Vonage, poised for IPO, has rivals at its heels

While Vonage is still the largest Net phone company, cable operators are rapidly catching up by offering bundled services.

Thanks to its relentless marketing and low prices, Vonage has quickly become synonymous with phone service over the Internet.

But when Brandon Sehlke and his wife, Jennifer, moved into a new home in San Antonio two weeks ago, they chose a new Internet phone service from Time Warner Cable, not Vonage or AT&T, his old provider.

The deal Time Warner offered was just too good: phone service with a television package and a broadband connection for a promotional price of $89.95 a month.

"Getting all three services was better than anything else we could find," said Sehlke, a 24-year-old dental student in San Antonio. "I briefly looked into Vonage. But paying $90 for all that was hard to pass up."

As more people make similar choices, Vonage's run as the industry leader is likely to end. While Vonage is still the largest Internet phone company, with 1.6 million subscribers, Time Warner, Cablevision, Cox and others are rapidly catching up, using their marketing heft and their ability to offer bundles of services.

The change comes at an inauspicious time for Vonage and its founder and chairman, Jeffrey Citron. The company is expected to go public this week in a roughly $500 million offering that, had it occurred a year ago, might have been hailed as a victory for a plucky upstart that outfoxed the traditional phone companies.

Instead, industry analysts are asking whether Vonage can compete--not just against giants like Time Warner, but against even feistier companies like Skype, which lets customers make free calls.

"Vonage is not the company people are going to identify with voice-over-Internet phones six months from now," said Jeff Halpern, a telecommunications analyst at Sanford C. Bernstein & Co.

Halpern said that the company "could be getting in under the wire" by going public now. "Vonage is going to be in a position where it is a single-product company, and other companies are offering multiple services," he added.

Brooke Schulz, a Vonage spokeswoman, said she could not comment, citing regulations prohibiting companies from discussing their business before a public offering. People briefed on the company's plans, however, said that Vonage would probably issue new shares on Wednesday.

For now, Vonage remains a success story. It is one of a handful of Internet companies that rose out of the ashes of the telecommunications bubble of the 1990s. While many start-ups ran through millions of dollars and attracted few customers, Vonage took a rather obscure technology and created not only a familiar brand but also a sizable business.

Vonage added 878,000 new subscribers in the last year, including 328,000 in this year's first quarter. Vonage accounted for 29 percent of new subscribers to domestic Internet phone services in 2005; at year's end, it had 31 percent of the market, according to Sanford C. Bernstein estimates.

Customers are moving to Vonage because of its price--$24.99 for unlimited local and long-distance calls in North America and some European countries. The service is so cheap because unlike traditional phone companies that maintain expensive copper networks, Vonage and its competitors turn calls into data and send them over the Internet.

Vonage also offers conveniences like call forwarding, voice mail through a Web site and a portable modem that can be used with any broadband connection, so customers can make "local" calls even if they are overseas.

Vonage has also struck deals with Best Buy, Target, Wal-Mart and RadioShack to sell its equipment and services in their stores, and it is working with an array of manufacturers to develop handsets and other products.

But Vonage's share of the market for Internet calling, also known as voice over Internet Protocol or VoIP, has slipped from 34 percent in 2004 because cable companies are grabbing a greater percentage of new customers. Time Warner had 1.4 million customers at the end of the first quarter, while Cablevision had 900,000 subscribers.

The Internet calling market, which also includes independents like Primus, SunRocket and Packet8, is still just a sliver of the overall phone business. But it is growing at the expense of Bell phone providers like Verizon and AT&T, which have introduced their own Internet phone services to keep customers from defecting. The Bells are also developing television services to win over cable customers.

As the big phone and cable companies lock horns, analysts say, one-product companies like Vonage risk being lost in the shuffle.

In some ways, Vonage may be a victim of its own success. The company helped popularize a product that most ordinary consumers did not think they needed a few years ago. Then imitators rushed into the market.

"Vonage is analogous to TiVo," said Renee Shaening, an analyst at Kagan Research, referring to the company whose name has become synonymous with its digital video recorders. "TiVo was on the forefront of offering time-shifted video service, but now the cable companies have their own."

Customers have also found that not all Internet phone services are the same. Vonage calls are connected by a variety of companies that route voice data over their networks. Some customers complain that calls can sound tinny.

Cable companies, by contrast, use their own networks to connect most calls, which can mean more reliable connections. They also have workers who can visit customers' homes, not just operators at call centers. And with deeper pockets, they can offer more discounts and new services.

Last week, for instance, Cablevision introduced a flat-rate plan that includes 500 minutes of calls to any foreign country for $19.95 a month.

Further net losses
Significantly, cable companies can also pitch their phone services to their millions of existing customers through the mail and on their television systems.

For now, Vonage plans to spend more on advertising to find new customers, instead of focusing on trying to turn a profit.

"In order to grow our customer base and revenue, we have chosen to increase our marketing expenses significantly, rather than seeking to generate net income," the company said in a regulatory filing this month.

"This strategy, however, will result in further net losses, which generally have increased quarterly since our inception," the filing said.

The company said it spent $88.3 million on marketing and lost a net $85.2 million for the first quarter.

In its filing, Vonage also acknowledged growing competition from cable companies that can bundle phones with broadband and television at a discount.

"These offerings," the company said, "could negatively affect our ability to acquire new customers or retain our existing customers."

Faced with Skype too
Though Vonage appears focused on the likes of Comcast, it must also grapple with services like Skype, which eBay bought last year. Since in most cases Skype routes calls entirely over the Internet, its service is less reliable than Vonage's. But it is also free when Skype users call each other using their computers.

Last week, Skype said customers in the United States and Canada could call free from their computers to traditional phone lines anywhere within their own countries until the end of the year. Calls previously cost 2 cents a minute. Skype hopes the promotion will encourage more people to buy a phone number from them so that others can call their computer from an ordinary phone line.

Even with all these challenges, most analysts expect Vonage to remain an attractive option for customers who do not like the Bells or their cable company, or who want a cheap second phone line for their home or office. Other companies, like Packet8 and SunRocket, which have more than 100,000 customers each, should benefit from the same anti-establishment sentiment, the analysts say.

But the rebel market is a limited one, and Vonage is likely to struggle against behemoths that are turning into one-stop shops for telecommunications services.

"I kind of assumed Vonage would go away after a while," Shaening said.

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