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Vonage Stares Down a Growing Web of Problems

Last week’s adverse court ruling sharpens the focus on the company’s viability“Vonage is not going out of business.” Those words from the company serve as a response to last week’s federal court order that it pay $58 million in damages to Verizon Communications in a patent-infringement case. The eight-member jury at the U.S. District Court for the Eastern District of Virginia also told the Internet phone service provider to pay Verizon monthly royalties of 5.5 percent of its sales for an unspecified amount of time.

Holmdel-based Vonage said it plans to appeal the ruling, and reassured its 2.2 million subscribers that their phone service would not be affected. Investors were jumpy anyway: The firm’s shares dropped more than 15 percent over the week to about $4.30, a painful discount off last May’s $17 IPO price. One analyst, Qaisar Hasan of New York City’s Buckingham Research Group Inc., cut his price target for the stock to $1.

Things were very different last year—before the stock offering—when Vonage was hailed for its lead in the Voice over Internet Protocol (VoIP) market.

The company was also seen as a comeback vehicle for its founder and chairman, Jeffrey Citron. In 2003, the Securities and Exchange Commission had accused him, along with others, of illegal trading while he was CEO of Datek Online Holdings in Jersey City. Citron paid a fine of $22.5 million without admitting any wrongdoing. He quit Datek in 1999 and went on to set up Vonage in 2001, which launched services in March 2002. Things began to get ugly again when the young telecom’s shares dropped 13 percent on the first day of trading and more than 30 percent in the first week.

Vonage will have its hands full dealing with Verizon’s legal assault. The telecom giant has requested an injunction barring Vonage from using technology protected by the five patents in question. That issue will be heard March 23 by Claude Hilton, the district judge who heard the first part of the case. If granted, the injunction would effectively block calls from Vonage customers to standard phones, allowing them to connect only with other users of Internet-based services. Vonage says it is confident of getting a stay on the injunction.

Industry observers, however, believe Vonage faces other major challenges to the survival of its business model. For one, better-heeled rivals—Verizon, AT&T and Comcast—are steadily ramping up their own VoIP offerings, but bundling them with cable-TV and Internet service. Compared with most competitors, Vonage also spends more on marketing to acquire new customers and has a higher customer-turnover rate. It is also leaking market share to smaller rivals.

As of July 2006, Vonage’s market share in the pure-play VoIP market was 56 percent, compared with 5.5 percent for Verizon’s VoiceWing service, according to Telephia, a market research firm based in San Francisco. However, the issues Vonage faces could threaten its current position as VoIP leader.

“There remains a question about the competitive advantage that Vonage has that eventually would create a sustainable business,” says Robert Rosenberg, president of Insight Research Group, a Boonton firm that does market research and strategic analysis for the telecom industry. “Size is the only thing that matters in telecom; it’s a business of scale.”

Verizon’s bundled package of cable TV, Internet and VoIP services costs $94.99 a month. Verizon spokesman Richard Young says his company will soon include wireless services in its bundled package. Meanwhile, Vonage offers unlimited local and domestic long distance phone service for $24.99 and limited calls for $14.99 a month.

Still, Vonage did have something to smile about after last week’s court order. The $58 million in damages the court awarded Verizon was far less than the $197 million it had sought for the alleged loss of 600,000 customers to Vonage’s depredations.

It’s possible that Vonage’s momentum could offer a cushion against these problems. It has posted 19 consecutive quarters of double-digit revenue growth and more than doubled revenue to $607 million in 2006, from $269 million in 2005. While Vonage is still unprofitable—with losses of $286 million last year, compared with $261 million in 2005—its operating margins and cash flow are improving. The company also added nearly a million new subscribers last year.

For 2007, Vonage says it expects to take its subscriber base to about 3 million and increase revenue to between $850 and $900 million. It also expects operating losses to decline to between $150 million and $170 million. More significantly, it expects to turn an operating profit by the first quarter of 2008.

Patrick Monaghan, senior analyst covering the VoIP business at Yankee Group, a Boston-based research firm, sees that as overoptimistic. “Vonage expects to become profitable in 2008, but this will be difficult if the court decision is upheld,” he says.

Monaghan also thinks Vonage’s cost of acquiring new subscribers—$306 apiece in the latest quarter—is uncomfortably high. “Vonage’s cost here is definitely higher than that of Verizon and AT&T,” he says, though neither of those companies discloses acquisition costs for VoIP service subscribers. Monaghan also questions Vonage’s claim that its average customer life span is about five years. “They have been around for just about five years, so that figure may change,” he says.

The firm’s customer turnover has improved to 2.3 percent in the latest quarter from 2.6 percent in the prior quarter. But that is still much higher than the 1.24 percent Verizon boasts for its wireless services or the 1.5 percent it claims for fiber-optic services.

One optimistic Vonage customer is Mori Fatehi, an associate at consulting firm Booz Allen Hamilton in Orange, Calif., and an affiliate faculty member at Stevens Institute of Technology in Hoboken, where he teaches telecommunications technology management. “Vonage is going to be a successful company because it is a leader and because of the advantages of being an early player,” he says.

Another Stevens faculty member sees trouble. M. Hosein Fallah, associate professor of technology management, says Verizon and Comcast will be able to do both cross-marketing and cross-subsidization with their bundled services, allowing them to “offer a lower price [than Vonage] if they want to.”

Even if all else were equal in the playing field, Vonage may be unable to shake the fruits of its early marketing investment. Five years ago, it spent big money to sell the very concept of Internet telephony. Later entrants will benefit from its success.

Rosenberg says that “Vonage breaks trails, takes arrows in the back and Verizon and AT&T come along later and scoop up all the settlers.”

E-mail to shankar_p@njbiz.com