Vonage, The Worst Tech IPO Since Pets.com (VG)

| About: Vonage Holdings (VG)

Ok, I’m being a bit facetious about the Pets.com comparison, but really… Vonage (NYSE:VG) is a horrible IPO to invest in. Avoid it like a rabid dog stumbling down your street. The company is nowhere near turning a profit, is spending crazy amounts of money on advertising (Super Bowl ads with sock puppets, anyone?), and is facing some of the most intense competition of any industry I track in the technology space.

Investors on Crack
The most surprising fact to me is that there is surprisingly robust retail investor demand about this stock. (You can find rants and raves from Mark Evans and Bottom Priced.) What I notice is the “Peter Lynch” and Motley Fool style of rationalization… Don’t get me wrong, I’m a big fan of Peter Lynch, but I fear that Vonage and WebVan are perfect examples of how individual investors can be lead astray by investing in companies that they are customers of. Let’s breakdown the pros and cons.

The Good: Vonage the VoIP Pioneer
Vonage was the early innovator in VoIP services for consumers and SMBs. For a low monthly flat fee of $25, you can spend an unlimited amount of time talking to anyone in the US or Canada. The company has 1.6 million subscribers as of April, by far the leading independent VoIP provider. VG is widely considered to have the greatest consumer mindshare, and has been growing revenues by about ~500% from 2003 to 2004, and ~300% from 2004 to 2005 — impressive by any standard. Consumers love the Vonage low price, the ease of installation, and the catchy commercials (you know the song I’m talking about).

Why Vonage Sucks
First and foremost, the company is bleeding cash. The company burned through $190 million in cash from operations in 2005, and another $150 million in investing activity in the same year. What’s more worrisome is that the company is unable to sustain pricing control in the market, as Skype, the cable companies and the telcos all roll out competively priced products. And consumers are notoriously fickle in having zero loyalty to telcom service providers, switching long distance carriers and local providers as soon as they get a good deal.

Pricing and revenues - Vonage charges $25 a month. In a year, that is $300 of revenue. As the consumer uses the phone service, Vonage pays a third party to “terminate” the call - this costs somewhere less than a penny a minute today in the US, but does add up if a consumer family is on the phone for say 2,000 minutes a month. This direct cost of telephony services costs VG about 32% of their total revenues. This leaves about $200 of gross margin dollars per account per year.

Customer acquisition - The company currently spends about $400 to acquire a new customer. In 2005, Vonage spent $243 million on marketing costs alone (doesn’t it only cost a couple of million for a Super Bowl ad with a sock puppet??), or about 94% of their revenue!!

ROI - Now, even without talking about capital equipment costs, customer premise equipment subsidies or paying employee salaries & rent, the math starts to look funny. Vonage is paying $400 to get a customer… but only making about $200 a year from that customer. That seems like a crappy business, especially given that pricing and revenues will likely further erode soon from all the stiff competition.

The Ugly
At Vonage’s valuation of $17 a share, that translates to a value per account of $1,600. Now after the brief math we did above, someone please tell me why I should pay this much value for a Vonage subscriber?

The competition is lead by cable company Time Warner (NYSE:TWX), which is signing up VoIP customers like gangbusters. Word is that they have about 1.4 million subs today. They simply bundle VoIP with their cable and Internet package, and offer the household a single consolidated bill that includes all three services. Brilliant and simple. And it costs MUCH less for a Time Warner or Comcast to market and sell VoIP service to their existing base of cable customers — whereas Vonage has to sign up a brand new customer that they have zero relationship with.

Word in Silicon Valley is that Jeff Citron (former CEO) is selling $80 million in the IPO, essentially cashing out a big portion of his stake. This tells me he doesn’t believe in the future of the company. This is always a red flag in venture-backed companies. You didn’t see Eric, Sergey or Page of Google selling shares the day of the IPO, did you?

Vonage in Trouble
The math doesn’t make sense to me, and worse still, I can’t see anyone acquiring the company. The cable guys have product already, and the telcos aren’t likely to step up either. Both camps are well capitalized to fight a long price war with Vonage, have large installed bases of existing customers that they can sell to, and most importantly — they control the pipes going into each house.

This stock is a dog. With bad fleas. Stay away.

Additional recent articles on Vonage (VG) include:

  • John Ogg and Evelyn Rubin's quick previews of the IPO
  • The Stalwart on Vonage IPO Gets Uglier and Uglier
  • Himanshu Pandya on Skype's threat to Vonage
  • Andrew Schmitt on Vonage IPO, Grassroots Desperation
  • All Vonage coverage on SeekingAlpha
  • Check out additional IPO coverage on SeekingAlpha's IPO Analysis page.