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. 

Comments

[John Scofield]

Good sound quality, but terrible customer service. I think Vonage can improve their revenue by paying more attantion to support.

[Ike Elliott]

Mr. Math,
True, the model used to make the chart makes some simplifying assumptions that may not reflect reality. As you point out, it could be that increasing the rate of customer additions may reduce quality and therefore increase churn. On the other hand, increasing the rate of customer additions may also increase the percentage of customers that are early in their contract, which might reduce churn. I didn't make any attempt to model these kinds of factors in the model.

I could be wrong, but I don't believe I am confusing the cost to add a gross subscriber versus a net subscriber. Yes, I did assume that the incremental cost of adding more gross subscribers (above the current 96,000 monthly baseline) is $454 per subscriber, and that is significantly higher than Vonage's reported average of $216 or the fully loaded average of $267. I arrived at the $454 by looking at the difference in gross customer adds at various marketing spending levels for the past 8 quarters at Vonage, and I found that to ramp gross customer additions by and additional 11,000, Vonage needed to spend an additional $454 per customer added.

Thanks for the additional information about the probably understatement of Vonage churn rates. That certainly makes Vonage's prospects worse, and decreases their chances for survival.

[Mr. Math]

You are confusing net cost to add a subscriber with gross cost. You do the payback calculation on "gross" not not "net". So it is not a 6 year payback. But in looking at cost to acquire ($216) you need to put in the $51 CPE subsidy ($267) since VG does not. And in looking at churn you need a real #, which Motley Fool and others believe is more than 3.3% since VG exludes certain churn.* But 3.3% is still killer. But once you do get the formula right assumptions still matter. You say:

"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."

$5 million/$11,000 = $454 cost to acquire gross
$5 million divided by $267 = 18,726 gross customers.

You then say:

"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."

Well if I can learn to sing and dance then I can win America idol.

As you try to get more incremental customers, quality can drop and churn rise. As you try to get more, the cost to get can go up per customer. The more customers you get, the more your cash drops since SAC/CPGA is an up front expense. VG may "just be saying no" to customer acquisition cost above a point that that know damages cash flow too much (i.e., only low hanging fruit is sought) thus the low growth).

VG is heading off a cliff since the result of a correct financial model is negative per new customer NPV.

* "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…"

[John]

How can they compete with cell phones?