Technology

Vonage's Lackluster IPO


What were they thinking? That's the question on the minds of skeptics watching the stock performance of Vonage on its first day as a publicly traded company. The closely watched and hotly debated initial public offering did get done Tuesday night at $17 a share -- valuing the Holmdel (N.J.) -based provider of voice phone calls over the Internet at almost $3 billion -- despite large and growing losses and deep concerns about rising competition.

When trading opened on the morning of May 24, there was no sign of the blind optimism that prevailed during last decade's tech bubble. Vonage VG

shares sank like a stone in early trading, moving as low as $14.50. "I haven't spoken to any institutional investors who have a strong [positive] conviction about Vonage over the long term," says Soleil Securities analyst Todd Rethemeier.

The debate over Vonage boils down to this: How much will the price of phone service fall in the next few years? Vonage Chairman Jeffrey Citron got the deal done in large part because Vonage had a much better than expected first quarter. The number of subscribers to Vonage's phone service, which tries to undercut local carriers on price by carrying calls over a broadband Web connection, rose to 1.7 million, up by almost 400,000.

PRICE RATIONALE. More important, the average monthly price those users pay rose by about $1, to about $26, Rethemeier says. That was the first year-over-year increase in average revenue per user Vonage ever had. And it apparently convinced some investors that competition from phone companies, cable providers, and very cheap Web-based services like Skype EBAY

may slice prices more slowly than institutions fear.

If prices hold, Vonage will begin to make money around 2008, analysts agree. James DeStefano, an analyst for Renaissance Capital in Greenwich, Conn., says Vonage's revenues should rise from $270 million last year to about $640 million this year, and to $1.6 billion by 2008. DeStefano says Renaissance expects revenue per user to be relatively stable in 2006 and 2007, in contrast to the decline that Soleil expects. The difference: DeStefano thinks Vonage can make up for erosion in basic residential service prices by selling more to business and by selling more extras like second phone lines and fax services to homeowners. "We see it declining slightly in 2008, but in the interim it will stay stable," he predicts.

Rethemeier says Vonage will make its first full-year profit in 2009 if prices fall by about 2% a year. He says the company could make money in the second half of 2008 as well. But that's a really big if. In Vonage's home turf around New York, Verizon VZ

has been slashing prices to make Vonage feel the pain. Since Vonage filed its IPO paperwork with the Securities and Exchange Commission the Big Bell has cut the price of both traditional phone service and of VoIP, which generally has lower sound quality but is cheaper .

STICKING POINT. Cable companies are bundling phone service with Internet access and cable to provide packages that are cheaper than a comparable combination of Vonage phone service coupled with broadband access and TV services Vonage doesn't offer. Pricing "will deteriorate, but how fast?" asks Renaissance partner Kathleen Smith, who co-manages Renaissance's IPO Plus Aftermarket mutual fund.

Another sticking point is Vonage's heavy spending on marketing. DeStefano says Vonage could spend $400 million on marketing this year -- and the sum could keep rising. The $221 it spends to attract the average new customer chews up a good chunk of the $300 or so a year Vonage gets paid; and customer churn of 25% a year means that many customers don't stay long enough to let Vonage recoup its investment.

Given those two big problems, coming up with a valuation for Vonage was tough. Rethmeier began coverage this morning with a hold rating and a $16-a-share price target. He says the stock is worth $24 a share if monthly prices for Vonage service hold around $26 per user. "But I don't expect that to happen," he says. His research assumes the average price will be $22 a month by 2012, and even that may be optimistic. "I think the price of voice service is going to zero," he says. "It's going to be bundled with Internet access."

LIKE SATELLITE RADIO. The more sanguine DeStefano says the $17 share price left room for upside. He compares Vonage with satellite radio providers like Sirius SIRI

and XM Satellite Radio XMSR

, which have profitability challenges of their own. Nonetheless, he says the satellite radio providers are valued at about $890 per subscriber, compared to about $940 for Vonage (at $17 a share) -- even though radio subscribers pay only $11 to $12 a month for service.

In the end, Vonage's salvation may be an acquisition, rather than a long, independent slog to profitability, DeStefano reckons. It will be easier or cheaper for a phone or cable company to buy Vonage's customer base than to take Vonage's customers away from them, and the price of satellite companies could be a starting point for acquisition talks. "All things being equal, you'd think they would trade at twice the value of the satellite guys," he says.

Meantime, Vonage will have to execute, now that it's a public company. Its SEC filings detail a long list of growth-related problems, from finding enough customer-support staffers to long delays in getting traditional phone companies to let customers take their existing phone numbers to use in setting up a Vonage account. But if prices for Internet phone service hold up, Vonage probably has a reasonably bright future. And if not, its IPO is likely to be remembered as the disappointment so many had predicted.


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