Telecosm - Ike Elliott

Four Different VoIP Business Models

My Grandad had a bunch of wise sayings, and just being around him, you could be guaranteed of hearing at least one per day.  One of his favorites was "It takes all kinds of people to make a world," and he would trot that one out whenever somebody did something strange, or whenever somebody issued a broad-brush complaint about a group of people. 

You can extend that to VoIP, too, where it takes all kinds of companies to make a VoIP world.  There's no guarantee that all of the different VoIP service provider experiments now underway will win out in the end, but there are a lot of experiments now underway.  We've looked a 8x8 and Vonage in depth over the past couple of weeks, and those two represent companies focused on the small end of the market:  residential and SOHO customers.  What are some the companies focused a little higher on the VoIP pyramid? 

The table below shows a half-dozen VoIP-based service providers, roughly rank-ordered by the number of extensions at the average customer site.  Vonage is at the bottom, because as a residential service provider they usually sell about 1 line at a time.   

Next up the list is 8x8's Virtual Office service, which averages less than five employee extensions per customer site. 

CBeyond averages about 7 extensions per customer site, and they differ from 8x8 in some significant ways.  For one thing, CBeyond is a CLEC and they re-sell local exchange carrier capacity to the customer, usually in T1 form.  CBeyond also does Quality of Service (QoS) management of that pipe so that voice packets have higher priority than other data packets.  They then sell both Internet access and voice services on that converged T1 pipe.  Lastly, CBeyond also does something unique among the service providers on this list:  they re-sell a wireless phone service and can bundle that into the service offering.  8x8 does none of these things, but 8x8 does offer a hosted IP PBX, while CBeyond does not focus on a hosted IP PBX offering.

Next up on the scale are Unity Business Networks, M5 Networks, and LightEdge Solutions.  All three of these companies are privately held, so there is little public information on these companies, and as a result, some of the data in the table should be considered an "educated guess".  For example, I'm guessing all three of these companies average greater than 10 extensions per customer site.  Part of the reason for that is that unlike CBeyond, these three private companies sell a full hosted IP PBX solution to their customers, while CBeyond does not. 

All of the top four service providers on the list use a "feet on the street" sales force.  Most of them use agents to sell their product as well.  All of the top four service providers have focused their sales efforts on selected cities, rather than attempting a national or international marketing campaign.   This has the disadvantage of reducing their market reach, but has the big advantage of helping to build local brand awareness and also helps to build deeper, more lasting relationships with customers and community leaders.

Different approaches should yield different results.  For example, I believe that if you go further up the customer size chart, and combine that with a geographically-focused, feet-on-the-street sales approach, you should see lower churn than the national marketing machines that sell to smaller customers.  So far, the data on the public companies is bearing that out, with CBeyond showing churn in the mid-2% range, and 8x8 showing churn in the mid 3% range for their business services.

Full disclosure: I am chairman of Unity Business Network's board of directors.    

Patent Warning Shots for 8x8

2007 was the year that Vonage surrendered much of its time and treasure in the form of patent license royalties and settlements paid to Verizon, AT&T, and Sprint.  Now, 8x8 has heard the first warning shots of what may become a similar assault.

8x8 just filed their 10-K with the SEC, and thanks to a heads-up from a Telecosm reader, my attention was drawn to this disclosure:

"For example, on May 2, 2008, we received a letter from AT&T Intellectual Property, L.L.C. ("AT&T IP) expressing the belief that we must license a specified patent for use in our Packet8 broadband telephone service, as well as suggesting that we obtain a license to its portfolio of MPEG-4 patents for use with our video telephone products and services. We have just commenced our evaluation of this letter and have not determined whether AT&T IP's suggestions have merit. At the same time, we have begun an evaluation of whether AT&T IP's affiliated entities may need to license any of our patents or other intellectual property. We are unable at this time to state whether we will enter into any license or cross-license agreements with AT&T IP or whether we ultimately anticipate any material effects on our operating results or financial condition as a consequence of these matters. "

And so, it begins. 

Of course 8x8 is not so defenseless as Vonage was, since 8x8 has 70 patents of their own.  We may see a cross-licensing deal or a license agreement long before a lawsuit is filed.  Still, here we have yet another example of the incumbent telco sumo wrestlers pushing around the independent VoIP junior high debate team.  I'm hoping that 8x8 has a better go of it than Vonage did.

Interesting, though, that 8x8 didn't mention this on their conference call...

Should Vonage Copy 8x8?

For the past several days we've looked at how 8x8 is successfully converting itself from a residential VoIP focus to a business VoIP focus, and is seeing improving profitability as a result.  So, what does this mean for Vonage?  Is there hope that Vonage can re-invent itself as well?

I don't think the simply copying 8x8 will rescue Vonage.  For one thing, 8x8 is less than one tenth the size of Vonage, small enough that it only took 8x8 about 18 months of new focus to have business revenues reach half of total revenues.  If Vonage were to try the same thing, it would take much, much longer for Vonage's SOHO revenues to match their residential revenues, and SOHO revenues might never reach those levels. 

Then there is the question of whether Vonage can achieve the same economics as 8x8 in a business play.  Part of why 8x8 is profitable in their SOHO market is that they wrote a lot of the IP PBX software themselves, so they don't have to pay as much in third-party licensing fees as competitors who use off-the-shelf software like Broadsoft.  Does Vonage have the software to offer the full suite of IP PBX features that businesses want?  If not, the economics of a big Vonage SOHO push will look a little worse than 8x8's. 

Intellectual property has to be a consideration, too, especially since Vonage has attracted patent lawsuits like teenage boys to a cage-fight.  Since Vonage probably doesn't have any IP PBX patents, they would need to license the technology from somebody who can indemnify them against lawsuits. 

So, while Vonage could dive into a SOHO offering in a bigger way, it is unlikely to generate complete replacement revenue for their residential business, and is unlikely to be the silver bullet that it has been for 8x8.  A ramped-up SOHO effort might help some, though, in combination with other initiatives.  It just won't be the complete answer by itself.

