VoIP's threadbare new clothes
Om has burnt the midnight oil analyzing Vonage's S-1 filing, coming to the conclusion that, while churn may not be as ugly as people thought, it's still cause for concern, and apparently intensifying. His point at the end about definitions is particularly good, as excluding cancellations in the first 30-days is undoubtedly flattering to the numbers.
The net present value of Vonage's lifetime customer revenues is an issue which VoIP-watchers have long speculated about with trepidation - what if marketing spending, churn, and price competition combined to form a toxic soup which fatally poisoned the economic proposition for access-independent VoIP? In other words, if the discounted lifetime value of a customer's expenditure is not considerably greater than the cost of marketing and delivering the service over that period, then what incentive is there for investors to get involved, because the business is unsustainable?
Looking at some of the metrics Om is writing about, let's take a stab at a valuation. ARPU in the first nine months of 2005 was $26.63, and with churn of 2.11% (excluding the 30-day cancellations), we get lifetime revenues of $1278. These should be discounted over the lifetime of the subscriber at an appropriate discount rate, let's charitably say 8%, which gives us a net present value of lifetime revenues of $1143 per sub. That's a $1.6bn valuation based on current subscriber numbers! But wait, this only works if pricing stays stable, and Vonage's ARPU fell at a CAGR of 20% between Q3 2003 and Q3 2005. Plug that assumption into the subscriber lifetime of four years and net present value of lifetime revenues drops to $879. Increase churn to 2.5%, and it falls to $792. Take churn to 3% and it's $708, which suggests a market valuation of $991m for the company. With very little effort, and some frankly benign assumptions, we've nearly halved the value of the company. Pick your own assumptions about competition levels, pricing, marketing expenditures, discount rate, and you can come up with all manner of scenarios ranging from a decent return to complete annihilation. I assume this is what potential investors are going to be doing over the coming weeks, and my gut feeling is that the $1bn mark is what will be aimed for.
My nagging question is why didn’t Vonage move earlier, while it still had the momentum of being market leader and the undivided attention of adoring potential investors everywhere? I first spoke to Vonage in the autumn of 2002, and wrote about the implications of the business model and technology (as well as Jeff Pulver’s Free World Dialup) for Europe at that time. It was an eye-opener for clients, and they were both appreciative and intrigued. By the following autumn, Vonage fever was in the air, and in October I accompanied John Rego and Brooke Schulz from Vonage on a mini-roadshow of our clients in Europe, not because we were angling for a banking mandate (we assumed that any forthcoming Vonage offering would be too small to involve a Japanese tranche), but rather because I knew our clients would be eager to meet the company and it would score some Brownie points for us. Visibly enthusiastic fund managers greeted us everywhere we went, and in every meeting the question of an IPO came up. One very bright fund manager stressed his view that, despite the small subscriber numbers of the time, the market would be inclined to be generous in its assumptions of future growth, and accordingly he thought the company would command a valuation of $1bn.
This was late 2003, Skype had just been born, and there was little inkling in the broader market of how the voice proposition was about to be turned upside down (though some would have said that the writing was already on the wall). Vonage was only 1/20 the size it is today, but it was the state of the art at the time. Perhaps $1bn would have been attainable given the attention the company was receiving at the time, as well as investor views of the likely progression of voice services in the future. In the intervening 2.5 years, however, all hell has broken loose, in Europe the alternative DSL and cable players are running away with the market for the most part, and employing some of the disruptive tactics of access-independent players in lowering costs and eroding legacy telco pricing (we will see more and bigger peering deals, mark my word). And legacy telco pricing, after all, provides the essential raison d’etre for access-independent VoIP as a commercial proposition. Once it goes, there is no model.
I think the smart money has already moved away from this issue, realizing that the next chapter of value creation is in integration of voice with other applications/behaviours, where presence, identity, collaboration, search, commerce are all essential and natural ingredients. I don’t see an easy migration path for Vonage into this new world. So, an uncharitable view of the situation would be to say that the long term business model for access-independent VoIP as a standalone proposition has to be an exit strategy. Fair enough, I just don’t understand why Vonage has waited so late to begin the exercise. I don’t necessarily think the ultimate fate of the company would have been any different, but I do believe getting the deal to fly would have been a lot easier three years ago than it may be today.