In spite of its IPO flop, setbacks from the FCC, and increasing competition from cable outfits, the Internet phone upstart insists it’s thriving

How bad are things going to get for Internet phone upstart Vonage (VG)? At first, after its disastrous May 24 initial public offering (see BusinessWeek.com, 5/24/06, “Vonage’s Lackluster IPO”), investment analysts merely questioned whether the IPO had been overpriced. But now analysts are increasingly concerned about the company’s outlook. Some are even beginning to question Vonage’s long-term viability.

This week brought more bad news. On June 19, giant Verizon Communications (VZ) sued Vonage, alleging that the upstart was infringing on its patents. Then on June 21, the Federal Communications Commission ruled that Vonage and other Internet phone companies must contribute to the federal Universal Service Fund, just as regular phone companies do. Until now, Net phone providers have been exempt from the fees, which help provide phone service to rural and poor communities.

CONTINUED LOSSES. Additional expenses, whether government fees or legal charges, are the last thing Vonage needs. The company is struggling mightily to reach profitability. It lost $261 million last year, on sales of $269 million. While the company has plenty of cash now, including $531 million raised in the IPO and another $175 million, analysts are concerned that it may not be able to stem the red ink. Pyramid Research analyst Nick Holland estimates that Vonage losses will increase this year to $330 million. That’s why he issued a report this week suggesting that Vonage may be “toast.”

Vonage spokeswoman Brooke Schulz said the cash burn shouldn’t be considered in a vacuum. “You need to look at customer churn, acquisition costs, and operating losses together to build the business model. My conclusion is we have a healthy business here…We’re not toast,” she said. The real question is whether the company can acquire its customers in an efficient manner and thereby narrow its losses, she says.

Some analysts are concerned about Vonage’s ability to meet that challenge. Holland notes that marketing expenses for 2005 were a whopping 90% of revenues. That means that for every dollar in revenue, 90 cents went out the door to cover advertising and other promotional costs. In addition, the company has to spend money on basic necessities such as employee compensation, computer equipment, and real estate costs. It’s unclear what it will take to improve that expense ratio.

NEW FCC FEES. The FCC’s ruling on the Universal Service Fund certainly won’t help. Vonage’s required contribution to the the fund, according to Schulz, will be either 6.8% of all revenues or somewhat less if the company separates phone revenue from other revenue that is exempt from the government charges. She also noted that the government recently exempted Vonage and other Internet phone companies from an excise tax, which will offset much of the USF cost. Vonage put out a public statement on June 21, saying the net affect of the FCC decision would be a “slightly higher customer bill.”

The long-term pressure from rivals may be more severe. Big telecom and cable TV companies such as Verizon, AT&T (T), Cablevision (CVC), and Comcast (CMCSA) are rolling out packages that include Internet phone service, wireless phone service, high-speed Internet access and TV (see BusinessWeek.com, 5/5/06, “). It will be tough for Vonage to compete as a stand-alone service that doesn’t own its own networks. And it faces competition from services like the Skype unit of eBay (EBAY), which allow members to make free PC to PC calls to other members.

The rising pressure from cable companies offering Internet phone service persuaded Pali Research analyst Rich Greenfield to put a “sell” rating on Vonage on June 20. It was an abrupt turn for Greenfield. He put a sell on the company prior to the IPO, but raised his rating to neutral on June 2. Comments by Cablevision COO Tom Rutledge subsequently convinced him that Cablevision could beat Vonage in a price war, raising concerns about Vonage’s revenue outlook.

UPSTARTS CAN GO DOWN. There’s no question Internet phone service is a disruptive technology that poses a huge challenge to established phone companies. But there’s no law that says upstart phone companies, even ones that got to market early, are safe from the disruptive power of that technology.

Internet phone service will probably force big players like Verizon to lower the price of voice calls to something approaching zero. But the big players are investing in new lines of business such as superfast Internet access and TV carried over fiber-optic lines (see BusinessWeek.com 5/11/06, “Verizon Mulls Cash for its Lines”). Companies such as Vonage may be thrown out of the game whose rules they changed.

