Is Vonage Overvalued?

To the investors who have pumped more than $200 million into the New Jersey-based VoIP pioneer, Vonage may represent the Amazon of IP telephony. But some pessimists think a more apt analogy may be that of the ill-fated WebVan. The future, of course, is probably somewhere between these extremes. But where?

Depending on whom you ask, Vonage is destined to be either the Amazon of VoIP or the Webvan of VoIP.

Investors who have pumped a total of $208 million into the Edison, NJ-based company — including a whopping $105 million in August, a sum Vonage CFO John Rego says is the single largest US public equity investment in 18 months — clearly have the Amazon model in mind..

Their optimism is countered, however, by those who believe that Vonage’s share of the increasingly crowded residential VoIP industry is destined to shrink dramatically. Bolstering this view is a recent study that shows there are already more than 400 residential VoIP providers in the US, including deep-pocketed players such as AT&T and Verizon, and many more major telephone carriers and cable companies ready to jump into the game.

Typically, venture capital investors are looking for a tenfold return from their investment, which means that, to those backing the company, Vonage’s total company value is about $2 billion.

It’s a pretty rosy outlook but not an unrealistic one given the size of the potential market — virtually anyone in the world with a broadband Internet connection. By comparison, 8×8, the publicly traded parent company of Packet8, a VoIP service provider with about a tenth of Vonage’s customer base, has a current market capitalization of about $144 million.

The model that Vonage boosters are looking at is of a company that designs a new market category, establishes itself as the de facto standard and then leads the market it has created.

But Yankee Group Analyst Kate Griffen, in her report “Fighting Goliath: Can Alternative VoIP Providers Survive?”, predicts that traditional carriers will prevail in the fast-growing VoIP market. Yankee’s numbers show the market share of alternative providers dropping to 19 percent in 2004 from 66 percent in 2003.

By 2005, Yankee Group projects that 80 percent of the market will be dominated by traditional telephone and cable service providers. According to Griffen, these companies will be able to capitalize on the market’s momentum with their subscriber base, customer support, and brand recognition.

Vonage is counting on marketing to help the company achieve critical mass. As reported by Adweek Online, the company is investing between $50 and $75 million in marketing and advertising this year (“Market Leader Vonage Weighs Its Options”, Aug. 9, 2004).

Vonage’s Rego believes that spending on marketing right now makes a lot of sense. “Most of our new customers — 80 percent — are a result of these efforts,” says Rego.

Some analysts say that this equates to customer acquisition costs of $375 per customer — $75 million in marketing divided by the approximately 200,000 customers the company estimates it will add as a result of the campaign. Rego doesn’t deny the figure, but counters that it is far less than AT&T’s customer acquisition costs for its CallVantage VoIP service.

According to Rego, Vonage is growing by 1,000 customers a day and the company projects 350,000 subscribers by year end. The company is also using the additional funding for international expansion. This week, Vonage announced it is establishing operations in Canada, and London is planned as the company’s next launch.

J. Sanford Miller, Managing Director of 3i US — one of Vonage’s major investors and the largest venture capital firm in the world — believes that Vonage is positioned for leadership and continued growth as an independent supplier.

“We have no specific plans, but a public offering would be logical,” says Miller. “We don’t envision being acquired. It could happen, but it’s not something we’re looking for.”

According to Miller, recent and announced entries into the VoIP market on the part of major telecomm players like AT&T, Verizon and SBC are good for Vonage because it validates the market and builds awareness.

“The first thing to understand is that Vonage is profitable on an operational basis,” says Miller. “including sales and marketing costs.” In other words, each customer is profitable for the company, giving Vonage room to reduce prices if necessary. Miller says that although the company is growing rapidly, “it is growing prudently — as fast as it can absorb customers without affecting service quality.”

Still, Miller’s assertion that Vonage is profitable requires a leap of faith, particularly if one accepts that $375 per customer acquisition cost.

Vonage accrues revenues from monthly service fees (currently the highest is $25/month for unlimited US/Canada calling), international calling fees, and features such as virtual numbers, and additional lines. Even without adding operation costs, it would take Vonage 15 months to recoup marketing costs for its basic “unlimited service” customer.

Adding up the cost side of the equation pushes the profitability horizon out even further. A conservative estimate for equipment is about $40 per customer — the Linksys PAP-2 telephone adaptor Vonage now ships to new customers wholesales at about $49. While call termination costs vary widely, economies of scale mean that Vonage is probably paying an average of about $0.003/minute for termination in the US. Add in server, gateway, switches and other technical infrastructure costs that increase as a factor of the number of customers. And then there’s the cost of technical support (VoIP is still not quite a plug-and-play experience for many), which increases with the number of subscribers.

So, reckoning the cost of providing service into the equation pushes profitability out into the second or third year of service. While companies like AT&T have deep pockets to absorb these costs until the market matures, Vonage could find itself hurting if the market doesn’t grow as quickly as projected.

But even the naysayers believe it’s unlikely Vonage will head into WebVan-like oblivion. The potential market is so huge — essentially any household or business in the world with high-speed Internet access — that even a small slice represents a very healthy business. According to a recent Wall Street Journal article, industry analysts project annual growth rates of more than 220 percent for the next five years. In other words, plenty to support plenty of suppliers.

The challenge, some believe, is for Vonage to adapt: From the biggest trout in a small pond to one of many whales, some much bigger, operating in an expanding ocean.

“The trick for Vonage,” says Yankee Group’s Griffen, “is getting the company’s long term plans in line with how the market will evolve. The company is well-funded and has experienced terrific growth. Whether or not Vonage can expand beyond the early adopters and reach the ‘mighty middle’ there will always be people who want to be on the leading edge. So Vonage should continue to innovate on a service basis.”

One VoIP supplier that concurs with this analysis is VoicePulse, which launched its broadband phone service in 2003. VoicePulse has developed its own switching platform — unlike Vonage — which CEO Ravi Sakaria says gives the company an edge in delivering advanced features.

“What I see in the market today could be compared to a group of people huddling in the corner of a huge corn field fighting over a single corn stalk,” Sakaria explains. “In fact there’s huge potential out there and plenty of business for a number of players.”

Tom Garland of Acuitive — an early stage venture services firm that numbers several startup VoIP companies in its client base — says that one hurdle Vonage faces is simply the fact that customers have to make a deliberate decision to change. Traditional service providers can make that transition transparent.

However, Garland says that Vonage “has done a lot of things right. They’ve made it easy to buy, easy to set up and it’s easy to understand their pricing plans. They keep it simple and focus on the consumer. The mistake people have made in VoIP has been focusing on technology. Consumers don’t care about technology. They want to plug in the device and save money.”

“Once customers have made a commitment, there’s a perceived cost associated with change,” Garland continues. “A lot rides on Vonage getting their brand out there before traditional service providers do.”