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Dial Up Profits With Vonage, a Busted IPO Favored By Insiders

By Michael Brush
Exclusively for InvestorIdeas.com
August 25, 2006

For years, the allure of cheap Web-based phone calls through a technology known as voice over Internet protocol (VoIP) has captured the imagination of consumers and investors alike.

So it was a surprise to some when investors recently hung up on the initial public offering of Vonage (VG), the first big pure play on VoIP. Since coming public at around $17 in May, Vonage shares have plummeted 59% to $7. That makes it a classic “busted IPO,” or an IPO that promptly falls below its offering price.

Down here, even the normally bullish sell-side analysts of Wall Street don’t think much of Vonage. They have a lukewarm “peer perform” ratings on the stock at best. They’re worried about poor customer service that’s recently ticked off lots of Vonage customers. They’re also concerned about downward pressure on pricing for Vonage service as a kind of fallout from the battle between phone companies and the cable guys.

While Wall Street is on the sidelines, Vonage insiders are another matter. Since August 4, chairman and chief strategist Jeffrey Citron and a director, Sandy Miller, have purchased $3.3 million worth of the stock at an average price of $6.50, or just below recent levels of $7.10.

So which side should you believe?

As always when the analysts face off with insiders, I’ll go with the insiders. Just remember it will take months – if not longer -- for investors to feel confident that the issues plaguing Vonage are subsiding. Plus we can probably expect more broad market volatility as we head into the seasonally-weak phase of the year that lasts from now through Oct. 15. So it’s probably best to buy Vonage stock with limit orders set closer to $6.50 than recent levels of $7.

The basics

With VoIP, a caller’s voice is transformed into a digitized version and sent through packets on the Internet. Vonage customers get their service by plugging an adapter into their DSL or cable modems and connecting a regular phone to the adapter.

Vonage offers two levels of residential service. One plan costs $24.99 a month for unlimited local and long distance, including calls to the UK, Ireland, Spain, Italy, and France. A second plan offers 500 minutes of local and domestic long distance for $14.99 per month. About 70% of the 1.6 million subscribers at Vonage go with the more expensive, unlimited plan.

Indeed, that Vonage plan sounds like a good deal compared to the $35 a month that customers at traditional phone companies – and cable companies -- pay for unlimited phone service.

But investors don’t think the advantage is worth much. They’ve trashed Vonage shares. Here are their main concerns, and my own speculation on why insiders may believe they aren’t really serious problems.

* Customer churn. Investors are worried that the increase in customer churn rates last quarter to 2.4% from 2.1% is a sign that Vonage may have problems competing.

Insiders know that part of the problem was the company simply grew too fast – a nice problem to have. The company also moved to new headquarters, which made matters worse.

Vonage has also upped the budget for customer care, and this may bring down the churn rate after the current quarter, perhaps early next year, says Deutsche Bank Securities analyst Greg Miller. The churn rate will be a key metric to watch for investors.

* Stiff competition. Investors are worried that as phone companies and cable companies slug it out for customers they will offer great deals on bundled services like the so-called “triple play” of video, voice and data. Vonage will get caught in the crossfire and have to cut pricing so much to keep up, profit margins will suffer.

Insiders are probably thinking about several reasons why this scenario will not play out.

First, despite price cutting by the phone and cable companies, Vonage is still a lot cheaper. Phone companies like Verizon (VZ) charge $35 a month for unlimited service, plus a slew of taxes and fees. Cable companies are charging about the same amount for their version of VoIP. That’s considerably more than Vonage’s service – which goes for $25 a month. “We see the best opportunity at the low end of the market for customers not looking for the full triple play,” says Deutsche Bank’s Miller.

Besides, says Miller, many people are fed up with their phone and cable companies – and they welcome the opportunity to go with a third party for their phone service.

Vonage also offers features not available from most phone and cable companies. Vonage VoIP is portable – meaning you can plug your adapter into any Internet connection anywhere and get service. You can’t do that with VoIP offered by the phone companies and the cable guys. You can also choose which area code you want. Instant messaging is on the way.

Finally, the market growth for VoIP in the coming years could be enormous, leaving enough room for several competitors to do well. Currently about 45% of U.S. households have high-speed internet service, but that should reach 75% by 2009, projects Bear Stearns’ Michael McCormack. Only about 5% of U.S. households now have VoIP but that should climb to 21% or 24 million households by 2009, says McCormack.

“We believe this segment of the industry to be so under-penetrated that significant incremental inroads can be accomplished by several leading VoIP companies, in addition to the cable companies,” agrees Deutsche Bank’s Miller.

As a major brand name, after spending over $490 million in marketing since it started out in 2002, Vonage is likely to capture a big piece of the growth.

* A looming put option. Vonage raised nearly $250 million in convertible debt offering in December 2005. The debt matures in December 2010, but holders can “put” the notes to Vonage in December 2008.

This looms as a potential problem for the company, says Bear Stearns’ McCormack. But management believes the company will be cash-flow positive by fist quarter of 2008. That’s not too far-fetched, since marketing costs as a percentage of revenue will decline as the customer base builds.

Risks

One big potential obstacle for Vonage would be the loss of “net neutrality.” The owners of much of the Internet backbone – the phone companies and the cable providers – want to be able to give priority to traffic from their own customers or others who pay a premium. If the government goes along, Vonage may have to pay as well, or see the quality of service decline. That’s a wild card that could hit profit margins down the road.

The bottom line: An end to net neutrality is a risk that’s hard to quantify. But all of the other major issue plaguing Vonage shares may not turn out to be so bad. That’s what insiders seem to be saying with their purchases. Bear Stearns’ McCormack puts the fair value of the stock at $6, and insiders see value at $6.50. I’d be a patient buyer, and purchase shares closer to those two prices, rather than chase the recent rally spurred by the huge insider buying that just hit the tape.

Disclaimer
At the time of publication, Michael Brush did not own or control shares in any of the companies listed in this column. Mr. Brush is an independent columnist for this web site.
For more on Insiders Corner disclosure, see the disclosure section in About Insiders Corner: http://www.investorideas.com/insiderscorner/. InvestorIdeas.com Disclaimer: www.InvestorIdeas.com/About/Disclaimer.asp. InvestorIdeas is not affiliated or compensated by the companies mentioned in this article.

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