8x8 and the Double-Edged Distribution Sword

Yesterday, we looked at how 8x8's Virtual Office hosted IP PBX product is having its greatest success in the SOHO (Small Office/Home Office) segment of the business market, and how the product would have its greatest appeal to that segment of the market.  Today, I'm looking at 8x8's distribution strategy and how the company's distribution methods also target the low end of the business market.

8x8's biggest sales channel is an inside sales team, tasked with taking calls and emails from interested customers and close deals.  The company also sells through big-box retailers like Office Depot, and has a trial relationship going with Staples as well.  Lastly, the company sells some of their services through outsourced telemarketing and through agent channels.  Based upon data from the company, in the first quarter of this year, here were their sales sources:

8x8 relies on a combination of advertising, lead generation, and distribution partnerships to generate inbound calls into the company's sales team.  The company has been very active in trying new marketing techniques, and the trial and error has likely generated quite a bit of tribal knowledge about what works and what does not.

The company's distribution strategy has a couple of great advantages:

1. An inside sales team is less expensive than a national sales force, so the cost of sales is lower, enabling the sale of a service with a lower price tag.
2. An inside sales team can achieve greater geographic reach more quickly than a "feet on the street" approach.

However, the inside sales approach is likely to be most effective in reaching SOHO businesses.  Call me old-fashioned, but I believe most businesses with a larger number of employees will want to see the face of a salesperson, and will want to hear first-hand that their needs will be met.  Not so many will be willing to buy on the basis of an online ad and a phone call. 

That's not to say that larger companies don't buy 8x8's service.  The company boasts some national names among its customer list, including Subway, H&R Block, and RE/Max.  For the most part, though, these companies have branch offices with a very small number of employees in each office, and for a very small office, a Virtual Office solution over third-party DSL is usually going to be less expensive than a managed T1 solution with a hosted Broadsoft service.

To reach more deeply into the ranks of the larger offices, 8x8 would either need to rely more heavily on an agent channel, or put their own feet on the street, in the style of Unity Business Networks and CBeyond.  However, the feet on the street approach is more expensive and doesn't cover as much geography as quickly, so for now, I expect 8x8 to continue to grow with its inside sales approach.  It will be interesting to watch their growth trajectory versus CBeyond's.    

8x8 climbing the VoIP Pyramid

About  18 months ago 8x8 shifted their focus from residential VoIP services to business VoIP services, and the company has seen an improvement in their financial results since then, due to greater revenue per sale and lower cost of sales.   It wasn’t such a radical change, though, because 8x8’s business customer base is concentrated in the ultra-small segment of the business market, averaging between 4 and 5 employees.  If you are going to move into business VoIP services, this about a small a step as you can take. 

The company has an interesting chart in their investor presentation from last week, showing the parts of the business market on which they are focused:

This is a typical investor presentation slide, designed to convince the reader that the target market is really big, so the company has great prospects for growth.  There's just one problem: If 8x8 is targeting companies with up to 99 employees, why does their average Virtual Office customer have less than five employees?

There are two related causes:

1. The Virtual Office product is designed to appeal to very cost-conscious buyers, and these buyers are concentrated on the small end of the small business size scale.  More on this in a minute.

2. The Virtual Office product is distributed primarily through an "inside sales" approach that relies on a call center of sales representatives taking calls and emails from small busineses that are responding to online advertising and other advertising networks.  More on this tomorrow.

Today, let's look at the Virtual Office product.  The product has decent business-grade PBX features and seems to rely on 8x8's extensive technology and patent portfolio.  It's got all the usual forwarding/transferring/extension dialing/voicemail things you expect from a PBX, plus an autoattendant, a conference bridge, and even some video conferencing.  So, from a feature list point of view it compares pretty well to what you might get from a customer premise IP PBX, or from a competing hosted IP PBX platform such as Broadsoft. 

So, how is it that Virtual Office is focused down-market?  The main issue is that 8x8 sells Virtual Office as an over-the-top service, on top of somebody else's broadband service, such as DSL, cable Internet, or third-party T1 services.  It makes Virtual Office orders easier for 8x8 to fulfill, since 8x8 doesn't have to install and manage the Internet access part of the service, but it does have its downsides. 

In particular, 8x8 doesn't control the quality of service provided for the VoIP calls on their Virtual Office product.  So, the quality experienced by the customer is outside of 8x8's control, and sometimes the quality can be pretty atrocious on an unmanaged Internet connection.  So, a certain percentage of 8x8's sales result in unhappy customers, due to factors outside of 8x8's control.  That's part of why 8x8's churn rate for the Virtual Office is at an estimated 3.3%.

The good news for 8x8: for folks who do have a good Internet connection, the Virtual Office service can be a good value for the customer, and an inexpensive sale and installation for 8x8.  The bad news is that 8x8 has to churn through some customers to find the ones that are happy with the service.

One other problem with selling an over-the-top VoIP service to businesses: your sales force is competing with alternatives that do bundle the hosted VoIP services with managed Internet access services.  Example competitors are M5 Networks, Unity Business Networks, LightEdge Solutions, and CBeyond.  Cable companies are starting to make inroads into this market as well.  These competitors make it hard for 8x8 to compete effectively for a customer with a larger number of employees, for whom managed quality of service may be of greater interest.

So, 8x8 has done a great job of finding a niche in the business VoIP services market, a niche that is a close relative to the residential voice services market where the company had some earlier success.  However, 8x8 might find stiffer competition if they try to climb higher on the VoIP pyramid.   

New Music: St. Germain

Okay, so I have paused my repetitive listening to Pinback's exquisite Summer in Abaddon CD long enough to listen to something else this morning, on the advice of my friend Bob Paulsen (CEO of Unity Business Networks).   Bob says I need to broaden my musical horizons into his favorite genre: jazz electronica, and his favorite example, St. Germain.

So, I did, and though I hate to admit it, Bob's right, this music is fantastic.  Start with "So Flute."  You'll want more.  Then try "La Goutte D'Or,"  and the hook will be set.  Both of these songs are on St. Germain's 2000 release, Tourist, which is a great place to start.  Another good song from that album:  "Sure Thing". 

How to describe the music?  A lot of blues-tinged jazz grooves, with tasty guitar, horn, or flute leads, sometimes mixed with interesting sampled vocals.  Kind of a cooler form of Moby. 

