of regulation as a risk to the company, as they may be forced to leave markets or raise prices as a result of new regulations. The company also mentions that it may be forced to contribute to the Universal Service Fund, which, of course, would increase costs.

Where is the Money Going?
As you guessed, the money raised from this IPO will be used for marketing and further expansion. The company mentions it may use some of the proceeds for an acquisition as well.

Other notable facts are that revenue per subscriber has decreased over the past two years due to price decreases and is now $26.63 per month.

The Vonage IPO was thought to be a multi-billion dollar event and it turns out now that it will only be worth $250 millions dollars. The reason for this lower amount is primarily due to the market share at all costs attitude. I am concerned that this attitude will generate many impatient investors who will push the stock to very low levels. Of course, if Vonage can’t pull off financing their operations for some reason, they can simply cut spending on marketing and make instant profit. On the other hand, if they can get the financing they need, at some point they could become a worldwide telecom giant.

Still, I grow concerned that the rest of the VoIP industry will be judged by what Vonage does or doesn’t do. The company certainly represents a sector of the VoIP market - but not all of it. Furthermore their business model sucks up much more money than that of, say Packet8, who is forming partnerships with companies around the world and allowing others to share marketing costs as well as rewards.

For those of you that remember when the VoIP industry was full of doom and gloom (circa summer of 2003), who would have thought then that we would hear the words VoIP IPO again? Who would have thought that the business would be where it is today? These are indeed exciting times and I wish Vonage a spectacular IPO that exceeds expectations.



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