Market Hangs Up on Vonage

A marketing blitz got the company's name out to the public. (The "Woo Hoo" song drives me mad, but, hey, it sticks.) During 2005, Vonage's subscriber growth tripled and revenues soared 238% to $270 million. It seemed like the little guy was sticking it to the big telcos. Gleeful prospective investors grew optimistic that if Vonage were to go public it might be the next Google (GOOG).

But then everyone looked a little more closely at the company, and people started wondering if Vonage could really hold its own against the Goliaths of the phone and cable industries.

After reportedly unsuccessfully shopping itself around for an acquirer, Vonage filed to go public in early February. It offered up 31.3 million shares, or about a 20% stake. As required by the SEC, companies planning to go public must air all of their once-closeted skeletons and expose their warts. For Vonage, the skeletons came in the form of founder Jeffrey Citron, who paid settlements to the SEC and NASD after being accused of trading abuses while he was running online brokerage Datek Online. The warts included the fact that the company reported losing lots of money — about $467.4 million since 2000 — and warned about the prospect of never making any. There was also the looming competition to contend with, especially from companies with a lot more cash to spare, like cable outfits Time Warner (TWX), Comcast (CMCSA) and Cablevision Systems (CVC) and Internet players such as eBay's (EBAY) Skype and Google, which has a beta version of its VoIP offering.

Even with all of these "cons" riding against it, Vonage's IPO priced Tuesday evening at $17 a share — the midrange of the Holmdel, N.J., company's projections. It raised $531 million and things were looking fairly optimistic heading into the first day of public trading. But soon after the stock opened Wednesday morning, the price plunged to $15 as investors expressed concern over those skeletons and warts. "[Vonage] doesn't have anything proprietary, unique or patentable," says David Menlow at IPO Financial Network, a research service that tracks public offerings. "The competition is the key distraction from this offering."

The question remains whether or not competition will continue to distract investors. For now, Vonage is leading the pack in the VoIP race, with 1.6 million subscribers, reports TeleGeography, an independent communications research group. Time Warner comes in second, and Cablevision is third. The much-heralded Skype, which often gets lumped in as a Vonage competitor, isn't included in TeleGeography's rankings. "They really are not in direct competition in any way. They are complementary like IM or email," explains Stephan Beckert, a research director at TeleGeography who uses both services.

With Vonage and the cable companies' VoIP services, users can hook their regular phones into boxes that allow calls to be routed directly through broadband connections. With these services it's not necessary to boot up the computer or don a headset to make phone calls over the Internet. Not so with Skype. To receive or make calls using the Skype service, the computer must be turned on and users are essentially tethered to their PCs via a headset or special phone.

Vonage seems well aware that its leading position in VoIP could be fleeting. Cable companies are grabbing customers by bundling television, Internet and voice into low-priced packages that make Vonage's already inexpensive service, which starts at around $15 a month, less appealing. The company hopes to keep subscriber growth heading northward by plowing much of the proceeds it received from the offering into marketing. Yet, the costs of bombarding TVs, radios and web pages with all of that woo-hoo-hooing and other sundry ads has weighed heavily on the company's financial health. Last year, marketing cost Vonage $243.4 million, almost eclipsing the company's $269.2 million in revenue and contributing largely to its $261 million in losses.

Vonage's heavy focus on grabbing market share is a strategy that Amazon.com (AMZN) pursued following its IPO in 1997, notes Ben W. Holmes, publisher of Morningnotes.com, an IPO research house. Amazon.com was bleeding cash and projecting losses for the foreseeable future when it went public. But that was then and this is now. People were a lot more willing to invest in a money-losing venture in the go-go '90s. Vonage's ability to grow its market share and reduce its losses is going to be under a lot more scrutiny than Amazon's was.

There will be opportunities for Vonage to shine. VoIP's growth is expected to be robust. TeleGeography expects the number of VoIP subscribers to grow to 9.6 million by the end of 2006 and 23.7 million by 2010, from 5.5 million at the end of March. As long as Vonage can keep its business financially viable, there's little doubt that it could find ways to maintain a healthy slice of the market. Whether or not it can keep its leadership position intact as the cable companies, in particular, gain ground is another question altogether though.

In the last quarter alone, Vonage lost 77,000 customers, a 2.11% churn rate. The company attributes that turnover to poor customer service, an issue resulting from its meteoric growth and inability to keep up with it. The company will have to tackle the issue promptly to maintain investor confidence. Lately, there's been a lot of buzz across message boards and chat rooms, as well as media coverage, of frustrating experiences with Vonage's customer service. The complaints include troubles with cancelling the service or transferring a phone number to another service. There's even a complaint alleging that one user's house burnt down because he was put on hold by Vonage when dialing 911. The cable companies aren't necessarily complaint-free in the customer-service department (how many hours have you waited for the cable guy?), but Vonage's newcomer status has brought its issues further out into the spotlight.

The prospects for Vonage's stock are speculative at best. Given that it has fallen well below the offering price in the first day of trading, Morningnotes' Holmes expects that $17 will be where the stock will cap in the near future. Investors who bought in at $17 won't want to necessarily hold on to the stock in anticipation of it going higher if they can sell it and break even. One thing that bodes well for the stock, he says, is the 13.5% of shares in the offering that the company set aside for VoIP customers who wanted to invest in the service. Holmes believes those customers who bought shares must believe in the service. "They are sticky hands," he says. "They will buy it and hold it."

A good David and Goliath story ends with the hero skillfully knocking his nemesis out with a well-placed stone. In the case of Vonage, while it certainly stunned the big telecoms and cable providers in the beginning, it's going to require tremendous effort to keep those giants down. Judging from the first day of trading, investors aren't convinced that outcome is certain.