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Vonage Churn Investor Heartburn

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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!

33 Responses to “Vonage Churn Investor Heartburn”

  1. It’s interesting, and perhaps telling, that most of the criticizing arguments are based on fundamental analysis of the financials and the supportive ‘buy’ statements are based on perceived customer service and personal experiences.

    Consider the mass market for IPOs – and especially where Vonage cashed in most of its shares. In approaching a generally uninformed public (as opposed to relying solely on traditional insitutional investors), I would say Vonage succesfully leveraged their existing marketing channels to raise exit capital for their investors. Granted they slipped up in the process, but from a strategic point of view, the dual approach of marketing the product/company seems to have worked out.

    Perhaps we’ll see more of this in the future? I’m thinking of Mark Zuckerberg’s holdout on Facebook and the recent Skype acquisition as overvalued branded products showing up on the capital market.

  2. I have been a Vonage customer since ’03. The only ‘service’ problems I have had were due to my ISP (Adelphia) and not to Vonage or the hardware (made by Cisco). I live in rural Vermont and the cost of landlines here is outrageaous, however, on the 911 issue, if I loose power or net service, I can plug my phone into the landline to dial 911.

    In regards to competition from packaged services by cable operators, you do not have to mobility that you do with Vonage. I tried a smaller VoIP provider before going to Vonage. I switched because the quality of calls with the smaller guy was horrible and touch and go. I have never had that problem with Vonage. I use alot of bandwidth here and it has never interfered with my phone calls.

    I am pleased with the customer Direct Share Purchase offer and despite some otherwise (potentially) troubling issues with the IPO, I am in and believe that it will go well. Name recognition, portability, and bottom line cost of service cannot be beat. BUY!

  3. The only place you can get a job that you can depend on its still being there would be the government!

    It seems to me that the companies that come into existence trying to undersell Vonage will fail even faster. Vonage has the advantage of name recognition. If they can outlast those who try to give it away, and the ‘RBOCS’ ( An obsolete term in my view) and cable companies calculate that VOIP has little ‘bang/buck’ for their tastes, Vonage could end up with all the marbles. Phone companies and cable ops. are concentrating on “content” for the foreseeable future because there is no money in bandwith going forward.
    Would I buy Vonage? Not since I got out of the stock market because Roulette looks more promissing.

  4. Also note the customer acquisition cost is typically rising as the installed base increases, especially as they rely heavily on infomercial TV advertising. On a TV networks – e.g. Vonag is big on USA Network – you are pretty much hitting the same viewers over and over again. Assuming there is a potential of say 200k customers amont a networks audience, and paying the same cost per TV spot, you would see the CAC rising by 100% once you already have signed up the first 100k of your 200k potential.

  5. Eliminating the first thirty days of churn would at the very least require the elimination of these sales from the acquired customer numbers and thus increase the recorded cost of acquiring a new customer. I see no notes to the effect that this has been done. Either way I find this practice has no virtues and makes it to easy to hide issues. Say for example the number of customers who acquire the technology but give up in the first month is considerable and growing as the product life cycle moves from fairly technology adept innovators to less adept adopters, this trend would be completely hidden. No, the first thirty day losses have to be included in churn. I have firsthand experience with Telecom churn and the effects of winback, and losing 25% of acquisitions in the first month is all to common. I wish I could make that disappear by simply applying my own definition but real business life isn’t like that. What happens when the incumbent telco’s start more agreesive winback …Von just makes that disappear with the wave of a dictionary?

  6. Churn at 2% really isn’t that bad relatively speaking in telephony – that’s the same as the average across the entire wireless industry and it’s a lower than the old res LD business and most CLECs. That’s why Vonage’s financials are actually in far WORSE shape than it appears. For a service just coming out of an early adopter mode they already do a good job on churn. And still their financials are horrible – it’s really the ARPU (market driven and falling), ongoing COGS, and marketing costs that are killing them. As long as ARPU keeps declining (a virtual certainty) and marketing costs remain as high as they are I don’t see how they even come close to profitability – ever. The one thing they can reasonably control is churn, and that’s already in decent shape. The rest of the variables are out of their hands unless they go to a more efficient (and far slower growth) sales and marketing model.

  7. I use Vonage and I have to say they are pretty good; they probably just need to curtail their go go internet era spending on marketing; my only issue with cable provided voip is when I need to move, it’s a pain to switch from them; plus the other thing is large telcos/cable firms are not known for innovating and adding new features quickly like pure internet companies like google, etc.

  8. High Infant Mortality Rate

    Om, the churn in the first 30 days is a big but expected problem. A significant percentage of people since the early days of personal computers have bought gear, and found they couldn’t make it work when they got home. That will be true of many Vonage customers as well. Jennie bought Vonage as a gift for a friend a while back, who never hooked it up. (Intimidated by the technology.) Some folks who try will discover router configurations problems, inadequate upstream cutting quality, and other difficulties, like calls being dropped when they are downloading. So many folks just cancel service.

    DSL in the early days had a massive problem like this. It was partially solved by things like better instructions, improved help phones, and proactively noting which new customers weren’t actually using the service and a support tech calling them up. All this took time and money.

    So you're right to include this as a major problem and expense.


  9. Some thoughts:
    1) Service providers usually do not pay retail commissions for gross adds that churn within 30 days.

    2) Vonage makes variable margin per sub of $17.5 per month (excluding the fixed costs for SG&A). It pays acquisition cost of $242 per gross add. At a churn rate of 2.1%, there is a substantially positive lifetime value per gross add. Please remember that fixed costs of SG&A are unlikely to grow as rapidly as the subscriber base.

  10. the churn and acquisition analysis is great, but look at the subscriber growth rate, subscribers are growing but the rate of growth has dropped dramatically, compare that with Time Warner or Cablevision growth rates and Vonage is falling behind, throw in the competition from RBOCs like Verizon who are starting to offer price comparable plans over copper as well as the bundles from the cable companies and competition is only increasing for Vonage

    lower growth + higher churn + higher acquistion cost + more competition + lack of competitive advantage = a company that won’t make it

    however, the IPO probably will do well and the stock would jump on the first day because the company has a high amount of brand awareness and your average retail investor isn’t going to analyze a company this much, they are going to buy on the hype

    wasn’t the company trying to sell itself? it seems like that is the better road for it? this all may be another attempt to get someone to buy them before the company goes public and the valuation becomes inflated

  11. The hardware costs and service start-up support costs also need to be factored in. I don’t think they are included in the marketing costs and may not be in the $8/mo. COGs. In the ISP and shared server web hosting business, the price competition is so intense that you are effectively gambling that the customer won’t call support > 1 time in the first month, and thereafter never (use the FAQs, bury the tel support number). One call puts you into a negative margin on the account.

    The other aspect of Vonage’s business that is crappy is they are a 1 trick pony: voice but no video or other bundled offerings. Between the telcos and cable cos who can offer bundles and who can roll a truck for install and support when needed they are will lose.

  12. Note that the $213 per customer doesn’t include the costs they pay for the ATA, rebates, the promotions where they give them away, etc. That cost is hiding under “cost of goods sold” rather than marketing and therfore not part of what they are reporting as acquisition cost.

    Also they calculate the MAC as a simple average, but hint that it is on the rise, so one has no idea what the MAC run-rate is.

    The other thing that looks a bit fishy to me is the steep increases in G&A. Either they have a very poorly scaling business, or they are hiding other ‘marketing costs’ or something in there too. Look at how fast it is increasing compared to subscribers.

  13. 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.

  14. Sunil Chhaya

    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.

  15. 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?

  16. 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)

  17. Andre Oppermann


    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.

  18. 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 $.