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 […]

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!

  1. Oh…..this is very interesting…

  2. Justin Gardner Friday, February 10, 2006

    Great research.

    Certainly opens my eyes to the sustainability of VoIP.

  3. Andrew Schmitt Friday, February 10, 2006

    Gee! Looks a lot like the RBOCs! Without the installed base!

  4. ok please excuse my ignorance on this: so they spend $213 per customer to acquire them. then receive on average $26/month in revenue from them. So right now their gross receipts come to $312/year per customer, subtract the acquisition costs, and you have roughly $99 in revenue the first year from these people, and then they have to hope to keep them after that in order to make real money off of each one. But then it says they spend $8/month keeping them, so there goes another $96…. seems to me like they need to put in a cancellation fee, or make the customer return the hardware at least. I had their service for a year, cancelled, and was never told how to return the voip box. surely that has to cost them $.

  5. Andre Oppermann Friday, February 10, 2006


    please be aware that the term VoIP has many meanings. The technology is ok, it’s the VoiceOverInternet using VoIP technology which has a problem with its business case.

  6. lets get this right

    Churn has been a tried and tested measurement amongst rbocs, switchless resellers and the larger telecom industry for decades.

    You overlook the importance derived from churn. Churn is a key variable in the calculation of average customer life. once you calculate this (i dont have the doc in front of me otherwise i would) you can measure against your cost of acquisition and establish what is called a ‘one account’ this is the true tell tale of how the comapany is doing as it will also drive what your marginal cost per new user is.

    Someone calculate the one account and put us out of our misery on how poor this business is doing (guess)

  7. I should mention – customer life is defined as 1 or 0 and its break point is < or > 50 obviously

  8. Having run a subscription service (Rhapsody), I can say it’s simply misleading to remove the first 30 days of churn from an equation, based on how most other companies measure churn. The only way to really do that is if the first 30 days were free, in which case you have an internal measure for conversion from free trial, and then you start measuring actual churn at day 31. Why not just remove the first 90 days while they’re at at it?

  9. Vonage is great and has worked for me since 2003. I believe that the trick with getting profitable is to raise the customer base as fast as they can, and do it at as low a cost as possible. From the numbers, they have 1.4M subscribers, with the average gross monthly profit to be about (26.44-8) = $18.44. If they are spending 213.77 to acquire and losing 2% monthly (isn’t that 24% annually? actually it should be 1.02^12-1, which is more than 24% annually), then, the acquisition costs go up by that factor (i.e., they have to get those many more people signed up, as Om mentions), which is 1.2847213.77 or $274.63 per customer that stays with Vonage rather than quits. This puts a payback period of 274.63/18.44 = 15 months. If the churn doubles, or if it’s calculated incorrectly by ignoring the first 30 days, this payback period goes to (1.04^12)213.77/18.44= 19 months.

    The other problem is declining revenues because of the competition. I think that Om has probably mentioned this earlier but Vonage’s ambition for the exit strategy has to be through strategic sale. In the environment with the cable companies being the 500 pound gorillas, and the landlines being obviated by wireless (albeit at a slower pace), the trouble with Vonage’s fundamentals is two-fold.

    Firstly, its potential market (although expnading) is only the broadband users (about 40M today?), in which it has a market penetration of 3.5% (1.4M/40M). Therein lies the first problem – people are not interested in switching to a phone service where you have to keep intervening to keep it running. I have had to reset the Vonage ATA adapter several times, and twice I had quality issues with it. So, the plug-and-play simplicity and the availability of service are not up to the mark, not to mention that e911 is an issue and without power and/or active broadband connection, there is no phone connection. It will also make an interesting survey to find out how many of the broadband owners are about to switch away from a landline phone altogether, if they haven’t already. So, landline phones are a shrinking market.

    So, Vonage has a limited broadband market, declining revenues, increasing churn, heavy competition with deep pockets (in the form of cable companies), an overall declining customer base (potentially switching over to wireless), and new upstart competitors such as Skype.

    Would I want to invest in this business? No.

  10. well you almost get the calculation right – what you are beginning to identify is the all important mariginal cost of adding 1 subscriber.

    No its not 24% annually. that is straightline – you dont calculate it straightline – woops! i just read on and you get it right. So the delta of your customer lifetime revenue (calculated by a one customer over churn) – your COGS (8) + fixed costs = your one account.

    What they need to be doing is fixing their variable costs and improving their marignal cost of adding a subcriber. Does not look good.

    Secondly – exit? in our business there are 2 exits – a sale and an IPO when you refer to their exit i thnk you ignore that this offering is providing just that.

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