Vonage on the Verge

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

by Olga Kharif

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 BusinessWeek.com, 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.