Vonage's Troubles Aren't Over

Operating results have improved and Vonage has settled its patent lawsuits, but it now faces a debt-refinancing crunch

by Olga Kharif

The news has rarely been better for Vonage after a nightmarish year of lost patent battles and weakening growth that left the Internet phone company drifting toward bankruptcy. In its third-quarter update on Nov. 8, Vonage reported that operations turned cash-flow positive for the first time.

Even better, Vonage (VG) announced the end of all current patent litigation, which had threatened to shut down its phone service since March (BusinessWeek.com, 9/27/07). Just weeks after settling patent suits brought by Verizon (VZ) and Sprint (S), Vonage said it also had reached a deal to resolve a new charge of patent infringement filed in October by AT&T (T).

Stock Surges on Settlement

Details are still being ironed out, but Vonage says it will likely pay AT&T $39 million over five years. "With litigation behind us, we are happy to refocus on our business," acting Chief Executive Jeffrey Citron said during the company's earnings call.

In a rare spurt of enthusiasm, investors pushed Vonage's battered stock nearly 14% higher, to $2.49 a share, after the report. The stock has recovered sharply from an all-time low of 96¢ reached Oct. 1, yet remains 85% below the $17 price of Vonage's initial public offering in May, 2006.

Overall, the company lost $161 million in its latest quarter, up from a $62 million loss in the same period last year. But excluding litigation-related royalty payments and restructuring charges, Vonage's operating loss narrowed to $1 million, down from $53 million in the third quarter of 2006. The company ended the quarter with 2.52 million customer phone lines, a net gain of 78,000. While well below the 204,000 added in the same period last year, that gain marked an improvement over the 56,000 lines Vonage added in the second quarter.

Losing Customers Fast

But one day of relatively good news does not a recovery make. The company has yet to stem a flood of customer defections. During each month of the third quarter, 3% of Vonage's customers closed their accounts, spiking from the second-quarter churn rate of 2.5% per month. And in a troubling sign, Vonage acknowledges about 70% of those who leave are unhappy with customer care.

Vonage says it is already pursuing several measures to address this problem—and seeing results. The company has begun rolling out new software for its customer call centers and plans to put out a new adapter by yearend to make it easier to connect a phone to a customer's Internet modem. Already, Citron tells BusinessWeek.com, the time a customer waits for Vonage to answer a service call is down.

Looming Debt Crisis

But even if those efforts succeed, there's another problem that may be harder to overcome. Vonage still faces a debt-refinancing crisis, a situation made more difficult by the mounting leeriness of lenders after the collapse of the subprime credit market. In December, 2008, some $250 million of Vonage's debt will come due for repayment. While the owners of those convertible notes can exchange them for stock, Vonage's share price has plummeted so far since the debt was issued it's highly unlikely the lenders will accept anything but cash.

Unfortunately, cash is not one of Vonage's strong suits. Despite the positive turn in its operating cash flows, the company's stores of currency are being depleted fast. At the end of September, Vonage had $355 million in cash and equivalents. But since then, the company has agreed to pay $80 million to $120 million in the Verizon settlement, with the exact amount dependent on the outcome of a pending court appeal.