Vonage Churn Investor Heartburn

Vonage, the New Jersey-based VoIP services provider filed documents with the Securities & Exchange Commission yesterday, hoping to raise a whopping $250 million in a widely anticipated initial public offering. The marquee group of investment bankers are hoping that investors would over look the obvious structural problems in Vonage’s financial model, and buy the stock in the company. Business Week has a rather in-depth look at the chances of the public offering. The Stalwart does a stellar job as well.

I spent the evening reading through the entire document, which frankly has more red-flags than the great Boston dig. And the biggest one is churn. Why is churn important? As someone who has sold internet services to consumers explains, “Churn reduces the lifetime value of a customer which affects the amount you can pay to acquire them. You can see how these problems compound and exacerbate each other.” Something akin is playing out with Vonage.

“During the nine months ended September 30, 2005, we experienced average monthly customer churn of 2.11%. Our churn rate among those U.S. direct and retail customers with us for more than six months was lower,” the company says, in its filing. That seems to be a rather innocuous number. To be fair, the company’s churn rate of 2.11% is pretty darn good – if you compare it to other Internet related services business such as web hosting and DSL High Speed Internet that see about 1%-to-3%. Vonage is actually doing much better than it had reported earlier. [Talk about being wrong in my estimates previously. The numbers reported in the S-1 were exactly half of what I had estimated with the help of others. My original estimate was 4% churn and $400-per-customer acquisition cost.]

Vonage in its S-1 filing that it lost 115,000 customers to churn. Given that it costs Vonage about $213.77 in marketing expense to win a new customer, the cost of replacing those 115,000 customers is about $24.5 million. That churn cost the company about $27.6 million in revenues (@ $26.63 a month per customer) for the nine months ending September 30, 2005. The churn cost the company about $52 million (in the first nine months of 2005.) The problem is that the churn is not going away and is in fact rising — from 1.7% in first quarter 2005, to 2.08% in second quarter to 2.26% in the third quarter of 2005. The irony of this is that if the current trends continue, it would become a mud-pit without a bottom.

We will always be required to incur some marketing expense in order to replace customers who terminate our service, or “churn.” Further, marketing expense is not the only factor that may contribute to our net losses. For example, interest expense on our senior unsecured convertible notes of at least $12.5 million annually will contribute to our net losses. As a result, even if we significantly reduce our marketing expense, we may continue to incur net losses.

Buried in the S-1 is the fact that Vonage had about 1.4 million subscribers. At the average churn of 2.11% (assuming it stays constant), one could estimate that the monthly loss of customers is in the 29,450 range and the estimated monthly cost to replace them will be $6.3 million, while the lost revenues (per month) would be around $784,000. In the September 2005, the S-1 says the company had a churn of 2.26% which comes out to about 23,997 and lost revenues of $639,000. (If you use the 2.11% average, then the number of customers lost to churn are about 22,403 and lost revenues were around $600,000 a month.)

A higher rate of customer terminations would negatively impact our business by reducing our revenue or requiring us to spend more money to grow our customer base …. Because of churn, we have to acquire new customers on an ongoing basis just to maintain our existing level of customers and revenues. As a result, marketing expense is an ongoing requirement of our business. If our churn rate increases, we will have to acquire even more new customers in order to maintain our existing revenues. We incur significant costs to acquire new customers, and those costs are an important factor in determining our net losses and achieving future profitability. Therefore, if we are unsuccessful in retaining customers or are required to spend significant amounts to acquire new customers beyond those budgeted, our revenue could decrease and our net losses could increase.

Churn is a nagging worry, and yet if the company can reign in other costs, it could one day hope to be a profitable company. “If they can maintain a true churn of 2.11% and maintain a $213 (in acquisition costs), they should have a profitable business on paper,” says Chris Lyman, founder and CEO of Los Angeles-based Fonality, a start-up that sells open-source Asterisk based PBX systems. “The only problem is it takes them 1.25-to-1.5 years to break even on a customer. This means they are going to suck cash as they grow.” The price wars are already in place, and the competition from cable companies, the time required to get profitable is going to stretch out.

There is one aspect of churn which made me queasy but I clearly am not understanding the implications. In the ISP business there is something called bi-modal churn. This is people who decide to cancel the service within first 30 days of signing up. This number is pretty high in the 3% range. (Any telecom analysts who have thoughts and explanation about this, please leave a comment or email me.)

Vonage’s S-1 says this.

Terminations, as used in the calculation of churn statistics, do not include customers terminated during the period if termination occurred within the first 30 days after activation….Other companies may calculate churn differently, and their churn data may not be directly comparable to ours.

How many customers do you think they lose in the first 30 days? Still that is big pop for retailers like Best Buy who might actually become the only folks to profit from Vonage!