Vonage Calls With Encouragement

On May 10, Vonage Holdings (VG) told Wall Street some of the things it wanted to hear. During a conference call on first-quarter results, interim Chief Executive Jeffrey Citron said Vonage has come up with ways to keep providing its Internet-calling service that don’t infringe on patents held by Verizon Communications (VZ). Those alternatives, known as a workaround, may provide Vonage a much-needed lease on life.

Vonage, which began to develop the workaround after a court ruled it infringed on three patents held by Verizon, says it has hammered out a way to provide automatic software upgrades to customer equipment. The fix covers two of the three patents. If all goes to plan, Vonage will no longer be liable for royalties to Verizon. Nor will it be subject to injunctions against providing service and recruiting new customers.

Assurances Lift Stock That’s all good news for a company under pressure to trim losses. In the first quarter, Vonage’s loss narrowed to $72.3 million, from $85.1 million a year ago, as sales leapt 63%, to $196 million.

Another encouraging piece of news: Vonage is working on a workaround for the third Verizon patent. That patent relates to use of wireless devices with Vonage’s Internet-calling service, though it likely applies to fewer than 10% of Vonage customers, Citron says [see BusinessWeek.com, 4/25/07, "Vonage: Away from the Edge, for Now"].

The litany of assurances continued. Citron told investors he will cut costs and focus on profitability, and in an interview with BusinessWeek.com pledged to introduce more innovative features and keep improving Vonage’s customer care. During the conference call, Vonage Chief Financial Officer John Rego added, “We believe we have enough cash on hand to continue to fund our business to profitability.”

There was enough good news to lift Vonage stock 8.2%, to $3.30.

Beyond Patent Woes: More Competition But shares are still down 80% from last year’s high of $17.25, signaling investors need a lot more evidence that Vonage is out of the legal and financial woods. The patent spat with Verizon is far from over, and another one is just beginning with Sprint Nextel (S).

Even if those get resolved, accelerating competition from cable companies remains one of Vonage’s chief concerns. “The fundamental problems that Vonage has are not intellectual-property problems,” says Blair Levin, managing director at Stifel, Nicolaus & Co.. “They have a single product, and face a lot of competition from cable companies and telcos.”

In the first quarter, the U.S. Web-calling industry generated more than $1 billion in sales for the first time ever, and Vonage lost its crown as the Web-calling market-share leader to cable giant Comcast (CMCSA), according to consultancy TeleGeography [see BusinessWeek.com, 4/27/07, "Comcast Goes for a Grand Slam"]. At the end of March, Comcast, with 22% share of the market, had 40,000 more customers. Paul Brodsky, an analyst with TeleGeography, expects Comcast’s market share to widen in the coming quarters.

Luring Customers with New Features Concern over customer losses was heightened as Citron declined to provide guidance on customer turnover or subscriber additions for the second quarter. “We are not seeing a mass exit of our customers,” he told BusinessWeek.com. Still, “it’s too early to tell if there’s a negative impact” from the publicity stemming from the Mar. 8 court loss to Verizon, he added.

To keep customers from leaving, Vonage is improving customer service and rolling out new features. By deploying new call-center software and restructuring customer care, Vonage has recently been able to answer most customer calls in less than 90 seconds, and to solve more problems with just one call, Citron told BusinessWeek.com. As a result, subscriber satisfaction has jumped by 15% to 20% vs. a year ago, he says.

The company is also adding features to set its service apart from rival offerings. On Apr. 25, Vonage launched Vonage Text, a feature that transcribes and forwards subscribers’ home voicemails as text e-mails. It added automatic call rejection from unlisted numbers and do-not-disturb features. And Vonage is in early trials of other services not currently available from telco and cable competitors. With V-fax, users will be able to fax documents from their PCs and receive an e-mail delivery confirmation. With V-me, a free service, Vonage customers will be able to provide contacts with a way to call them without actually disclosing their phone numbers. The contacts will simply click on a link, received via e-mail, enter in their own phone number, and Vonage will facilitate the call.

Possible Legal Scenarios But Vonage won’t be able to fully focus on the cable and telecom threat until it gets beyond the patent tangles. Vonage is still fighting the infringement ruling through an appeals court. Whatever that decision, Verizon will almost certainly take pains to prove the workaround violates its patents.

From there follow any number of scenarios–none of which bodes well for Vonage. If Vonage loses the appeal, Verizon could file a motion of contempt, claiming that Vonage is disobeying the appeals-court order to cease infringing on Verizon’s patents, says Nolan Goldberg, a lawyer at law firm Proskauer Rose. If the court decided that Vonage’s workaround still infringes on the patents, Vonage could face stiff penalties. If, on the other hand, the court denies Verizon’s motion of contempt, Verizon could still file a new lawsuit, claiming patent infringement by Vonage’s new technology, Goldberg says.

For his part, Citron says he’s confident the workaround steers clear of Verizon’s patents. “Obviously, in designing the workaround, our team examined the Verizon patents very carefully,” Citron told BusinessWeek.com.

Executive Changes on the Horizon Other challenges remain. Vonage has promised to cut its marketing costs from $365 million in 2006 to $310 million this year to reduce customer acquisition costs, which keep rising. In the first quarter, Vonage’s marketing costs of $273 per subscriber were 11% lower than in the fourth quarter, but 30% higher than a year earlier. First-quarter marketing, selling, and administrative expenses rose significantly as well. Vonage has recently hired a new marketing chief and has decided to move from national to local ad campaigns. Other marketing changes may follow, Citron says.

And the biggest change of all has yet to be made. Vonage is on the lookout for a permanent replacement for former CEO Michael Snyder, who stepped down in April. Citron declines to say when the search will end, but notes it’s “going well.” That’s one more of the handful of news items investors and analysts are happy to hear.