Telecosm - Ike Elliott

Vonage Skid Continues Amid Debt Uncertainty

Vonage missed a commitment to refinance their $253M in convertible debt in the 2nd quarter, and as a result, the company's stock price is losing ground, hitting a year-to-date low closing price of $1.55 per share on Monday.

The convertible debt must be paid back in December, so the company has only five months of runway left to resolve the issue.  Most of the $253M must be refinanced because the company does not have enough cash on hand to pay it off, and because the company does not generate much free cash flow from operations. 

Vonage signed a non-binding letter of intent with a financier in April to refinance the debt, saying that two-thirds of the financing should come from a senior secured credit facility, and one-third from new convertible debt.  In May, CEO Jeffrey Citron said that he expected the transaction to close in the 2nd quarter.  The company missed a June 13th deadline to finish the deal, and then missed the extended deadline set for June 23rd.

Now the company hasn't set any public deadlines. 

Without a refinancing, the options are slim:

• Sell the company to a public or private buyer, or
• Declare bankruptcy

I don't think there is public company that wants to buy the company and assume the debt, so if the debt can't be refinanced in this tough market, maybe the company would declare bankrupty to erase the debt, and then be sold. 

Of course, if Vonage can complete the debt refinancing, then they get to live another day.  However, every day that goes by without debt refinancing increases the chance of bankruptcy.  And the stock price shows it:

   

QoS Strategies of Business VoIP Providers

For the past few days I've had a series of posts showing the results from an informal survey of Business VoIP service providers.  Wednesday, we looked at size rankings by number of seats served, and yesterday we looked at which providers sell retail, wholesale, or both, and the geographies served by each.  Today, we'll look at quality of service strategies of the various providers.

As you can see from the table, all seven of the pure retail providers actively manage the quality of service provided for their retail customers.  In order to do that right, you generally also have to sell Internet access to the customer and you have to provision a circuit to the customer site, connected to a managed router on the customer end, and connected to your own network-side router on the other end. Then, you configure the routers on either end of the dedicated circuit to prioritize VoIP packets over other plain data packets, so that voice quality isn't disrupted by a burst of data traffic.

The hybrid wholesale/retail providers are more of a mixed bag.  8x8 and Junction Networks do not actively manage the quality of their VoIP services, preferring to rely on the public Internet for their customer connectivity.  This gives 8x8 and Junction Networks easy access to a national footprint, but it also means that customers may sometimes suffer from poor quality if their Internet connections are either overutilized or low capacity. 

The other hybrid wholesale/retail providers, Bandwidth.com, Simple Signal, CommX, and PBX-change, offer some degree of quality of service management, at least in some circumstances.

The wholesale players, such as New Global Telecom, often rely on their service provider customers to provide the Internet access link to the retail customer, so quality of service management is sometimes incomplete.  Unless the wholesaler controls the routers on both the customer premise and on the network side of the customer connection, or asks the retail service provider to do the same, quality of service cannot be guaranteed.  With that in mind, I'd be interested to learn how Vox Communications, a wholesaler, carefully manages quality for "TDM-like voice quality".  It might be that Vox is relying only on an adaptive codec, like Skype. 

      

Wholesale and Retail Business VoIP Providers

This week, I'm publishing the results of an informal survey of fourteen business VoIP service providers.  Yesterday, I published the list of survey respondents ranked by number of seats served.  Today, I'll look at the breakout of which companies are wholesale, retail, or both, along with whether the companies are focused in specific geographic areas, or are focused nationally.

The chart below shows the results.  You can click on it to see a bigger and better resolution version of the chart.

The size of the bubble indicates the relative size for the company, based on number of business VoIP seats served.  If a bubble straddles the wholesale/retail line, then the company serves both wholesale and retail customers.

The main take-away from the chart is that all of the pure retail companies, led by CBeyond, are focused on selected cities or are focused regionally.  That makes sense because it often takes a local sales presence for retail sales.

