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Vonage: Worst IPO Candidate This Year?

A story is emerging that some folks on Wall Street think Vonage is shopping itself around as a takeover target, rather than an IPO.  S1’s have been filed, but there has been no further action.  Furthermore, Vonage continues to chew through massive amounts of capital, without any sign of abatement. 

Vonage may be the worst choice for an IPO this year.  Why?  Two words: price elasticity. In economics, price elasticity is the notion that propensity to buy varies in proportion to price.  Drop the price, volume goes up.  For some kinds of products, notably commodities, this relationship holds true.  It’s the classic "Vinnie — drop the price, we’ll make it up on volume!" gambit.

This graph is something I sketched out from publicly available FCC data.  It shows daily usage (in minutes) of the telephone, sketched against price.  Notice how, as price drops, minutes increase.  Voice minutes, it turns out, are price elastic.

Price Elasticity

Now, consider the following thought experiment.  What happens if the price of the underlying commodity (voice) drops to zero, or near zero?  After all that’s what’s happening in voice today.  The graph I sketched out shows the cost of minutes at about 10 cents.  It ends in 2001.  Today, in 2006, that cost is at 2 cents, and still in free fall. 

If the price goes to zero, usage should skyrocket.  If usage skyrockets, then the costs associated with running the network also rise.  Cost basis increasing, revenue decreasing… does this sound like an IPO to you?  Not on your life!

Not only does Vonage have the problem just described, it also has all of the same customer retention, and customer acquisition costs of the big telcos.  It simply started with a lower cost basis, which allowed it to price itself aggressively into the market.  Despite what Vonage says, its business is no different from the incumbent carriers — the guys who are losing land lines at 10,000 lines per day.

So I find myself drawing the same conclusions as Om Malik

Who is going to buy them? Isn’t that the billion dollar question? Gorbatenko suggests Qwest, but I find it hard to buy into that. I think like the IPO, finding a buyer would also be a big challenge for the company.

And that, my friends, is the crux of the problem.  Buying Vonage, or buying into the Vonage IPO, could be the ultimate triumph of greed and stupidity over common sense.

Friday March 31 — Update: This generated quite a bit of traffic.  Suffice it to say, there’s some solid research and thinking behind what I am saying here, which is going into a presentation I am preparing for VON Canada on Monday.  I’m writing about the IP Telephony industry in general.  It just happened that the Vonage piece appeared yesterday in CNN and I had some ready analysis to contribute to the discussion.  Stay tuned. 

{ 12 comments… add one }

  • Jack Bennings March 30, 2006, 11:58 pm

    I switched over to Vonage a month and a half ago since my former telephone carrier did not service this part of Weston, Florida and they still can't complete the porting of my telephone number. As I sent a very pointed email to Vonage's CEO they'd better be more concerned with satisfying their customer base and working with their prospective new customers than worrying about an IPO.

    I agree about the IPO consideration, they'd be better off concentrating on the business basics of taking care of in-house problems instead of trying to go public. If you can't change someone's telephone over to Vonage in less than 45-50 days when you say 20 business days … something is definitely wrong.

  • Zak March 31, 2006, 9:15 am

    At the end of the day, strength lies with those who are owners of the network. Vonage must leverage its critical mass to truely leverage its business model, and that model cannot be executed at a national level giving the state of the competitive market it is almost easier to execute this model on a local level where everyone can sign up to the ip network. Also, i have serious questions about the business management– where the philsophy is to spend as much money as possible..i also can acquire thousands of customers by saying free…..at $180 plus per customer…you might as well give free…..

    Regards,

    Zak
    CEO

  • Derek Kerton March 31, 2006, 2:21 pm

    Some of the assumptions you make may well be wrong. Are there not limits to the amount of Minutes each person uses a phone per day? There are limits, and these will impede MOUs from “skyrocketing”. The math and graph you display and discuss are ignorant of these limits, so you should introduce them into the analysis:

    There are only 24 hours in a day, so no matter how low the price drops, users still won’t exceed that limit. But there are other practical considerations, too. People tend to sleep, eat, go out, study, work, watch TV, surf the net, speak to others face-to-face, and a couple of other activities that burn time each day, but don’t translate into telecom MOUs. This means that the yellow line in your graph can be expected to taper off to the horizontal at some limit. At the limit, there would be NO price elasticity. And in fact, the evidence you show (the graph itself) suggest that this limit may already be reached (the usage AND price both dropped in the last leg).

    I’m not arguing for or against an investment in Vonage here, but merely that your assumption that the graph above has no natural contraints is incorrect.