As usual, this "new music" pick is new only to me...St. Germain has been releasing music since 1995.  If Wikipedia is to be believed, St. Germain's real name is Ludovic Navarre, and he is a French jazz musician who has released music under a bunch of aliases, including Deepside, LN's, Modus Vivendi, Nuages and Soofle. 

Try it!  You won't be disappointed.

Tornado Demolishes Windsor, CO

A huge tornado ripped through Windsor, Colorado, just before lunch yesterday, destroying much of the town of 19,000.  Miraculously, only one person was killed, a camper at a former missile silo now turned into a campground, just to the southeast of town. 

Windsor is about 50 miles north of where I live, in Broomfield.  I'm an assistant scoutmaster of Boy Scout Troop 767, and we camped at the missile silo campground about 8 months ago.  The troop got to know Peter Ambrose, the caretaker of the campground, and his collie, K.C.  Ambrose survived the twister while holed up in a cinderblock restroom, but the dog ran out into the storm and was so severely injured that he had to be euthanized after the storm.  Ambrose's mobile home was swept away.

Troop 767 is going to try to raise some money to help Peter Ambrose and his wife, Sharon, get back on their feet.   If you would like to help, please let me know at ike@practiq.com, and I'll connect you with the Troop's treasurer.  We might also put together a work team to go up to Windsor to help, once we know more about the best way to help out, so please let me know if you're interested in helping out with that, too.

"Level 3 is Back"

The world is starting to wake up to Level 3 again. In an article from Telephony Online, Janco Partners analyst Donna Jaegers says "Level 3 is back," referring to reports that Cogent is feeling pricing pressure for wholesale Internet access, and noting that the pressure is coming directly from Level 3. 

This is great news for Level 3, and the first market evidence I have seen reported in the press that Level 3 is once again aggressively ramping its sales efforts.  Go get 'em!

Has 8x8 Solved the Vonage Conundrum?

Back in the summer of 2006, 8x8 (NASDAQ: EGHT) was worried about their VoIP services business.  The company offered residential VoIP services, packet video telephony services, and a small-business VoIP service called Virtual Office.  The bulk of the business was in residential VoIP services, though, much like Vonage today, and the company was having difficulty making residential VoIP services profitable.  So 8x8 took a hard look at their portfolio of services.

I wasn’t  sitting there doing the analysis with them, but I suspect that 8x8 found that the Virtual Office service had better economics than residential VoIP:

-          Cost of subscriber acquisition was lower, at about $125 to $150 per extension (versus $216 per line in Vonage’s latest quarterly report)

-          Revenue per seat was a little higher, at about $32.18 per month per service and a retail price of close to $50 per extension (versus about $28.85 per subscriber per month in Vonage’s latest quarterly report)

-          Churn was probably in the same 3.3% range that Vonage is now reporting (although Vonage’s real churn is probably higher than that because Vonage excludes certain customer cancellations from their churn statistics). 

So, with the cost of customer acquisition being a much smaller fraction of revenue, the company decided to place its bet on the Virtual Office product, and it has resulted in an improving business outlook for 8x8.  The company is a lot smaller than Vonage, with about $16M per quarter in revenue, versus Vonage’s $225M per quarter.  But the company has had positive net income in three of the past four quarters and seems to have found a more sustainable business model by emphasizing VoIP services for small businesses.  Here are their recent financials:

 

Can Vonage copy what 8x8 is doing?  Should they? On Monday, we’ll start digging a little deeper on 8x8, with a focus on pointing out some of the differences between the two VoIP players.

Solving the Vonage Conundrum

I devoted a half-dozen blog posts to Vonage over the past week or two, and the general conclusion is that Vonage is still a pretty risky bet.  The company’s cost of customer acquisition in its core residential phone service business is high, and with a reported churn rate of 3.3% per month, the 2.5-year customer tenure does not generate enough profit to pay back the marketing costs incurred to get that customer.  So, the company must now do at least one of three things:

1.       Reduce real churn to under 3% per month

2.       Increase gross subscriber additions to at least 110,000 subscribers/month

3.       Find a new line of business that has better economics and refocus the business there.

The company’s announcement that it is reselling Covad DSL service doesn’t qualify as a new line of business that has better economics.   As a resale of a resale, the DSL announcement can only be viewed as a defensive measure to stem the tide of customer defections to double, triple, and quadruple-play offers from cable and traditional telco service providers.   

So, what is Vonage to do? 

It just so happens that Vonage is not the only company to face this conundrum.  Tomorrow, we’ll start to look at another VoIP provider that is trying to remake its business, and we’ll take a look at how it is working out. 

Telecom's Naval Arms Race

Rob Powell has an excellent post today, describing the Telecom M&A world in terms of a warships: the big battleships and carriers, the heavy cruisers, the destroyers, and down in the comments, even the submarines.  It's an entertaining read! 

Rob commented on yesterday's post on this blog about Level 3 getting back into the acquisition game, saying that he thinks the soonest that will happen is in the Fall.  It will be fun to watch!

Level 3 on the Hunt Again?

Rob Powell has a couple of interesting posts over on the Telecom Ramblings blog about Global Crossing's UK unit being up for sale.  Rob speculated about potential buyers in a post the next day, including the possibility that Level 3 Communications might buy the unit, or the whole company, but worried that LVLT isn't operationally or financially ready to make that purchase yet.

Then came yesterday's Level 3 Annual Stockholders Meeting, in which CEO James Crowe said that Level 3 is open to doing the right acquisitions in Europe or in content delivery networks.  Could it be the Level 3 is on the hunt again, and this time the prey is Global Crossing UK?  Or is Limelight in the crosshairs?

The Poison of Bitterness

As you might guess, I hang out in the blogosphere and on investor message boards now and then.  It's a fascinating world, and I get much more from it than I give.  That's the magic of it.

Sometimes I catch the scent of bitterness while exploring topics online.  The Internet is great for that...a good place to vent, and you often get to do it anonymously.  The Internet has become a massive complaints department in the sky.  I admit that I have contributed a bit of whining myself.