The pure retail players are led by CBeyond, followed by M5 Networks, Zayo Managed Services, and Unity Business Networks, Versature and Vivid IP - LogiSIP.  Fusion did not report their size, so the "proper size" of their bubble isn't known.  PBX-Change, a Tampa-based wholesale/retail player operating in the southeast, also did not report their size.

There are two pure wholesale companies that responded to the survey, led by New Global Telecom, at 82,000 seats served. Vox Communications did not report their size so the proper size of their bubble is not known.  Of course, their are other pure wholesale companies in the market, but they just haven't responded to the survey, yet.

The hybrid wholesale/retail players are lead by Bandwidth.com, followed by 8x8, Junction Networks, Simple Signal, and CommX. 

More data to come tomorrow! 

Business VoIP Survey, July, 2008

It's time to publish the first Telecosm Business VoIP Survey, in which Business VoIP companies self-report about the rapidly growing Business VoIP segment of the market.  This is a little experiment I started about a month ago, when I published a blog post asking Business VoIP companies to give us a little more insight into their business. 

This market segment is served by many regional players and many of them are privately held, so it's sometimes hard to get a handle on how the segment is growing.  I hope this little survey will help to shine a little light on the industry.  This should be the first of many periodic editions of this survey, and I hope that other business VoIP providers will join in.  I am very thankful for the fourteen companies that did respond.

There were fourteen responses to the survey, but since CBeyond is public and an ackowledged leader in the space, I added them to the list as if they had responded to the survey.  Fifteen companies does not make a very comprehensive industry survey, but it's a good start and begins to paint the picture of this emerging market segment, and I expect that the publication of the first survey will attract the attention of other companies in the space and the survey will grow as I publish it again each quarter. 

Here are the size rankings of the thirteen companies in the report:

After CBeyond, it looks like Bandwidth.com and 8x8 are the next-largest challengers, at a about a quarter the size of CBeyond.  Junction Networks and M5 Networks are next, followed by a batch of mid-sized providers: Simple Signal, Zayo Managed Services, CommX, and Unity Business Networks. 

I'll publish excerpts from the survey over the next couple of days and will publish the entire survey on Friday. 

Here is the contact information for each of the survey respondents:

Note: you can see larger versions of either of the images in this post by clicking on the image.

Final Call for Business VoIP Provider Survey Responses

Back in early June, I put out a call for Business VoIP service providers to respond to a survey, and promised to publish the results in early July.  Well, the time has come, and tomorrow is the day to publish the results.  It's not too late to get your response in...I just need to receive it by the end of the day today.  Just follow the instructions on the June 6th blog post.

So far, I've got responses from:

• 8x8
• Fusion
• M5 Networks
• Simple Signal
• Unity Business Networks
• Versature
• Vivid IP - LogiSIP
• Zayo Managed Services

I'll also throw in data about CBeyond, gleaned from their public reports.    Nine entries in the table is a good start, but I'd love to see a few more service providers participating in the survey, so spread the word and ask your service provider to lob in their survey response!

Skype 4.0 For Windows Places Bigger Bet on Video

Skype launched a beta version of their new Skype 4.0 for Windows software this morning with a worldwide conference call.  Skype calls the new 4.0 beta a "major redesign" of the user interface to try to make the client software easier to use, and to upgrade the video quality in the client. 

What's new? The most impressive work centers on improved video quality.  The video capability is truly outstanding, taking advantage of a larger window size, and an improved user interface lets you start a video call with a single click.  Skype uses an adaptive video codec that adjusts the amount of bandwidth used to the capacity of your Internet connection, so a video call can use as little as 48 Kbps, but the video really starts to look good at about 300 Kbps.  Skype is clearly trying to ride the momentum of a growing base of video callers, saying that the percentage of calls carrying video has grown from 8% three years ago to 28% today. 

One of the questions on the conference call asked "Why do you think video will take off with VoIP, when it clearly hasn't with 3G video calling?"  Michael Bartlett, Director of Windows Product Management at Skype, answered by saying that the mobile phone form factor doesn't lend itself to video calling as well as a desktop or laptop computer, and that Skype's own data show that video is taking off, again citing that 28% of calls carry video.  They clearly expect that percentage to grow.