  • Alec March 31, 2006, 2:50 pm

    It’s true Derek. The graph does have a natural limit, bounded by how much we are willing to talk in any given day. Even if the yellow line does taper off, though, it’s unlikely to fall. Prices, however, do continue to fall. You are right though. Usage of telephony, in all forms, continues to grow at this point, but that doesn’t mean it will continue to grow for ever. More on this later. The research I am doing at the moment is part of a presentation I’m building for VON Canada.

  • skibare April 2, 2006, 8:38 am

    Why buy vonage when you can get SunRocket for $17 per month??? Nobody is going to buy Vonage in their right minds
    Skibare

  • Brian Jerome April 2, 2006, 5:09 pm

    Vonage has already gone through approximately $250 Million plus, almost all of it on advertising. I have heard some estimates of $15 Million per week. They say they have approx. 1 Million customers. Taking them at their word, that equals $250USD per customer as an aquisition cost. They will never recover that. EVER. So all that money is basically gone, never to be seen again. VERY bad business decision. But hey, live and learn. At the end of the day, Vonage will probably go into bankruptcy and their customers will be looking for a new home. Asterisk is the way to go anyways, everything else is pretty much obsolete. With the availability of IAX2, SIP/h323 will be slowly phased out, making skype and vonage dinosaurs…….of course that is over time, but it is heading that way. Forget those guys, Mark Spencer is the genius. http://en.wikipedia.org/wiki/IAX http://www.asterisk.org

  • Dali April 3, 2006, 5:00 am

    I think the $250 per customer can be recovered in 1-2 years as the revenue from one customer per year is about $250. Actually, per their word, Vonage has 1.5 million subscriber as of end of March. Also, don't forget that the advertising cost you're mentioning ($250 million) will not increase proportionally to subscriber number increases, or I would say will stay about the same even with 6 million customers. The word of mouth will play a decisive role here, I think.

  • Matt May 8, 2006, 8:17 pm

    "Also, don't forget that the advertising cost you're mentioning ($250 million) will not increase proportionally to subscriber number increases,"

    Actually, if you read their prospectus, advertising costs have done exactly that. In fact, since 2003, it's been getting worse. In 2002, marketing was $11 million and garnered revenue of $18 million; in 2005, marketing was $243 million and garnered revenue of $269 million. However, even if their marketing costs were 0, they would still have lost money (about $18 million). Their non-marketing costs are still higher than revenues.

    You are correct that eventually this will level off. However there is nothing to indicate when it will do so. Further, they continue to act as if they have not reached it. In the first quarter of 2006, marketing was $88 million; $33 million more than the first quarter of last year. In the prospectus, they say they will use the IPO money to continue running operating losses and to finance even more marketing. No talk of resting on their laurels and relying on word of mouth.

    It's also worth noting that Vonage is *already* the biggest purchaser of online advertising. If anything, the rational choice at this point would be to level off marketing. If they set marketing to 25% of current levels, their growth would be slower but so would their costs (there are non-marketing costs to growth as well). They would still be the biggest advertiser.

    Vonage also fails to show any reason why they would make money in the future. Do they have economies of scale? They seem to lose money on every customer (even without marketing). What's going to change? When is it going to start changing? It seems that the best hope for Vonage is that some entering the market might want to buy their market share. Unfortunately, I've seen no evidence that anyone is willing to pay the premium ($14 per $17 share) that they are requesting. It seems more like a $5 stock ($3 book value plus another $2 for market share).

  • Trever May 12, 2006, 8:12 pm

    The thing that the graph and none of the conversation really reflects is the fact that no matter how much people use the service, there isn't much overhead of a VoIP phonecall (cost wise). If someone places a local call, a long distance call or an international call, Vonage is only having to pay local LEC fees since everything is being routed over the internet. Not to mention the fact that as the Vonage customer base continues to grow, vonage-to-vonage customer calls will be placed that cost virtually nothing, if anything, to connect.

  • Steve May 17, 2006, 2:17 am

    …”It seems that the best hope for Vonage is that some entering the market might want to buy their market share. Unfortunately, I’ve seen no evidence that anyone is willing to pay the premium ($14 per $17 share) that they are requesting. It seems more like a $5 stock ($3 book value plus another $2 for market share).”

    I’m wondering where you came up with $5 stock (3/2)? At $2 per share for 1.4 mil customers, considering they are only offering 31 mil. shares with 155.7 mil outstanding–is my math correct in putting your customer valuation at about $44? That’s almost 1/6 of what they are willing to spend per customer, putting market share stock value at about $11, not including anything for book, brand recognition and growth potential, I’d say their valuation is about correct.

  • Alec May 17, 2006, 8:04 am

    Trever – I think the point about low overhead is in my original post. The cost basis to provide Vonage’s service is lower than a traditional telco (although, not by much).

  • Clayton March 30, 2007, 1:22 pm

    The end must be near. Search for “Vonage Domains” on eBay and you can get domains poised for Vonage’s death…

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