However, there is "constructive criticism," and then there is the more damaging form of complaining.  When I say damaging, I mean that the damage is self-inflicted. 

I remember hearing that bitterness is like "taking poison and hoping the other guy will die."  There have been times in my life when I have held bitterness in my heart for far too long, so I know its killing power. 

So now I try to make a practice of catching myself being resentful, and letting it go before it can wreak too much havoc.  That doesn't mean I won't ever complain, and won't ever offer constructive criticism, and won't ever post about pet peeves.  It just means that I try hard not to harbor hate.  It's not worth it, and it's liberating living without it. 

Easier said than done, for sure, but I recommend giving it a try.  Nothing ventured, nothing gained.

Level 3 Annual Meeting Report

I have just returned from the Level 3 Communications Annual Meeting, held here in Broomfield, Colorado.  CEO James Crowe and CFO Sunit Patel hosted a meeting that was in some ways surprisingly tame, given the company's most recent twelve month history, including the announcement of the Big Miss in October and the resignation of the President and COO in March.  We seem to be far enough removed from these events that the shareholders are optimistic, once again.

I'll skip all the formalities in this report...yes, they re-elected the board and approved a motion to maybe do a reverse stock split, and a few other odds and ends.  Not a lot of suspense there.

Instead, I'll skip right to the fun part: the presentation by Jim and Sunit on the company's results and prospects, and then the Q&A.  Jim was his usual eloquent self, reminding me once again of why he inspires such loyalty.  His presentation was full of worthy Crowe-isms, including these:

"Make no mistake about it, at the end of the day the problem is management, meaning myself and the other top managers of the company." (referring to the company's widely-reported provisioning issues announced in the 2nd half of 2008).

"We screwed up, and I assure you it won't be the last time.' (in the apology to shareholders that Jim issued at the end of the meeting)

"Only two?" (answering a question about two complaints from former employees about "fear management": a lack of management by walking around and a perception of an old boys network more interested in self-preservation than the best interests of the company.  Of course, Jim went on to say that the company is now focused on reaching out to all employees).

Jim has an honesty, humility, and buck-stops-here mentality that is all too rare among chief executives and is refreshing to see.

Jim and Sunit gave the standard Level 3 pitch (here), and then took questions.  Here are some paraphrased highlights from the Q&A:

Q: Are WiFi networks and mobile phone networks a threat to Level 3?

A: A good part of our business is connecting anntenas together.  Today, most antenna towers don't drive enough traffic to justify fiber connectivity, but over time, that is changing.  It's a future opportunity for us.

Q: When will Level 3 be operationally ready to do more acquisitions?

A: "If business plagiarism were a crime, we'd have to go to jail, because we want to be the UPS or FedEx of our industry."  Project Unity (the project to integrate and automate the operational systems of the most recent six acquisitions) should be 2/3rds complete by the end of the year, meaning 2/3rds of orders should flow through Unity by then.  Our operational problem, though, wasn't in Content Distribution or in Europe.  If we had an opportunity in Content or in Europe, we might do it.

Q: (Ike made a thinly-veiled attempt to settle his bet with Dan Caruso by asking) Is Level 3's 75-80% growth in IP traffic representative of the industry or is the industry growing more slowly, meaning Level 3 is taking market share by growing more quickly?

A: (Jim refused to take the bait, and confessed he reads this blog by way of saying he had to be careful with his answer) Level 3 can only speak for traffic on our own backbone.  We grew, what, 90% last year, is that right, Jack? (CTO Jack Waters confirmed from the audience) We're projecting 75%-80% this year.  The industry lacks good third-party measurements of Internet growth.  We believe that 70% of demand comes from individuals, now, people with broadband in the home.  We expect more video traffic to continue to move to the Internet, because it is cheaper.  Standard-definition TV became cheaper to distribute on the Internet back in 2003, and HDTV became cheaper in 2006.  We think the Internet will grow in the range of 60%-110%, and we see no end to that.  And whether it is 60% or 110%, it is extraordinary unit growth.

Ah well...I was hoping Jim could get me off the hook from buying Caruso dinner, along with some outrageously overpriced wine.  No such luck, yet.

If you are not familiar with my bet with Dan, click the continuation link below to learn more.

More on LEC Line Losses From Tech Untangled

Senaka Balasuriya, who authors the Tech Untangled blog, has a report on a Harris Interactive poll that provides some additional insight into where all those LEC line losses are going.  I had a series of posts last month that analyzed quarterly earnings reports of public companies to try to glean where the LECs lost their lines.  Now, we have a recent survey that shows who uses what kinds of service:  traditional landlines, wireless phone service, or Internet telephony.

The survey showed that only 0.5% of the respondents use Internet telephony by itself.  15% of respondents use Internet telephony in combination with either wireless phone service or landline phone service, or both. 

And, of course, survey says: wireless is the big winner!

Vonage Needs A Miracle?

There's an interesting post on the Mr. Blog site from over the weekend rebutting my Saturday assertion that Vonage must ramp marketing spending to survive.  David says it won't work, for the following reasons:

1. "Limited market size - Vonage’s niche of people willing to act for cheaper phone service is small
2. Reaching beyond that niche will require Vonage to spend more per subscriber
3. Intense competition and low barriers to entry adds more to customer acquisition costs
4. Market dynamics reduce the value of the “cheaper phone service” message, further increasing customer acquisition costs "

He's basically saying that Vonage is wasting their money and needs to "do something radically different, not just increase their marketing spend singing the same old song." 

You know, he could be right.  It could be that ramping up marketing spending at Vonage won't produce the same results it did two years ago.  In any case, it's a thought-provoking post and I encourage you to head over to Mr. Blog to give it a read.

It's one thing to say that ramping marketing spending won't work, and quite another to suggest something that will work instead.  I think that Vonage was trying to change the game for itself when it announced it would re-sell Covad DSL service last week.  However, "resale of a resale" can't be considered "radically different", so Vonage is still left searching for a solution.

My guess is they don't have anything radically different in their plan, and therefore are stuck trying the old solution of ramping marketing spending, knowing that there is a risk that it may not work as well as it used to.  It will be interesting to watch the results.

