Vonage on the Verge

Amid weak sales and a critical patent fight, the CEO heads for the exit. Will customers follow?

As it battles soft sales and a court ruling that could spell its demise, Vonage Holdings (VG) is slashing costs and hunting for a new chief executive. All that uncertainty around the Internet telephone company says one thing to longtime customers like Ann Christiansan: time for a telecom contingency. "We are definitely shopping around to transfer our service since everything is so 'up in the air' at this moment," Christiansan wrote in an e-mail.

On Apr. 12, Vonage announced the resignation of CEO Michael Snyder after just 14 months on the job, the same day it pre-announced dismal first-quarter results and a broad restructuring aimed at slashing costs. Even more worrisome to customers: The Holmdel (N.J.) company has lost several critical rulings in a patent infringement fight with Verizon Communications (VZ), the latest on Apr. 6 when a federal judge issued a partial injunction and said Vonage must stop signing up new customers. (A higher court later stayed that decision pending appeal.) The company has about 2.4 million customers.

In the quarter ended Mar. 31, Vonage booked $195 million in revenues, up 63% vs. the year-ago quarter. But it added only 166,000 subscriber lines—half the number in the same period of 2006. While Wall Street expected a sharp drop, consistent with an earlier, fourth-quarter slowdown, the numbers missed most analysts' estimates widely. The company's customer churn rose as well, from 2.3% in the fourth quarter to 2.4% in the first quarter. Vonage attributes the increase to an accounting change in how it processes customer requests. But the fact is, some of Vonage's customers are starting to play the field. "Anecdotally, customers appear to be canceling," says Clayton Moran, an analyst with Stanford Group. "And the ability of the company to add new subscribers has slowed down considerably."

Talk About Cash Burn

Some of Vonage's current customers are starting to scout out alternative Web-calling services. B.J. Morgan, a marketing professional living near Boston, is nervous about the recent headlines. Morgan now pays Vonage $14.99 a month for 500 minutes. While he's not canceling his Vonage service just yet, he is planning to open an account with Web-calling provider Skype, a property of eBay (EBAY). "There's a probability that they are going to go out of business," says Morgan, who wants "a Plan B in place" if Vonage disappears.

While Vonage has repeatedly stated that its customers will see no disruptions in service, some users are starting to worry their phone lines will go dead. In an Apr. 9 report, Citigroup (C) analyst Michael Rollins warned that "the risk of a financial recapitalization and/or bankruptcy in the 2008-2009 time frame has increased materially as our financial model now forecasts the need for Vonage to borrow additional money in '08 and '09."

Here's some math behind those numbers: After posting a $66 million bond required as part of the Verizon appeal process, Vonage still has $420 million in cash and marketable securities (see, 4/6/07, "Vonage: Gasping for Air"). But it burned through some $80 million of cash in its latest quarter, and its legal expenses are mounting. In addition, until its appeal is heard, Vonage must deposit 5.5% of its revenues into an account each quarter that is payable to Verizon if courts uphold the earlier ruling. As a result, on Apr. 12, Jeffrey Citron, the company's returning, albeit interim, CEO, said he couldn't reaffirm the company's prior guidance of reaching operational profitability in the first quarter of 2008.

Global Ambitions Muted

The cost cuts and restructuring could help somewhat—indeed, Vonage shares rallied 6.7% on the news, to $3.20—but they could also hurt future revenue growth. Citron is aiming to save $30 million. The company declined to say how many of its 1,790 staff would be laid off. Wall Street would typically hail deep cost cuts for a company that lost $286 million last year, but the consolidation in the U.S. and Canada indicates a major strategic shift of the company's focus away from a global expansion. "Our international operations have been curtailed given that the staffing cuts are worldwide, as are the marketing cuts," Vonage spokeswoman Brooke Schulz said in an e-mail.

That's troubling, as it's outside the U.S. where Vonage has the opportunity to operate without the constraints of the Verizon ruling. Globally, Vonage's brand is strong, and a further expansion could have lit a fire under the company's subscriber growth, says Jon Arnold, principal with Web-calling consultancy J Arnold & Associates.

Vonage will also slash its marketing budget, the main expense dragging down its bottom line, by more than $100 million to $310 million this year. While analysts have long complained that Vonage spent too much on cute TV ads, the cuts could further curb the company's quarterly subscriber acquisitions, which, in the future, could fall to below the current quarter's levels, says Stephan Beckert, an analyst with consultancy TeleGeography. Beckert, who is a Vonage customer, says he is not switching just yet: "I think only the most paranoid people are switching right now."

Customers Flee to Rivals

After all, Vonage could still win its appeal, which is expected to take up to two years. It could also find a "work-around" for the Verizon technology at issue, and such a solution would obviate the need to pay Verizon royalties. But in his first comments as interim CEO, Citron refused to explain exactly what the company is developing or how far it is from any such solution. "We are confident in our ability to win an appeal," said Vonage's chief legal officer, Sharon O'Leary (see, 3/9/07, "What the Verizon Verdict Means for Vonage"). The company hopes that, on Apr. 24, courts will grant it a stay to continue recruiting new customers. Even in the worst-case scenario of a legal defeat, Vonage would likely be acquired by a rival, such as Verizon or Sprint Nextel (S), which is also suing Vonage for patent infringement, says Arnold. Chances are, Vonage customers will still get their service.

But the uncertainty is worrying enough subscribers that some of its competitors are starting to see growth at Vonage's expense.

Rival Charter Communications (CHTR), the nation's third-largest publicly traded cable company with some 11 million customers, says it has received many inquiries about switching from current Vonage users. The St. Louis company, which sells Web-calling services to 500,000 customers, recently told potential switchers they could get free same- or next-day installation. "Because Charter telephone service representatives had been hearing from concerned Vonage customers, Charter merely reiterated our same-day/next-day installation offer mentioning Vonage customers in a media release," says Charter spokeswoman Anita Lamont.

Showdown at the Switchboard

Another Web-calling competitor, SunRocket, reports seeing an influx of Vonage refugees as well. "[Switching from Vonage] has certainly picked up in the past several weeks," says Lisa Hook, CEO of Vienna (Va.)-based SunRocket, which said it surpassed the 200,000-customer mark this month. "That's something we haven't seen before."

For its part, Vonage is firing back at poachers with increased focus on customer service and cheaper prices. In March, Vonage reduced select international calling rates to a penny a minute. "There's no way they could be making money on this," says Arnold. "This doesn't help [the company's financials]. They'd only get the bottom-feeders."

Many Vonage loyalists say they'll stick with the company until the dial tone fades. "The service has been phenomenal," says Michael Crotty, a financial adviser in Braintree, Mass. "For the hassle of changing right now, I am not shopping for other providers." At the moment, Vonage is hoping it has many more such customers.

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