Monday, September 4, 2006

Telio and Vonage Revisited � the Song Remains the Same

I may be the only one out there talking about these two operators in the same breath, and you know what? � I�m going to keep on doing it. Their IPOs were very close together, and in June I posted about them, and how they have taken two different paths to market while essentially being in the same business.

Last week, Telio posted its Q2 results, and Vonage did the same earlier last month. After having a cursory read of their filings, I felt it was a good time to revisit things and see if the storyline has materially changed. A line-by-line analysis of their filings may lead to such a conclusion, but a quick read was enough for me, especially since I�m following this space regularly. So, in short, my earlier position has only been validated by the Q2 results � Telio�s business model has a much better chance of success than Vonage�s.

Aside from Vonage�s post-IPO share price free fall, nothing dramatic has happened since their IPOs. The changes have really been incremental, and the Q2 numbers simply provide some substance to important trends that show how these two operators are on different trajectories.

First, let�s look at Telio. The big story there is crossing the 100,000 subscriber plateau in Q2. Compared to Vonage this is puny, but their main market, Norway, is 1/70th the size of the U.S., and relatively speaking, this is a noteworthy milestone. In addition to the total number growing, Telio is having success selling into multiple markets. Norway is their home base, but the Q2 numbers also show growth in Denmark and Holland.

On May 15, Telio also added a mobile offering via a reseller deal with Telenor. Their offering � Telio Mobil � represents a small fraction of the overall total, but provides valuable experience selling into the mobile market, which can only be good going forward. I�m not alone in thinking that this has long been a missing link for Vonage, and I suspect it�s late in the game for Vonage to be going down this road.

In short, the subscriber count is growing, revenues are growing, marketing costs are staying in check, and channels are expanding. In Denmark, Telio is available across 55 7-11 stores � can you imagine signing up for Vonage with your Big Slurpee in the U.S.? Not me. Another thing they�ve done is taken more of their telemarketing in-house, which they claim has resulted in �more than 20% increase in sales efficiency�. I�m not sure how you measure this, but it�s not a big leap to conclude this will be more economical than outsourcing.

The number that really jumps out for me is that for Q2, sales and marketing expenses were 15% of revenues � down from 17% in Q2 last year. Not only is the trend in the right direction, but the level of spend is orders of magnitude lower than Vonage, and really is the key to explaining the financial health of these operators.

Now let�s look at Vonage�s Q2. We all know what happened to their IPO, and this filing is a timely reality check. Their share price has settled into the $7-$8 range, more than 50% below opening day, but has been trending up recently, and is now just shy of $9.

As expected, subscriber growth continues to be strong, hitting a bit above 1.8 million in Q2. They�ve added a million subs since Q2 last year, which is probably more than all the U.S. VoIP pureplays combined. Correspondingly, the revenue story shows significant dollars, coming in just below $250 million for the first half of 2006.

As a sidebar to these particular numbers, I should add that in today�s NYT, there�s an interview with Jeff Citron, and the story reveals that Vonage has just topped 2 million subs. I wrote this post prior to seeing the NYT article, which I came across on Andy Abramson's blog today. Andy has a great analysis of the story and provides a link to the full text of the interview. I find the timing interesting that the day I run this post, there's a NYT interview with Jeff Citron. If anything, Jeff's comments reinforce much of what I'm saying here, and I didn't see anything there that would change my thinking.

On face value, the above fundamentals of subscribers and revenues are to die for in the VoIP market, but as we know, that�s just one side of the coin. I have no doubt that these numbers will continue to grow, but the Q2 filing shows signs of realism and the bigger picture which tells the full story.

First is the tacit recognition that the competitive environment will make the future less certain � �we do not expect to sustain our historical subscriber line growth rate��. That is not news, but comments like this are setting the stage for what Vonage knows will be a more normalized growth path.

Secondly, contrary to Telio�s story, there is no evidence that customer acquisition costs will be declining in a big way any time soon. Q2 marketing spend was $90 million - $1 million a day � up 46% from a year ago. A big part of this is the inevitable maturation of the VoIP market, as it shifts from early adopters to mass adoption. This is reflected by the need to shift spending from relatively inexpensive online advertising to mass market media like TV and direct mail. They may be spending big dollars for online marketing in an absolute sense, but clearly, to reach the broader market, Vonage will have to migrate to more expensive media and high profile event marketing such as this year�s World Cup.

In their words, �for 2006, we will continue to incur a significant amount of marketing costs as we pursue our growth strategy��. That says it all for me, as the name of the game appears to be acquire as many customers as possible � as opposed to a strategy of finding a more economical way to do business, even at the expense of rapid growth.

Finally, some commentary about the costs of doing business. As Vonage grows and competes more intensely against incumbents, they must bear a variety of costs, such as termination fees to legacy carriers, E-911 compliance, co-locating fees to expand their network, and porting phone numbers for new subscribers. So, while they report a slight decrease in direct costs from last year - $7.52 per line � it seems clear that over time, these costs will likely creep up.

There is a similar story on the revenue side. ARPU was $27.70 in Q2, up from $26.63 last year. This looks like good news until you realize that most of the increase is coming from the E-911 Cost Recovery fee they are now charging. Furthermore, starting in May, Vonage added free calling to some European countries, which will now slightly erode ARPU, since subscribers were previously paying for those calls.

And let�s not forget churn, the acid test metric for telcos. Q2 monthly churn was 2.3%, up slightly from 2.1% a year ago. The difference is small, but the trend is not in the right direction, and based on Telio�s claims, Vonage�s churn is quite a bit higher than theirs.

All of this points to a very challenging environment for Vonage, and I�d say their direction and prospects remains quite different from Telio. That said, I can�t help but cite Russell Shaw�s Aug. 30 post noting Vonage�s recent stock uptick. Their stock has been at $7 or less for several weeks, and Russell ponders if the current upward trend is sustainable. He�s pretty skeptical, and I�m of like mind.

I think the big issue and difference facing Vonage and Telio is the simple fact that the U.S. market is much more competitive, and as the MSOs start to dominate, it becomes harder for any VoIP pureplay to make a go of things. This is underscored by Vonage�s closest pureplay rival, Packet 8. They have been public for years, and have little to show for it. Their Q2 results tell a similar story to Vonage, but not quite as good.

Packet 8�s subscriber growth is positive, and they hit 151,000 lines in Q2 � 1/12th of Vonage. However, they report lower ARPU from last year, and churn is way up, from 2.6% to 4.1%. Q2 showed a modest operating loss of $6 million, but the scary number is the accumulated deficit of $201 million. Yeow. And the future doesn�t look much better � �we will continue to incur operating losses for the foreseeable future, and such losses may be substantial�.

So if this is the state of the nation for the #1 and #2 pureplay VoIP operators, you really have to wonder where the upside is � for anybody � these companies, their investors and their customers. One can only hope they can find a viable business model, or failing that, a buyer that understands how to profitably leverage their assets.

And to make things interesting, rising star SunRocket just announced fresh funding. They claim to have bigger numbers than Packet 8, and look to be ramping up to become the undisputed #2 VoIP pureplay. Looks like they can do that � especially with their aggressive annualized pricing plans - but I�m just wondering what that really adds up to. Clearly, some people still see value investing in this space, and maybe I�m missing something here. Whether I am or not, I�ll still take the Telio story over any of these, and until we see Q3 numbers I�m not about to change my mind.

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ipcom said...

Posted by: Don Alexander

Have you been following the massive insider buying of CounterPath stock?

ipcom said...

Posted by: jon arnold

Thanks for comment Don. No, I haven't. I know the company, but I don't typically track this type of activity.