If the company doesn't show progress, then the customer base will probably be sold.  Unfortunately for Vonage shareholders, the "milk it" value of the customer base, at current churn rates, may only be enough to pay off the $253M debt (even counting cash on hand), leaving little for the equity holders at the end of the day.  If you believe the Vonage brand has value, then you might throw a little more money into the sale price.

My guess is that Vonage has about a year to show some progress, and even less time if they can't refinance the debt.   The clock is ticking.

Managed Video As A Service Blog Is Launched

My friends at Envysion have just launched a blog of their own, the Managed Video blog.  It'll be fun to watch Matt Steinfort, Rob Hagens, and the whole Envysion crew share their managed video wisdom.  Welcome, Rob and Matt, to the blogosphere!

Vonage Can't Afford Not To Ramp Marketing Spending

This week, we've been investigating Vonage's churn rate and the impact that churn has on a recurring revenue business.  Vonage's 3.3% churn rate in the first quarter of 2008 implies that each customer they add will only be with Vonage for about 2.5 years before moving on.  However, Vonage spent over $2,000 for each net new subscriber they added in the first quarter, and at $28.85 in average revenue per subscriber per month, it would take Vonage about 6 years to pay off the marketing costs for each added subscriber. 

Let's see...I usually keep a customer for 2.5 years, but I need to keep the customer for 6 years to pay back what I spent to get that customer.  Clearly, this is a money-losing proposition.

Unless something changes, that is.  As we saw in yesterday's post, Vonage's 2-year public company history suggests that the more they spend on marketing, the greater number of subscribers they add, and the greater number of net new subscribers they add, and the lower their net cost of adding each new subscriber.  So, if Vonage ramps up marketing spending, they should be able to reduce the amount of time they need to keep a customer in order to pay back their marketing costs, reducing it to something lower than their average customer tenure.

The following chart shows the average customer tenure for a range of churn rates (the pink line), and against that pink line it charts the number of months that Vonage has to keep a customer in order to pay back the marketing costs that were spent in keeping that customer, at various rates of overall marketing spending, ranging from $20M per month up to $50M per month. 

Key assumptions in this chart: Vonage has about a 2.6M subscriber base, and for each $5M of incremental monthly marketing spending, the company adds 11,000 gross subscribers. 

The objective for Vonage is to keep their marketing cost payback tenure well below their average customer tenure, so that they can spend some of their revenue on other things, like cost of goods, for instance.  So, Vonage would like to keep the blue, red, and green lines below the pink line on the chart.

In the first quarter of 2008, Vonage spent about $20M per month on marketing, and had 3.3% churn, so you can see on the blue line in the chart that Vonage's marketing cost payback timeframe was well above the average customer tenure...a bad bad thing.

However, the chart suggests that if Vonage were to ramp up marketing spending to the $35M per month range, and simultaneously bring churn down below 3%, then marketing cost payback timeframes can be reduced well below average customer tenure. 

That's the challenge for Vonage now.  They need to get churn below 3%, consistently, while ramping up marketing spending to attract more subscribers.  If either of these efforts fail, then the company will stop growing in any exciting way, and it is highly likely the subscribers will be sold for their remaining cash flow value. 

Thanks, Telecosm Readers: We've Hit A New Milestone!

I want to say a big thank-you to all of the many Telecosm readers on a big occasion.  The blog has now hit a high water mark of 301 Feedburner subscribers!  Not bad for a blog that started only last October, and of course, it is the readers that make it possible.  Thanks for reading and commenting both on the blog and offline.  It is gratifying to know that people are enjoying it as much as I am.

Thanks,

Ike

How Can Vonage Grow Its Subscriber Base?

This week we've looked at how the churn ceiling may limit Vonage's total subscriber base to about 3.5 million subscribers over the long term, which would be a disaster for the company.  Of course, if Vonage can find a way to add more than 96,000 new subscribers every month, then they can raise their churn ceiling.  The more gross subscribers Vonage can add every month, the smaller the impact of churn on their net subscribers at the end of every month, and the more their customer base can grow.

Can Vonage ramp up the number of subscribers they are adding?  In the company's two-year history as a public company, the Vonage subscriber base seemed to grow largely as a function of marketing spending:

If the company spent about $90-$100M per quarter on marketing, it added 312,000-380,000 gross subscribers in that quarter.  In quarters where Vonage spent $60-$70M  on marketing, it added 236,000 to 300,000 gross subscribers. 

So, it seems that Vonage's only tool for growing more subscribers is to spend more marketing dollars.  The company spent $216 per gross add in the 1st quarter, and predicts that marketing spending per gross add will increase in the coming quarters, to the range of $225 to $250 per gross add for the full year.  In other words, the company expects to become less efficient with their marketing dollars in the quarters to come.

While Vonage could change the game by adding new and more appealing products to its product mix, so far the company has only demonstrated the ability to add more subscribers by spending more money.  One of the problems with that approach is that the company doesn't have a lot more money to spend.  At the end of the first quarter, the company had $148M in cash, and seems to be on a path to use about $38M of that cash to pay off the portion of the $253M in debt maturing in December that it doesn't expect to refinance.  At least the company isn't really burning cash operationally at the moment, and even generated about $10M in positive cash flow in the first quarter.  Still, it will likely take $30M in additional quarterly marketing spending to increase gross subscriber additions to about 330,000 per quarter, which will likely mean that Vonage will return to deficit spending in the near term.

Suppose Vonage can successfully increase their monthly subscriber additions from 96,000 per month to about 110,000 per month by spending an additional $10M per month on marketing, while simultaneously reducing churn to 2.7% per month.  How would that increase the company's churn ceiling?  It would increase the churn ceiling from a current 2.8M subscribers to about 4.1M subscribers.  Still not where the company wants to be. 

Vonage is stuck climbing a ladder of ever-increasing marketing spending in an effort to expand their subscriber base.  I expect this marketing spending will soak up almost all of the operating cash flow of the company. 

Tomorrow we'll take another look at Vonage's cost per net subscriber addition, and look at the future impact of changes in this key ratio.

How Can Vonage Break Through the Churn Ceiling?