In spite of its IPO flop, setbacks from the FCC, and increasing competition from cable outfits, the Internet phone upstart insists it’s thriving

How bad are things going to get for Internet phone upstart Vonage (VG)? At first, after its disastrous May 24 initial public offering (see BusinessWeek.com, 5/24/06, “Vonage’s Lackluster IPO”), investment analysts merely questioned whether the IPO had been overpriced. But now analysts are increasingly concerned about the company’s outlook. Some are even beginning to question Vonage’s long-term viability.

This week brought more bad news. On June 19, giant Verizon Communications (VZ) sued Vonage, alleging that the upstart was infringing on its patents. Then on June 21, the Federal Communications Commission ruled that Vonage and other Internet phone companies must contribute to the federal Universal Service Fund, just as regular phone companies do. Until now, Net phone providers have been exempt from the fees, which help provide phone service to rural and poor communities.

CONTINUED LOSSES. Additional expenses, whether government fees or legal charges, are the last thing Vonage needs. The company is struggling mightily to reach profitability. It lost $261 million last year, on sales of $269 million. While the company has plenty of cash now, including $531 million raised in the IPO and another $175 million, analysts are concerned that it may not be able to stem the red ink. Pyramid Research analyst Nick Holland estimates that Vonage losses will increase this year to $330 million. That’s why he issued a report this week suggesting that Vonage may be “toast.”

Vonage spokeswoman Brooke Schulz said the cash burn shouldn’t be considered in a vacuum. “You need to look at customer churn, acquisition costs, and operating losses together to build the business model. My conclusion is we have a healthy business here…We’re not toast,” she said. The real question is whether the company can acquire its customers in an efficient manner and thereby narrow its losses, she says.

Some analysts are concerned about Vonage’s ability to meet that challenge. Holland notes that marketing expenses for 2005 were a whopping 90% of revenues. That means that for every dollar in revenue, 90 cents went out the door to cover advertising and other promotional costs. In addition, the company has to spend money on basic necessities such as employee compensation, computer equipment, and real estate costs. It’s unclear what it will take to improve that expense ratio.

NEW FCC FEES. The FCC’s ruling on the Universal Service Fund certainly won’t help. Vonage’s required contribution to the the fund, according to Schulz, will be either 6.8% of all revenues or somewhat less if the company separates phone revenue from other revenue that is exempt from the government charges. She also noted that the government recently exempted Vonage and other Internet phone companies from an excise tax, which will offset much of the USF cost. Vonage put out a public statement on June 21, saying the net affect of the FCC decision would be a “slightly higher customer bill.”

The long-term pressure from rivals may be more severe. Big telecom and cable TV companies such as Verizon, AT&T (T), Cablevision (CVC), and Comcast (CMCSA) are rolling out packages that include Internet phone service, wireless phone service, high-speed Internet access and TV (see BusinessWeek.com, 5/5/06, “). It will be tough for Vonage to compete as a stand-alone service that doesn’t own its own networks. And it faces competition from services like the Skype unit of eBay (EBAY), which allow members to make free PC to PC calls to other members.

The rising pressure from cable companies offering Internet phone service persuaded Pali Research analyst Rich Greenfield to put a “sell” rating on Vonage on June 20. It was an abrupt turn for Greenfield. He put a sell on the company prior to the IPO, but raised his rating to neutral on June 2. Comments by Cablevision COO Tom Rutledge subsequently convinced him that Cablevision could beat Vonage in a price war, raising concerns about Vonage’s revenue outlook.

UPSTARTS CAN GO DOWN. There’s no question Internet phone service is a disruptive technology that poses a huge challenge to established phone companies. But there’s no law that says upstart phone companies, even ones that got to market early, are safe from the disruptive power of that technology.

Internet phone service will probably force big players like Verizon to lower the price of voice calls to something approaching zero. But the big players are investing in new lines of business such as superfast Internet access and TV carried over fiber-optic lines (see BusinessWeek.com 5/11/06, “Verizon Mulls Cash for its Lines”). Companies such as Vonage may be thrown out of the game whose rules they changed.