The new software has also made a number of other improvements to the user interface, also taking advantage of greater screen real estate.  It is now easier to find friends or contacts, easier to start and manage conversations, and easier to share files with each other in a conversation.  Skype is eating deeper into the territory of Webex and the other web collaboration players.  

Skype hasn't set a hard date for launching the final public version, saying they really want to listen to users during the beta testing to "make sure this is the best piece of software we've launched in our history."

Skype says they "anticipate some criticism" as users adjust to the new software.  First impressions are good, though, and in my view it represents another step forward for Internet video in general, and for Skype in particular.

Cheap VoIP Service: iCall on the new iPhone

With yesterday's launch of the new 3G-capable Apple iPhones, VoIP over WiFi is getting a boost.  I still believe using VoIP over WiFi will be often be plagued with quality problems, but if you are really interested in conserving your cell phone minutes, you might want to check out a new iPhone app called iCall. 

iCall is a free VoIP over WiFi application for the iPhone, and you can download a beta version of it now.  Basically, it's a tool to save minutes if you are on a limited minutes cell phone plan.  Whenever you are within range of a WiFi network, you can elect to make outbound calls over the WiFi network instead of AT&T's mobile network, and you can elect to transfer calls that you have received on AT&T's mobile network over to the WiFi network.  When the call is on the WiFi network and not on AT&T's network, then you are not eating minutes from your cell phone plan's minute bucket.  

This is a lot like the T-Mobile "Hotspot @Home Talk Forever Mobile" service that won a BUNGL few months ago, except that it's free.  (That was probably the most controversial of the BUNGL awards...took a lot of heat for that one!  Needless to say, iCall won't be winning a BUNGL.)

How can iCall afford to give away domestic long distance and local phone service?  Good question.  The web site says this about that:

"Why would we give this to you for free? The answer is simple - iCall wants you to call the businesses who pay to be listed in our directory, and we'd also love to sell you a headset or dirt cheap international calling rates."

So, it's an ad play, supplemented by upselling on international long distance and accessory sales.  I hope they generate enough revenue from that to cover their costs, or there are going to be a lot of disappointed iCall users!

More on Magic Jack

Coincidentally, Doug Mohney over at FierceVoIP also posted on Magic Jack today.  He added a bit more detail to the business plan, that I didn't cover in my post: the company plans to sell advertising and reserves the right to tailor ads based on the phone number that you dial.

According to Mohney's post, Magic Jack is adding users at a rate of over 7,000 a day, faster than Vonage! 

Cheap VoIP Option: Magic Jack

My friend Michael Remacle, who now runs business development for Vail Systems, suggested I do a post on Magic Jack, one of the truly inexpensive VoIP options out there for consumers.  No, I'm not talking about Level 3 CTO Jack Waters...though I understand how you might think that!  No, Magic Jack is a separate company that sells a really cheap consumer VoIP device and service.

Here's how Magic Jack works:

1. You buy a USB "magic jack" dongle for $40, which includes all of the fees for your first year of service.
2. You plug the USB dongle into a USB port on your PC.
3. You plug your standard, traditional analog phone set into the phone jack on the USB dongle.
4. You start to make and receive unlimited VoIP calls to and from any regular telephone.
5. You also get free voice mail.

So, it's basically $40 for your first year of service (including the USB dongle), and $20 a year for every year thereafter.  This computes to about $3.34/mo in the first year and about $1.67/mo for every year thereafter.  Cheaper than chotskis at a VON conference!

I have never used the service so I can't vouch for it.  It certainly is low-cost, though!

How can anybody afford to sell VoIP service so cheap?  After all, if you assume an average of 500 minutes of long distance per user, per month, then in the second year they are basically charging $1.67/500 = $0.00333 per minute of use.  That's well below current wholesale long distance prices, let alone retail pricing, so you do have to wonder how Magic Jack is selling phone service for so little.

