It may sound crazy just to think it: Might it be time to buy shares in Vonage (VG)? The company has had one of the worst initial public offering in years, as concerns about mounting losses and increasing competition helped drive its stock down 30%, to $12, since the May 23 IPO (see BusinessWeek.com, 5/22/06, "Vonage On the Line"). If that wasn't enough, the company got into an ugly dispute with its customers over shares in the IPO that Vonage reserved for them (see BusinessWeek.com, 6/1/06, "Vonage to Customers: Pay Up").
Still, most every company is worth something, and analysts are beginning to say that Vonage's stock has fallen far enough that it may be time to buy. Last week, two small research shops that had rated shares in the Holmdel (N. J.) provider of Internet telephone service a "sell" raised their stance to "hold." American Technology Research says it's time to buy, even though Vonage lost $261.9 million last year on sales of $269.2 million. Do they know something the rest of the world doesn't?
Leading the bull case is Albert Lin of American Technology Research. Give him credit: His case is as quantitative as it is bold. Its centerpiece is Vonage's low subscriber churn -- at current rates of defection, the average Vonage customer will stay with the company for almost four years. Four years times the average bill of almost $26 a month gives you $1,246. It costs about $9 a month to provide the service, leaving $814 per customer. It costs about $230 in marketing spending to find each customer now, he says, which leaves Vonage with a pre-overhead profit of $574 on every customer.
WOO-HOO-HOO. The stock's price values the 1.6 million customers Vonage has now at about $1,100, less than half the value of each similar account at Verizon Communications (VZ), as implied by its stock price. But Lin expects Vonage to reach 4 million to 4.5 million subscribers by the end of 2007, making the valuation gap even larger.
He thinks the company will be able to turn a profit with 8 million to 10 million customers, which should happen in three or four years. If it gets there, the company will be pulling in about $2.7 billion when it hits profitability. "The bear case is so well understood, people lose sight of the facts," he says. "Telcos are shocked that Vonage is so efficient about marketing. Every consumer can sing [Vonage's jingle] 'Woo-hoo, woo-hoo-hoo.'"
The other linchpin of Lin's argument is its assumption that the price of Internet phone service will stay close to stable. Lin concedes that the price of basic service will fall -- he guesses 25% to 30% within a few years -- with the rising tide of competition from giants such as Verizon and AT&T (T), as well as smaller players such as Skype (EBAY) and 8x8 (EGHT). But he says the real competition will be over features rather than price. He foresees consumers laying out the same $26 or so they do now, but for service that includes extras like voice-mail archiving and conference calling.
PRICING PRESSURE. He points out that Vonage's primary competition comes from Comcast (CMCSA), Cablevision (CVC), and other cable companies that want to sell telephone service that works over their existing networks: Any cable company to earn a reputation for competing hard on price, he notes, will be the first. So far, cable companies have steadfastly resisted pushing down the price of broadband Net access even as they compete with DSL service offered by phone companies, and Lin expects more of the same.
The price of Net telephony is the very factor that keeps other analysts from turning truly bullish, even if they raised their ratings. Richard Greenfield of New York-based Pali Research, who went from sell to hold, says his forecast is based on annual price declines of about 2.5% a year. He thinks the declines could be much worse, but says even those are enough to keep Vonage from becoming a good bet.
He says profits will stay low, with Vonage not making a net profit until 2009. At today's price, Vonage is already commanding 18 times 2009 earnings -- and maybe much more, if the price of Net telephone service falls more than Greenfield expects. That's because earnings will vary vastly depending on what prices do. If average revenue per user stays flat, Soleil Securities analyst Gregory Lundberg calculates that Vonage will make $563 million in 2010 before interest, taxes, and non-cash charges. If that $25.97 average monthly bill falls to $20, though, the same profit is likely to be just $100 million. "Small adjustments can dramatically affect valuation," Greenfield says.
TAKEOVER BAIT? But there are other nagging concerns about Vonage and its management. The churn figures that Lin relies on are based on relatively little data, since more than half of Vonage customers have been clients for less than five quarters: No one knows yet whether newer customers will stay as loyal, especially since Vonage's marketing is so heavily tilted toward price-conscious buyers who might chase the next deal. And no one can do much to quantify how much risk Vonage faces from free or nearly free Net phone service from Skype, Google (GOOG), and Yahoo! (YHOO).
The bears also split from Lin on Vonage's value as a takeover candidate. Lin, a former Verizon manager, says a big telco could provide phone service with Net technologies (known as Voice over Internet Protocol, or VoIP) over a vast network for as little as $3 a month. That bolsters his argument that Vonage may be worth more to a buyer than it is independent. But Greenfield says Vonage's national footprint won't interest big telcos or cable companies, who will only want to add subscribers in geographic areas they already serve.
So why did bearish analysts such as Greenfield and Lundberg raise their ratings? Mostly because the stock has gotten cheap enough to be close to discounting those problems, and because of expectations that Vonage will report strong growth and stable pricing for the second quarter. But they don't think it will last. "2006 is likely to show accelerating net subscriber additions and stable [prices]," wrote Lundberg, who declined an interview. "We think this gets the bull-case investors excited, but we don't think it's sustainable."
SKITTISH BULLS. Vonage remains a balance of a lot of risk and not all that much reward. All of the valuations are based on what finance wonks call sensitivity analysis -- that is, there are actually different models reflecting different assumptions.Those models that assume VoIP prices will fall faster than a couple of percentage points a year value Vonage at as little as $3 to $5 a share. Models that assume everything breaks its way put Vonage's value at about $20 a share.
Little wonder, then, that even some bulls might not put their money where their mouth is. James DeStefano, an analyst with Greenwich, Conn., research firm Renaissance Capital was bullish on Vonage on IPO day, comparing the company's growth prospects to those of satellite radio providers Sirius (SIRI) and XM (XMSR) (see BusinessWeek.com, 5/24/06, "Vonage's Lackluster IPO"). But Renaissance's IPO Plus Aftermarket mutual fund has sold its Vonage shares, fund manager Linda Killian says.
Cautious investors may want to wait until late 2007 to see what happens to the price of VoIP -- and whether the doomsday scenarios are likely to come true.
Mullaney is E-Business editor for BusinessWeek in New York
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