Vonage: Rocky Road, not Road Kill

The remarkably uniform pessimism regarding Vonage’s prospects, reflected in the share price, would lead you to believe that Vonage is on the death bed, gasping its last breath. The $58 million potential payout to Verizon has the gravediggers out in full force. The B-word is being thrown around. However, Vonage’s reported results and financials do not support a conclusion of imminent demise.

The supply and demand mechanism of the stock market reflects investor sentiment, not company performance. Vonage fan club meetings have become increasingly lonely affairs, as investors discount for the fact Verizon wants Vonage to die. That is ironic, because Vonage is less than 1 percent the size of Verizon.

Anyway, the loss of this patent case is not as desperate a situation as most think. In the most recent quarter, Vonage used only $28 million of its $500 million cash reserve; so paying Verizon $58 million (if the companies don’t settle for less) does not threaten bankruptcy.

Secondly, Vonage gets $16 per month of incremental margin from each subscriber addition, so an injunction requiring payment of 5% or $1 per month per line does not destroy the prospects for profitability.

In a quick-to-judge reaction, many have forgotten that the successful imposition of E911 requirements on VoIP companies in 2005 cost Vonage more than the worst-case scenario outcome of the patent dispute. And the application of Universal Service obligations in 2006 added another $1.25 per line to Vonage’s costs.

Somehow, Vonage has survived, and posted impressive growth over past five years, if not profits, mostly because it adopted the flat-rate-plan that is typical of Internet companies. With that move it has forced a radical change in the incumbent business model of charging per minute, thus forcing new pressures on incumbents’ revenue streams. To compete, incumbents have to deal with the flat-rate voice plans. And maybe that is why the Bells want to see Vonage die.

Here is a little historical perspective. The breakup of AT&T in 1984 did not eliminate monopoly control over local telephone service. The Telecom Act of 1996 removed restrictions on long distance and consolidation setting up Verizon and AT&T with $200 billion in revenue.

The Bells defeated the wannabe competitive local exchange carriers created by Telecom Act (and $500 billion of investment capital). They now own the long distance carriers they once dueled with – MCI and AT&T. CLECs are all but gone, though a handful are hanging around.

So what makes Jeffrey Citron hope for a different outcome? The Internet! MCI used microwave transmission to overcome barriers to entry associated with the wired networks. Vonage leverages the Internet to similar ends.

The pristine anti-competitive track record of Verizon et al suffered its first blemish with the defeat (for now) of efforts to unwind net neutrality. Vonage’s national reach makes it difficult for the regional Bells to apply a price squeeze (raise costs and reduce revenues) that worked so well against the CLECs and LD companies. The cost side of the strategy is working, but the relatively high price umbrella allows Vonage to pass through the cost of the E911 and USF to customers.

Vonage can take a similar approach with any patent royalties or just go with a generic line item called anti-competitive pass-through fee.

A low stock market valuation does not directly impact prospects until Vonage needs to raise additional capital. Funds obtained through the IPO leave Vonage flush through 2010. Status as Jim Cramer’s most hated stock does not help morale, but Citron needs the endorsement of customers more than investors. As long as they keep voting with their subscriptions, reports of Vonage’s demise are still an exaggeration.