Here are some theories on how Magic Jack can sell so cheap:

1. They are enjoying interest on the float, since they are collecting annual fees up front.
2. They are benefiting from some breakage from folks who buy the service but end up not really using it (so the average long distance minutes used per month is actually lower than 500 minutes).
3. They are gaming the reciprocal compensation system to get paid for some of their inbound calls (more on reciprocal compensation in a future post).
4. The cost of goods on their magic jack dongle is really tiny, like less than $5.00, so if you attribute $20 of the intial $40 payment as the retail price for the jack itself, then they are making really healthy margins on the cheap hardware.  (It would have been great to have a sub-$5.00 dongle 9 years ago...this would have come in real handy when we were searching for cheap bricks back then!)

Even with these benefits, though, it's hard to see them making much money at it.  Just another example of how it's hard to compete as a consumer VoIP service provider these days.  It's a good deal for consumers, though!   

VoIP Business Survey Responses Starting to Roll In

On Friday, I put out the call for responses from all business VoIP service providers to participate in a survey of this emerging space. The responses are starting to roll in, thanks to some help in spreading the word from Peter Radizeski at RAD-INFO, and from Rob Powell over at Telecom Ramblings. Many thanks to those who have already responded to the survey, including VoxBone, Vivid IP - LogiSIP, and Versature.

The survey responses will be published in early July. Please help to spread the word...the more responses we get, the better picture everyone gets!

Calling All Business VoIP Providers

A few days ago I posted a small roundup of business VoIP service providers (see "Four Different VoIP Business Models"), and I have had a bunch of comments and emails about that post, wondering why I didn't list any of a number of other examples of business VoIP service providers in that post.  The truth is, business VoIP providers are thicker than summertime flies in Maine right now, and there are many more than four different variations of VoIP business models.  Most of these companies are privately held, so they are harder to track than public companies. 

There is a real lack of comprehensive information about these companies, so I am proposing that we keep a public listing of these companies in a quarterly posting on this blog.  This could be a win-win for everybody:

1. The VoIP company gets a little more publicity, and I'll post email/phone/website contact information for each company on the list.
2. The blog's readers, the VoIP companies, and I get a more accurate view of how this market is developing.
3. I get to put interesting stuff up on my blog!

Here is how I propose it should work:

• If you are a VoIP company that focuses on serving businesses, email me (at ike@practiq.com) all the info you are willing to make public, hopefully including:
  1. company name,
  2. contact phone,
  3. contact email,
  4. web site URL,
  5. number of seats served at the end of your most recent quarter,
  6. Sales strategy: wholesale/retail/both,
  7. Sales geography: selected cities/national/international (list specific geographic focus if you wish)
  8. Distribution strategy: feet on street/telemarketing/retail stores/indirect channels (agents, etc.)
  9. QoS strategy: managed/unmanaged
  10. Do you sell Internet Access?
  11. Do you sell a service that allows your customer to run their own traditional PBX (often called a "trunk replacement" service)?
  12. Do you sell a service that allows your customer to run their own IP PBX (often called a "SIP trunking" service)?
  13. Do you sell local and long distance minutes?
  14. Do you sell hosted IP PBX services?  If so, do you own and operate your own IP PBX, or do you purchase acess to a wholesale IP PBX service?
  15. What is your average number of employees per customer site?
• Any info you don't want to share I'll just list as "DNR", or Did Not Report.
• I'll compile all of the responses I get in tabular form and post it once per quarter.  First posting will be in early July so the deadline for responses for the first posting will be June 26th. 
• I'll also do interviews with executives from this company list from time to time, and post them on the blog.

So, submit your info, and we'll get going on this!  If you are a Telecosm reader and know of companies who may want to participate in this survey, you can help by sending a link to this post to your contacts, so we can get as comprehensive a view of this market as possible.

Thanks!

   

Why SIP Hasn't Won Yet

Brough Turner has a wonderful, succinct summary of why the Session Initiation Protocol (SIP) hasn't realized its potential, at least not yet.  Brough and I agree that peer-to-peer SIP is the best chance for the protocol to completely change communications as we know it.  Check it out!

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.    

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.   

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. 

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.

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. 

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!

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: