"Altruistica": Seeking a return to full financial disclosure and regulatory oversight. A financial market analysis blog for "entertainment purposes" only by an experienced CFA seeking new hedge fund engagements for investment writing and analysis. The author has experience investing internationally, running a hedge fund, making angel investments, and helping launch five startup companies. Investors should do their own due diligence.

29 November 2006

Vonage (VG:NYSE) -Time to Hang Up

It doesn’t take a rocket scientist, or a financial analyst for that matter, to see that a company with decelerating sales growth, increasing customer defections, aggressive new competition, and soaring marketing costs will suffer operating problems. But what if it faces lawsuits, cash shortages, and an increasing non-competitive offering?

For anyone with access to cable television, radio or the U.S. postal system, a nearly ubiquitous and annoying “wooHoo” advertisement has saturated the “airwaves” since 2003- yes, it’s that competitive voice service provider (CVSP),Vonage (VG:NYSE). After a U.S, entry in October 2002, in Canada in November 2004 and in the United Kingdom in May 2005. By mining the bottom end of the telephony customer base, VG has spent a couple of billion dollars adding almost 2.06m subscribers as of 30 September 2006 – yet producing an accumulated deficit of $604m. And during this most recent quarter, VG claimed to add 359,000 subscribers which declined from 377K during Q206 or a deceleration to 11% sequential growth. However, VG lost a staggering 154K subscribers in Q3, yielding a net reported subscriber addition of 204.6K, down 20% sequentially from 256K during Q206. Revenue was up 12% sequentially, and 118% year-over-year; that’s good, but not as good as last quarter, when revenue grew 21% sequentially and 141% year-over-year. The Holmdel, N.J., Internet phone flogger posted an adjusted net loss of $62 million, or 40 cents a share, compared with a Q206 pro forma loss of $74 million, or $1.16 a share, as VG pumped out more shares but lost as much as last year.

But wait, VG cut its forecast for 2006 year-end subscriber count to 2.2 million, from a previous forecast of 2.3 million to 2.45 million. Now VG forecasts revenue of between $600 million and $615 million for fiscal 2006. Oops! But VG projects “positive adjusted operating income” What? By Q1 2008. When? VG’s key problem is that it will likely never make it there, barring some financing miracle from a non-discriminating private equity buyer playing financial musical chairs. Its core Voice over Internet Protocol (VoIP) offering only made sense for people with a cable modem initially but now almost all cable companies offer VoIP phones, and the real draw for customers is to purchase bundled service options including cable, high speed internet and phone service. Why add another service provider?

Customer Regret about the “Bad Vonage Decision”

Some analysts see VG as overstating subscribers numbers since, unlike cable operators which report customer statistics, Vonage reports customer lines ( nearly 1.25) due to heavy promotion of line adds to existing customers, thereby losing signup fees and other startup customer charges. Pushing customers to take new lines, without any service improvement or service enhancement, leads to customer dissatisfaction.

So customers have figured out VG has flat to falling quality, generating a quarterly 5% disconnect rate relative to the total subscriber base is a massive warning flag. Okay, everyone knows that subscriber disconnects relative to the overall subscriber base (i.e. customer churn) hurt profits sharply for cell phone firms and online Internet service providers (remember AOL?). Average monthly churn in Q306 was 2.6%, up from 2.3% in Q206 and the year-ago quarter. Worse, subscriber revenue generation is slipping with average telephony revenue per subscriber line (“ARPU”) down from Q206 to just $26.33. And gross margins have been slipping from 32% as VG is exposed to volume-related third party call termination costs – flat fee users maximizing total monthly minutes above 1,500/month. But as customer loss rises, VG DOUBLED its assumed customer retention life from 30 months in FY04 to 60 months in FY05. On what evidence??

But the real shocker is that this company has no sense of cost controls. Marketing costs were up sequentially at $91 million, yielding marketing costs per gross subscriber line of $254, up 6%. But on a net subscriber addition basis, it soared to $444.79, from $351.56, indicating a dramatic deterioration in success in adding and retaining customers. With a $29 customer equipment subsidy, the VG model yields no payback from adding customers even with a four year timeline. That’s right: VG’s incremental subscriber revenues are falling sharply away from rising incremental subscriber addition costs. In 2005, VG burned $243 million on marketing costs alone or about 94% of their revenue and it’s tracking for $350m for 2006. VG used $190 million in cash from operations in 2005, and another $150 million in investments with no incremental revenue gains. It’s akin to the domestic auto industry model: lose money on every vehicle you sell, but, ummm, make it up on volume.

Surging New Competition

Although connectivity, equipment add-ons and audio clarity has been an historic problem for VoIP service providers, according to the second Keynote VoIP Competitive Intelligence Study of Internet telephone service, improvements have been made with Time Warner Digital Phone ranked first for both reliability and audio clarity while audio delay plagues VG and other non-cable players. With hindsight, VG only made sense for people with a cable modem in 2003 and 2004, but now all of the cable companies are offering VOIP phones. Over time, both phone companies and cable companies will have high speed digital connections to homes and will offer digital TV, phone, and internet service with Time Warner (TWX:NYSE) and Comcast (CMCSA:NAZ) controlling two thirds of 8.2m domestic VoIP customers at September (up from 3.5m a year ago, according to market-research firm TeleGeography Research). And early mover Telio and newcomer SunRocket are looking to leverage new devices, such as the new Nokia N80i with Gizmo software. Yet the failure rate is huge in the VoIP business with 85 failures in 15 months. (

New offerings from Google, Yahoo, and the eBay Skype upgrade are predicated on a coming VoIP “open standard” that will allow users to access the voice network through the multi-thousand “wireless internet” or wifi networks. Instant messaging clients can also access the networks. The VG holders are getting desperate: they now claim that the company is a buyout candidate. Good luck, WebVan.


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