We saw yesterday how Vonage's current churn rate and their gross monthly subscriber additions combine to create an absolute limit on the number of subscribers in their customer base, which I called a "churn ceiling."  If Vonage's astronomical 3.3% churn rate continues, their churn ceiling is just under 2.9M subscribers.

There are two ways to raise the churn ceiling:

1. Reduce the rate of churn, or
2. Increase the rate of subscriber additions

We'll look at the first of these today, and will save the task of increasing subscriber additions for tomorrow.

Since going public in the 2nd quarter of 2006, Vonage's monthly churn has ranged between 2.3% and 3.3%, with the general trend being toward higher churn.  In an interesting post on the Bear On Business Blog yesterday, Dan Caruso postulated that Vonage's worsening churn could be due to an increasing average customer tenure, noting that early in a company's life, all of the customers are newer and are less likely to churn, but as the company ages a greater percentage of their customer base is at the end of a contract and has the option of churning.  Also yesterday, a commenter speculated that wireless substitution is eroding VoIP customers more quickly than landline customers.  Both of these theories seem reasonable to me, and I will add a couple more: 

• Cable VoIP services are eroding Vonage's customer base more quickly than landline customers because Vonage customers have already demonstrated a willingness to try VoIP, and Cable VoIP services have the twin advantages of bundling and managed quality of service. 
• Vonage itself is somewhat to blame for a lack of focus on customer service in the past.

Reducing the churn rate is a tall order for Vonage, but they are saying they are trying to address the things that are in their control.  They are at least making an effort to fight their bundling competitors by partnering with Covad to resell DSL-based Internet access.  They are also ramping up customer service and new product development efforts. 

Call me a pessimist if you must, but I don't believe these efforts will cut Vonage's churn rate back to the 2.3% level.  My best guess is that with a concerted effort their churn rate will settle down to between 2.5% and 3.0%. 

Where would that put Vonage's churn ceiling?  The chart below plots the churn ceiling for three different churn levels:

If Vonage continues to add just 96,000 subscribers per month, with a 3% churn rate, Vonage tops out at under 3.2M subscribers.  With a 2.5% churn rate, the ceiling is just over 3.8M subscribers.

Clearly, churn reduction by itself isn't going to get Vonage where it wants to go... the company's investors wouldn't be excited at the prospect of topping out at 3.5M subscribers.  In addition to reducing churn, Vonage is going to need to ramp up subscriber growth.  More on that, tomorrow!

HBO Caves Under Pressure From Telecosm

Time Warner's HBO subsidiary is about to do a deal with Apple to distribute its shows on iTunes.  Of course, this breakthrough was only made possible by the Telecosm blog, which awarded a BUNGL to HBO in January for it's prior online distribution strategy, which allowed you to get HBO shows online only if you were a digital cable subscriber and only if you bought your Internet access from a cable provider.

Now, the immense pressure brought to bear from winning a BUNGL has clearly caused TW and HBO to change strategy. 

"When we got the BUNGL a few months ago, it was a real wake-up call," said Jeff Cusson, HBO's spokesman.  "That's when we knew our marketing strategy was deranged, and needed an overhaul."

HBO's coming deal with Apple still has some catches: the shows distributed through iTunes will have delayed availability, only after the full-season DVD for each show is released.  Still, it's a step in the right direction...thanks to the incredible power of the BUNGL.

Editor's note: this article is an example of what happens when an over-imaginative blogger  gets his tongue stuck in his cheek. In other words, I made it up.

Vonage and the Churn Ceiling

This week is all about churn.  Monday we saw how Vonage's 3.3% subscriber churn in the 1st quarter has driven their cost per net subscriber addition above $2000, meaning that Vonage will need to keep each customer it added in the 1st quarter for 6 years just to pay back the marketing costs it took to win that customer.  Ouch!

Today, we'll look at how churn actually creates a ceiling on how big a service provider's subscriber base can grow.  It turns out that the limit is really easy to calculate: 

Max subscriber base size = Monthly gross subscriber additions / Monthly churn rate

Now, I don't believe that Vonage's rate of churn in the first quarter of 2008 will persist...I think that churn will come down a little for Vonage next quarter.  Also, I don't believe that Vonage's rate of gross subscriber additions will stay at recent levels, as the company has to ramp up its marketing spending and should see a corresponding ramp in subscriber additions.  But if you assume that Vonage's 1st quarter subscriber addition and churn figures will persist, then Vonage's maximum customer base is calculated as follows:

Max subscriber base size = 95,558 gross monthly adds / 0.033 churn rate = 2,895,694

Unfortunately for Vonage, their current customer base is about 2.6M, so if the can't get their churn to come down or their monthly gross adds to come up (or both), Vonage is currently close to reaching their subscriber base ceiling. 

Of course 1Q08 was Vonage's worst quarter ever in terms of churn, so it paints an uglier picture of subscriber ceiling than will probably be the case later this year.  To see how Vonage's subscriber ceiling has changed from quarter to quarter ever since Vonage went public about two years ago, see the following table:

Vonage's Subscriber Ceiling by Quarter
	2Q06	3Q06	4Q06	1Q07	2Q07	3Q07	4Q07	1Q08
Monthly Marketing Spending	$30.1M	$30.4M	$31.9M	$30.3M	$22.6M	$20.6M	$23.6M	$22.6M
Monthly gross adds	125,668	119,716	104,031	110,831	78,947	99,993	99,537	95,558
Actual Monthly churn achieved	2.3%	2.6%	2.3%	2.4%	2.5%	3.0%	3.0%	3.3%
Possible Churn Rate Range (below)
3.5%	3,590,524	3,420,457	2,972,324	3,166,600	2,255,619	2,856,933	2,843,910	2,730,225
3.4%	3,696,127	3,521,059	3,059,745	3,259,735	2,321,961	2,940,961	2,927,554	2,810,526
3.3%	3,808,131	3,627,758	3,152,465	3,358,515	2,392,323	3,030,081	3,016,268	2,895,694
3.2%	3,927,135	3,741,125	3,250,979	3,463,469	2,467,083	3,124,771	3,110,526	2,986,184
3.1%	4,053,817	3,861,806	3,355,849	3,575,194	2,546,667	3,225,570	3,210,866	3,082,513
3.0%	4,188,944	3,990,533	3,467,711	3,694,367	2,631,556	3,333,089	3,317,895	3,185,263
2.9%	4,333,391	4,128,138	3,587,287	3,821,759	2,722,299	3,448,023	3,432,305	3,295,100
2.8%	4,488,155	4,275,571	3,715,405	3,958,250	2,819,524	3,571,167	3,554,887	3,412,782
2.7%	4,654,383	4,433,926	3,853,012	4,104,852	2,923,951	3,703,432	3,686,550	3,539,181
2.6%	4,833,397	4,604,462	4,001,205	4,262,731	3,036,410	3,845,872	3,828,340	3,675,304
2.5%	5,026,733	4,788,640	4,161,253	4,433,240	3,157,867	3,999,707	3,981,474	3,822,316
2.4%	5,236,181	4,988,167	4,334,639	4,617,958	3,289,444	4,166,361	4,147,368	3,981,579
2.3%	5,463,841	5,205,043	4,523,101	4,818,739	3,432,464	4,347,507	4,327,689	4,154,691
2.2%	5,712,197	5,441,636	4,728,697	5,037,773	3,588,485	4,545,121	4,524,402	4,343,541
2.1%	5,984,206	5,700,762	4,953,873	5,277,667	3,759,365	4,761,556	4,739,849	4,550,376
2.0%	6,283,417	5,985,800	5,201,567	5,541,550	3,947,333	4,999,633	4,976,842	4,777,895

Vonage is now faced with the difficult task of reducing their churn rate, while simultaneously increasing their rate of gross adds, while limiting marketing spending.  I do expect to see Vonage's subscriber ceiling rise in the coming quarters, but It's a tricky business, so it will be interesting to watch.

(Many thanks to the Telecosm reader who reminded me of this interesting aspect of churn)

"Toes" Starts a Blog!

I have just discovered that Rob Powell started a blog last week, and for those that track Level 3 Communications, this is big news.  That's because Rob Powell is one of the best of the "anonymous analysts" that haunt the Level 3 Investor Village message board, where he goes by the alias "toes_that_twinkle." 

In my occasional trips to the Level 3 Investor Village message board, I have learned to scan for posts from "toes," because they are almost always thoughtful, never ranting, and most importantly, on the mark.  He really digs through the SEC reports, and as a result has very deep and informed perspective on Level 3.  If you track Level 3, you are going to want to add Rob's new blog to your RSS reader. 

To start, I highly recommend Rob's post on the "Virtuous Circle" that awaits Level 3 if the stock rises enough to start calling their convertible debt. 

Rob, welcome to my blogroll!  I will be an avid reader of your posts.

Churn Week Continues: Sprint's Struggles

Sprint Nextel announced their first quarter earnings yesterday, and it looks like their struggle to keep subscribers in their Nextel unit are getting worse.  Yesterday's post focused on Vonage's atrocious 3.3% monthly churn, and today, we'll look at Sprint's 2.45% churn in post-paid wireless subsribers.

Here is Sprint's pattern of post-paid subscriber losses since the beginning of 2007:

	1Q07	2Q07	3Q07	4Q07	1Q08
Net change in Sprint post-paid subscribers	(220,000)	16,000	(337,000)	(683,000)	(1,070,000)

Sprint did say that they expect an improvement in churn in the 2nd quarter, but til now, churn has actually worsened.  Last quarter, and the quarter before, post-paid churn was 2.3%.

It is enormously damaging to a recurring revenue service business to experience churn above 2% per month.

For example, did you know that if you assume a constant rate of gross subscriber additions, a service provider's churn rate can predict the maximum size of the service provider's subscriber base?  The higher the churn rate, the lower the maximum size of your customer base.  Tomorrow, we'll look at how this works.

Vonage: Mixed 1st Quarter Results

Vonage announced their first quarter earnings last Thursday, and while the company is still in a precarious position, it may be able to survive in the short term.  However, investors have to be wondering if "survival" is anything to be excited about, since the cost of adding net subscribers is skyrocketing.

The good:

• Revenue per month per line is up to $28.85, up from $28.18 last quarter.  This is quite a bit higher than I had forecast.
• Quarterly revenue was over $225M, about $4M higher than I had expected, mostly due to the larger increase in revenue per month per line.
• SG&A was lower, down to about 35% of revenue, down from about 37% of revenue last quarter.

The bad:

• Monthly customer churn is getting worse, now at 3.3%, up from 3.0% last quarter and up from 2.4% a year ago.
• Gross subscriber adds continue to decline.  The company added 281,329 subscriber lines, down from 283,907 last quarter and down from  332,493 a year ago. 
• Costs per subscriber were up, with direct cost of goods per sub per month jumping to $2.83 (up from $2.29) , and cost of telephony service per sub per month jumping to $7.26 (up from $7.11)
• As a result, gross margin is down to about 65%, down from 66.7% last quarter.

The ugly:

• Vonage still has not finalized their debt refinancing.  While it seems they are making progress in negotiations, until the refinancing is completed it represents a significant risk to the company.
• While Vonage added 281,329 subscribers, they lost 251,196 subscribers due to churn, netting only 30,133 subscriber additions.  The company's marketing cost per gross subscriber line addition was $216.47, for a total marketing cost of about $61M.
• Vonage prefers to report their marketing cost per gross subscriber addition.  It looks a lot worse, though, if you view it as marketing cost per net subscriber addition:
  

  Vonage	1Q07	4Q07	1Q08
  Marketing Cost Per Net Subscriber Addition	$     549	$   1,130	$    2,021

Bottom line, at $2,021 in marketing cost per net subscriber add, you need to keep a $28/month customer for six years, just to pay back the marketing cost of adding the subscriber.  Then you can start to repay the cost of goods involved in serving that customer for the past six years.  That's not a sustainable business.

This is why I have focused on Vonage's churn stat as the number to watch in past posts on Vonage.  Unfortunately, the company has yet to demonstrate its ability to reverse the negative trend in churn.  Until Vonage can do that, the future of their business is at risk.

