May 24, 2006, 7:38 am


The following was available to subscribers last Friday well before deciding on allocations:

VG - Vonage

VG, Vonage plans on offering 36 million shares (assuming over-allotment) at a range of $16- $18. Citigroup, Deutsche Bank, and UBS are lead underwriting the deal. Post-offering VG will have 160 million shares outstanding (again assuming over-allotment) for a market cap at $17 of $2.72 million. IPO proceeds will be used to expand business and in a rare sign of company straight talk, to 'fund losses'.

Founder and Chairman Jeffrey Citron will own 33% of VG post- offering. Mr Citron has a rather colorful past. While employed with Datek Securities he was charged with fraud by the SEC related to improper order execution and filing false reports with the SEC and he paid nearly $23 million in penalties.

Of note: VG has set aside up to 13.5% of the shares offered in the deal to customers who opened an account with Vonage America prior to Dec. 15, 2005.

From the S-1:

“We are a leading provider of broadband telephone services with over 1.6 million subscriber lines as of April 1, 2006. Utilizing our innovative Voice over Internet Protocol, or VoIP, technology platform, we offer feature-rich, low-cost communications services that offer users an experience similar to traditional telephone services.”

VoIP technology converts voice signals into data packets which travel through the internet before being converted back to voice at other end of line.

VG is currently the leading US provider of VoIP services. Customers in the US currently account for 95% and VG has seen hypergrowth in the US. In 2005 alone subscriber growth tripled for VG's VoIP service. This is exactly what one wants to see in an IPO. However VG's growth has not gone unnoticed and massive competition is aligning against VG.

VG offers its VoIP service at a fixed monthly price of $24.95 for unlimited calls in the US/Canada and $14.95 for 500 minutes of calls in US/Canada. Plans include caller ID, call forwarding and voice mail. The Vonage VoIP system enables customers to utilize a standard phone to make/ receive VoIP calls. Main VoIP competitor Skype does not offer this feature, calls using Skype must be placed through computer/laptop. However the Vonage service does require a broadband connection.

VG delivers its service over existing broadband infrastructure avoiding the need to build-out or lease from telco/ cable expensive last mile connections. These 'last-mile' buildouts are what eventually did in the pureplay broadband companies of the '90's all of whom spent massively on broadband infrastructure leveraging themselves heavily....That leverage bankrupted nearly all of them in the early 2000's. VG's system also bypasses expensive telcom switches. The result is that VG has a pretty nimble infrastructure which does not require immense capital investments and can be scaled rather rapidly and relatively cheap. Relative being the key word and is in comparison to the traditional telco capacity buildouts.

VG has a roughly 2% churn per month which really is pretty good. However note that this number does not include those that cancel service within 30 days of subscribing.

VG brings in new customers by spending heavily on advertising and marketing. Nielsen/Net Ratings have stated that Vonage was the top internet advertiser in the world in the past 15 months. What VG is not spending on network buildouts, it is plowing into advertising.

Okay those are the basics. Before we get into the financials let us look at the immense pricing pressure coming into the VoIP space. VoIP offers a potentially much cheaper form of communication. VGs hyper growth and the overall cost structure of VoIP to providers has recently brought in both more competition and pricing pressure. Pricing pressure is an understatement. Let us instead say massive pricing pressures from all corners of the communication provider sector. Skype, [who Ebay purchased for $2.6 billion in 2005] has recently announced FREE calls to anywhere in the US/ Canada through the end of 2006. Free beats Vonage by $24.99 monthly. No catch either, apparently Ebay is willing to use Skype as a loss leader the remainder of 2006 to bring in new customers for the Skype service. As noted above with the Skype service a customer makes a call through their computer using headset/ microphone not a traditional phone set. However the free Skype offer does include calls made to traditional phones, phone lines and wireless. In addition Verizon just introduced VoIP service at a price that matches or beats Vonage, Cablevision recently doing similar and only a matter of time before the other telcos/cable offer prices that beat Vonage.

Here is the problem for Vonage. Traditional carriers like Verizon and the cable companies offer multiple services. VoIP's low cost structure will allow the Verizons and Comcasts of the world to bundle VoIP with cable, broadband and wireless services at a price point that makes unlimited VoIP calling essentially free to the consumer. Vonage has nothing to bundle and needs a strong price point for their VoIP service in order to survive.

In addition Ebay, with very deep pockets, can also afford to offer the Skype service free to 1) build the customer base and 2) utilize the service as a loss leader and entryway into add-on services such as pricier worldwide calling. Again VG cannot do this, they absolutely need a strong price point for their VoIP service.

Wireless also offers stiff competition as many households (including mine) have eschewed wireline service for wireless only. I'm not alone either as the traditional telcos are seeing their landline count drop annually. VG is essentially a landline telco, just one with a lower cost basis due to the cost structures of VoIP. Not only will the telcos/ cable/ skype price them out of the market, they've got to deal with the 'wireless trends.'

Before the IPO, VG tried to sell themselves to a larger communications player. Why? I think they realize what they're up against here. This is the big issue with this offering: The lower cost structure for providers of VoIP allows VG's competitors to offer VoIP at a very low price point in order to sell-in additional higher margin products/ services such as cable, broadband, digital content, and in the case of Skype, products such as worldwide VoIP calling. VG has only VoIP and to keep its customer base in the long run, VG will face heavy industry-wide pressure to significantly reduce its service price point.

The odds are really against VG ever being able to turn their VoIP service into a profitable enterprise due to increased massive pricing pressure. Frankly I don't see VG ever becoming profitable due to pricing pressures. VG has a greater chance of being bought out for their customer base then of turning a profit I think.

I believe a reason that VG is offering IPO shares to customers is to assist loyalty to the Vonage brand. Going forward loyalty is going to be crucial to keeping customers as they won't be able to compete on price.


$3 a share in cash minus debt post-offering. VG will most likely burn through this cash by first quarter 2007 and need to come back to the market for more capital. Revenue has ramped massively since start-up stage in 2002. In '04 VG had $79.8 million in revenue. In '05 that revenue increased nearly 240% to $269.1. First quarter 2006 showed another rapid revenue rise.

Gross margins are strong, reflecting the lack of extensive infrastructure costs. For the 15 months covering 2005 and first quarter of 2006 gross margins hit 54%.

Operating expenses are massive, reflecting the heavy commitment to adverstising/ marketing(A/M). A/M expenses grew 335% in 2005 to $243 million. Keep in mind revenues increased 240%, meaning VG is most definitely 'buying' revenue through hefty advertising. That can be acceptable assuming that you're able to retain new customers over time, bringing in a continual revenue stream. As I've noted though, I don't see any way VG can keep their current pricing points. I'm always wary of companies obviously 'buying' revenue through 1:1 ad/ marketing expenses and I'm even more so when looking at the competition coming VG's way.

All this has resulted in heavy losses to date for VG. In fact the losses are increasing even as VG has swiftly grown their customer and revenue base. In 2004 VG lost 35- 40 cents a share, in 2005 they lost $1.60 and are on a pace in 2006 to lose $2.50 per share.

So we've a company facing massive pricing pressure that seems to have an ability to steepen losses as they grow customer base and revenues. What happens the next 3 quarter going head to head with FREE service from Skype? I don't think it will be pretty at all. Not at all.

Conclusion- A number of IPO websites are high on this offering. I'm not. VG is about to face overwhelming competition and I feel they'll need to lower their price point in an attempt to compete. This will steepen already heavy losses and I think this means the odds are small of VG ever reaching profitability. The hope here for those buying VG is that Google or Yahoo make overtures to buy them out. I don't know how realistic that is, although since Ebay purchased Skype for $2.6 billion is stands to assume any buyout price for Vonage might be fairly hefty. That is it though in my eyes and that in itself is not enough of a reason to own VG. Heavy losses and heavy competition leading to eroding price points lead me to pass here. Hype may help this one early, but I've no interest in the Vonage IPO