Technology

Trouble on the Line for Vonage?


When Vonage Holdings was preparing for last week's initial public offering, it made an unusual appeal to its customers. The Internet phone service provider set aside shares in the company for customers, and aggressively marketed the opportunity through e-mail and automated voice mails. It even let customers "purchase" shares in the IPO without putting any money down, with the understanding that they would pay up a few days later.

Now that decision is turning into a problem for Vonage (VG), its underwriters, and the customers who agreed to buy stock in the offering. Shares in the company started trading May 24 on the New York Stock Exchange at $17 apiece. Since then, the price has tumbled 26%, to $12.50, making Vonage the worst-performing IPO of the year to date (see BW Online, 5/24/06, "Vonage's Lackluster IPO").

When Vonage initially set up the program, its execs probably thought they were doing customers a favor. Many hot IPOs go almost exclusively to institutional investors, such as mutual funds and university endowments. Vonage's program looked like an attempt to spread the wealth: Individual Vonage customers could reserve shares in advance of the offering, and didn't have to pay for them until May 30.

CROWDED LANDSCAPE. Now, customers face the prospect of having to hand over more cash for their Vonage stock than it's currently worth. If they reserved 100 shares, they would have to pay $1,700 for stock now worth $1,250. One big question: Will customers in fact pay up. Another is whether Vonage will try to pressure them, which could alienate the very people it depends on for its torrid growth.

The carnage might not be over. Analyst Richard Greenfield of Pali Research just reiterated his "sell" rating on the stock, with a price target of $11.50. He has several concerns. For one, he's worried that the prospect of customers losing money in the IPO could turn into a business problem, in which customers drop the service. Such defections, known as "churn," are an important measure of performance in the telecom industry. "The catalyst for our concern is the fact that Vonage reinstituted its One Free Month of Service promotion this morning," Greenfield wrote May 30.

He's also concerned that Vonage might feel compelled to buy back shares from institutional investors, which bought the same class of stock as the participants in the directed share program. Separate from the IPO issues, he's concerned about Vonage's ability to slug it out with a flock of new rivals. "The $17 price didn't take into account the fundamental competitiveness and lack of visibility surrounding the telecom landscape," Greenfield said in an interview. Vonage declined comment, citing a 25-day post-IPO quiet period.

DELIVERY REFUSED? The financial implications for Vonage could be significant. Its amended prospectus, filed with the Securities & Exchange Commission May 24, says the company won't make underwriters Citibank (C), UBS (UBS), or Deutsche Bank (DB) pay for shares that customers reserved and didn't purchase. "We have agreed to indemnify the underwriters against certain liabilities, including those that may be caused by the failure of Directed Share Program participants to pay for and accept delivery of the common stock which had been allocated to them or were subject to a properly confirmed agreement to purchase," the filing said.

The filing said up to 15% of all shares could be at risk. "We have requested that, pursuant to our Directed Share Programs, the underwriters reserve up to 13.5% and 1.5% of the common stock offered in this prospectus for sale to certain of our customers and other persons related to us, respectively, at the initial public offering price," the filing said.

The company warned last week that expected net proceeds of the IPO could be reduced if the participants in the directed-share program failed to pay for and accept delivery of their shares. As of May 30, the company had 155 million shares outstanding. Its market cap totaled $1.95 billion.

'90s FLASHBACK. Vonage has been growing at a torrid pace. It now serves about 1.6 million customers, up from 857,000 at the end of 2003. Its subscribers can use a combination of regular phones, adapters, and broadband connections to create an inexpensive alternative to the traditional phone service provided by the likes of Verizon (VZ), AT&T (T), and Sprint (S).

But Vonage has never made any money (see BW Online, 2/9/06, "Vonage's Iffy IPO"). It has, however, spent a lot of money on advertising and marketing, and it has run up more than $250 million in debt.

Vonage, founded by entrepreneur Jeff Citron, has a financial profile much lke that of a '90s dot-com. While the current crop of Web powerhouses, such as Yahoo! (YHOO), Google (GOOG), and even News Corp.'s (NWS) MySpace unit, are profitable, Vonage reported a 2005 net loss of $261 million on revenues of $269 million. Revenue grew 2.3 times from the $80 million it pulled in in 2004. But that growth came at a price: Marketing expenses grew even faster. They hit $243 million in 2005, up 3.3 times from $56 million a year earlier.

THE ROAD AHEAD. While it's easy to pitch the disruptive aspects of Vonage's Internet phone technology, it's not clear why Vonage itself is disruptive. Lots of companies, including Verizon and AT&T, offer similar services. And there are other Internet phone rivals, such as eBay's (EBAY) Skype unit, which are even more disruptive because they focus on helping users make free calls from one PC to another.

Citron, 35, made his name in the '90s as the founder of Datek Online, a stock-trading company. The SEC banned him from the brokerage business in 2003 over issues regarding Datek. He agreed to pay $22 million to settle the matter, but didn't admit any wrongdoing (see BW, 6/20/05, "Vonage: Spending as Fast as It Can").

Citron has worked hard on his comeback vehicle. But while he and others may have made money on the IPO, it appears some investors may be in for a rough ride.


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