New Music: Phil Stacey

My colleague Greg Menard (CTO of Unity Business Networks) turned me on to a new CD by Phil Stacey that is excellent.  Phil Stacey was one of the finalists on American Idol last year, so you may know about him already.  His self-titled release is in the country genre, yes, but not over-the-top country like the kind that keeps me from listening to country stations.  He's got a great voice that could sing other styles, and the arrangements are the kind of "barely country" arrangements that without the slide guitar you might not know were country. 

Anyway, believe it or not, I have never watched an episode of American Idol, and I usually avoid country music like I avoid house cleaning, but there are some really good songs on this CD.  I especially liked "If You Didn't Love Me", "You Are Mine", and "Identity".   It's hard for me to say it, but I guess I do like some country music.

A Day In The Studio

I took the day off from blogging yesterday, choosing instead to spend the entire day at Derryberry Audio, a recording studio in Westminster, Colorado, and it was a blast.  It was a day of great fun, and sometimes exhaustion, as a fantastic group of volunteer musicians came together to lay the foundation tracks for seven songs. 

It was my first time in the studio since my college band recorded a song for a James Madison University compilation album back in 1985.  Yesterday's recording session was much more intense.  Back in 1985 it only one song and it was lead guitar player John Romeo's music.  This time, it was seven of my own compositions.

A couple of years ago I started to write music, which has been a life-long dream but a dream that I had never really pursued...so I decided to change that, and got some rudimentary recording gear and started to put together some ideas.  Over the past two years I have written about 15 songs, and I worked with a bunch of local musicians from my church and the surrounding area to put together a low-budget plan to record seven of the songs, market them on iTunes, and donate all of the proceeds to charity.  We hope to have the songs finished and ready for sale by the end of the summer.

I am thrilled with the musicians who have donated their time and talents to the project so far...they are incredible.  I want to thank them personally here:

Electric Guitar: Mitchell Ashley
Acoustic and Electric Guitar: Gordon Clouse
Piano: Jeremiah Horner
Bass: Skye Perry
Drums: Rich Guess
Production and Engineering: Jeremiah Horner

Jeremiah did a fantastic job in the production role, it was a pleasure working with him.  Also, I want to especially thank our sponsor, Tim Draughon, for making this project possible, and also thank Mark Derryberry, owner of the studio where we recorded and enjoyed fantastic hospitality. 

I think everybody is having a great time with the project and we are looking forward to our next studio session.  I'll keep you posted on our progress!

Inflationary Trends in Retail Internet Access

Isn't competition supposed keep prices in check?  Apparently not in retail Internet access these days. All three of the big phone companies are making noises about price increases for their retail Internet access services:

• In February, the Chicago Tribune reported AT&T is raising prices $5 per month on their DSL-based Internet access services.
• Verizon announced on their late-April quarterly earnings call that they plan to raise Internet access prices on their FiOS based services in the 2nd quarter by similar amounts.  Verizon also plans to raise prices on FiOS-based video services.
• Qwest made a similar announcement on their quarterly earnings call last week, saying they will raise prices on DSL-based Internet access by as much as 11 percent.

Will the inflationary environment in retail Internet access creep into the wholesale Internet access market as well?  If so, that would be a huge turnaround in the wholesale Internet access market (where large companies, content providers, and carriers are charged by the megabit for access to an Internet backbone), which has experienced price declines in the 25% to 35% range for several years. 

Sprint and Nextel's Excellent Adventure

It's been a big week for Sprint Nextel, who for the last several years has been telecom's most notable slacker.  Now, Sprint has leveraged its assets and its position to cobble together an alliance of convenience with cable companies, Google, Intel, and yes, Clearwire, in the form of a joint venture that helps Sprint cover the cost of its big WiMax bet.

The week started with rumors that Deutsche Telekom was thinking about buying Sprint.  The next day, we heard that Sprint may sell its Nextel unit.  Today, the long-rumored cable-Google-Clearwire-Sprint-Intel alliance has come together.  It seems that Dan Hesse, Sprint Nextel's CEO, is making progress in Kansas...at least it's the kind of progress his shareholders might want to see.  Om Malik believes this is the start of a hack job in which WiMax is the first of three separate parcels for sale, with the others being Nextel, and then the remaining Sprint properties. 

The new joint venture helps fill a need for each of the participants:

• Sprint gets $3.2B in funding for its $5B WiMax rollout, and sheds much of the operational responsibility for the rollout, allowing it to focus on the atrocious customer churn in their wireless business.
• Comcast and Time Warner Cable get to partially fill a gaping hole in their product bundle: wireless phone and Internet access.
• Google gets a captive platform for its Android intitiative, which it needs in order to help close the gap with Microsoft and others in the crowded mobile operating system field.
• Intel gets a boost for the WiMax technology in which it has invested so heavily.
• Clearwire renews its WiMax relationship with Sprint, helping ensure the viability of both Clearwire and the WiMax technology on which it has placed its bets.

It's a deal that had to happen.  However, the history of joint ventures with widely-varied participants with competing interests is spotty, so success is far from certain.

Meanwhile, this development is just one of two big developments for mobile Internet access this week.  The other is from T-Mobile, as reported by Brough Turner on his Communications blog:

T-Mobile USA has launched their first 3G service using the spectrum they won in the 2006 AWS auctions.  For now, it's only New York City, but Reuters reports that T-Mobile plans to launch in 20 to 25 new markets by the end of the year and T-Mobile's stated intention is a full national HSPA network. In 2009, this will be our fourth national 3G network fully capable of multi-Mbps down and multi-hundreds Kbps up.

So, between AT&T, Verizon Wireless, Sprint Nextel, T-Mobile, and the new Clearwire WiMax joint venture, Brough predicts that we will have five competing wireless broadband Internet access networks by 2010.  I wouldn't be surprised to see this consolidate back to four players before 2010, with T-Mobile and Sprint joining forces.

Anyway, this looks like good news for consumers, and good news for companies selling bandwidth, like Level 3 Communications. Fatter wireless links, like those promised by WiMax, will need fatter fiber-optic networks to carry all of that traffic.