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Is Vonage Overvalued?
Written by CAROLYN SCHUK Monday, 29 November 2004
Depending on whom you ask, Vonage is destined to be either the Amazonof 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 equityinvestment in 18 months — clearly have the Amazon model in mind..Their optimism is countered, however, by those who believe that Vonage’sshare of the increasingly crowded residential VoIP industry is destined toshrink dramatically. Bolstering this view is a recent study that shows thereare already more than 400 residential VoIP providers in the US, includingdeep-pocketed players such as AT&T and Verizon, and many more majortelephone carriers and cable companies ready to jump into the game.Typically, venture capital investors are looking for a tenfold return from theirinvestment, which means that, to those backing the company, Vonage’stotal company value is about $2 billion.It’s a pretty rosy outlook but not an unrealistic one given the size of thepotential market — virtually anyone in the world with a broadband Internetconnection. By comparison, 8x8, the publicly traded parent company of Packet8, a VoIP service provider with about a tenth of Vonage’s customerbase, has a current market capitalization of about $144 million.The model that Vonage boosters are looking at is of a company that designsa new market category, establishes itself as the de facto standard and thenleads 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 willprevail in the fast-growing VoIP market. Yankee’s numbers show the marketshare of alternative providers dropping to 19 percent in 2004 from 66percent in 2003.By 2005, Yankee Group projects that 80 percent of the market will bedominated by traditional telephone and cable service providers. According toGriffen, these companies will be able to capitalize on the market’smomentum with their subscriber base, customer support, and brandrecognition. 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 VonageWeighs Its Options”, Aug. 9, 2004). Vonage’s Rego believes that spending on marketing right now makes a lotof sense. “Most of our new customers — 80 percent — are a result of theseefforts,” says Rego.Some analysts say that this equates to customer acquisition costs of $375per customer — $75 million in marketing divided by the approximately200,000 customers the company estimates it will add as a result of thecampaign. 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 thecompany projects 350,000 subscribers by year end. The company is alsousing the additional funding for international expansion. This week, Vonageannounced it is establishing operations in Canada, and London is planned asthe company’s next launch.
Is Vonage Overvalued?Page 2 of 3
J. Sanford Miller, Managing Director of 3i US — one of Vonage’s majorinvestors and the largest venture capital firm in the world — believes that Vonage is positioned for leadership and continued growth as anindependent supplier. “We have no specific plans, but a public offering would be logical,” saysMiller. “We don’t envision being acquired. It could happen, but it’s notsomething we’re looking for.” According to Miller, recent and announced entries into the VoIP market onthe part of major telecomm players like AT&T, Verizon and SBC are goodfor Vonage because it validates the market and builds awareness. “The first thing to understand is that Vonage is profitable on an operationalbasis,” says Miller. “including sales and marketing costs.” In other words,each customer is profitable for the company, giving Vonage room to reduceprices if necessary. Miller says that although the company is growingrapidly, “it is growing prudently — as fast as it can absorb customerswithout 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, andfeatures such as virtual numbers, and additional lines. Even without addingoperation costs, it would take Vonage 15 months to recoup marketing costsfor its basic “unlimited service” customer. Adding up the cost side of the equation pushes the profitability horizon outeven further. A conservative estimate for equipment is about $40 percustomer — the Linksys PAP-2 telephone adaptor Vonage now ships to newcustomers wholesales at about $49. While call termination costs varywidely, economies of scale mean that Vonage is probably paying an averageof 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), whichincreases with the number of subscribers.So, reckoning the cost of providing service into the equation pushesprofitability out into the second or third year of service. While companieslike AT&T have deep pockets to absorb these costs until the marketmatures, Vonage could find itself hurting if the market doesn’t grow asquickly 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 orbusiness in the world with high-speed Internet access — that even a smallslice represents a very healthy business. According to a recent Wall StreetJournal article, industry analysts project annual growth rates of more than220 percent for the next five years. In other words, plenty to support plentyof suppliers.The challenge, some believe, is for Vonage to adapt: From the biggest troutin a small pond to one of many whales, some much bigger, operating in anexpanding ocean. “The trick for Vonage,” says Yankee Group’s Griffen, “is getting thecompany’s long term plans in line with how the market will evolve. Thecompany 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 Vonageshould continue to innovate on a service basis.” One VoIP supplier that concurs with this analysis is VoicePulse, whichlaunched its broadband phone service in 2003. VoicePulse has developed itsown switching platform — unlike Vonage — which CEO Ravi Sakaria saysgives the company an edge in delivering advanced features. “What I see in the market today could be compared to a group of peoplehuddling 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 thatnumbers several startup VoIP companies in its client base — says that onehurdle Vonage faces is simply the fact that customers have to make adeliberate decision to change. Traditional service providers can make that
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