Warning Signs Point to Independent VoIP Carriers’ Days Being Numbered

| July 26, 2007 | Digital Home - U.S. | Advisory Report

| Analyst: Bruce McGregor

Issue

There is growing speculation that third party VoIP carriers like Vonage, Packet8, and Lingo are in danger of going out of business. Recent events have concerned current customers who use independent VoIP carriers as well as potential VoIP customers by indicating that these companies are too unstable to provide a primary residential phone line.

In April 2007, the U.S. District Court in Alexandria, VA issued an injunction against the largest independent Internet phone carrier, Vonage, that limits the VoIP provider's ability to offer service to new customers unless Vonage changes the way the new customers’ calls connect to the PSTN to cease violating Verizon's patent. However, the U.S. Court of Appeals stayed the injunction until a permanent ruling is made.

In July 2007, just when assertions about Vonage’s risk for going out of business quieted down a bit, SunRocket abruptly closed its doors, leaving many of the company’s 200,000 customers without a dial tone. While concessions have been made available for SunRocket customers to port their VoIP phone numbers over to 8x8’s Packet8 and Unified Communications’ TeleBlend, it left these customers wary of signing up with a similar VoIP provider that could very well become the next SunRocket to go belly-up.

Not helping the situation, cable companies have made a big push into VoIP and in Q1 2007 Comcast passed Vonage as the largest U.S. VoIP provider. Cable has become a more reliable alternative to replace the local phone company than the far smaller Internet phone companies.

Current Analysis Perspective

In the last few years, tech savvy consumers looking for a less expensive substitute phone service have embraced independent Internet phone companies. The chief motivating factor getting consumers to switch to VoIP service has been the cheap price; for example, Vonage offers unlimited domestic local and long distance calling for only $24.99 a month. In the long run, a business model solely based on lower prices is unsustainable and third party VoIP providers need to bring more to the table with added value through unique features. Another weakness of independent VoIP carriers is that consumers must first have broadband access from a competitor, which limits the size of the market it can sell to because while broadband access is increasingly used, not every home subscribes to a broadband connection. Phone companies’ best DSL pricing requires a local phone line and cable providers have been successfully bundling together voice service with their digital cable TV and broadband offerings. Furthermore, since subscribers are already buying their broadband connection from a cable company or phone company, buying a bundled offer from their current access provider that includes both broadband access and unlimited domestic calling may be nearly as price-competitive as buying the voice and data services from different providers.

Problems with Internet phone companies began to surface in the press with the leading carrier, Vonage, running into legal issues with Verizon for patent infringement. On March 8, 2007, a U.S. District Court jury in Alexandria, VA found that Vonage had infringed on patents held by Verizon that define how callers are connected to the PSTN. In that decision, Verizon was awarded $58 million along with future royalties of 5.5% against revenue for continued use of the infringed patents. On March 23, the District Court judge ruled that the fine wasn’t punishment enough, and issued an injunction that would keep Vonage from using the technology that violated the patent. On April 6, the judge issued a further injunction that would prevent Vonage from signing up new customers if the company uses the patent-violating technology, and would further require Vonage to post a $66 million bond. In theory, the District Court judge could have ruled that Vonage would be required to cease operations; in practice, forcing Vonage to shut down service and disconnect its current 2.2 million customers, leaving them high and dry, was not a viable option.

Following the decision, Vonage filed an emergency appeal with the U.S. Court of Appeals which temporarily stayed the injunction until a permanent ruling is made, allowing Vonage to continue acquiring new customers while the appeals process is in progress. On April 24, 2007, the U.S. Court of Appeals for the Federal Circuit issued Vonage a permanent stay from the previous court's injunction that would have barred it from signing up new customers. The permanent stay allows Vonage to acquire new customers as it goes after its appeal. As a result of all this legal turmoil, on April 12, 2007, Vonage announced that its CEO and member of the Board of Directors, Michael Snyder, had resigned. The interim CEO was announced as Vonage’s Chairman and founder, Jeffery Citron, as it looks for Snyder’s replacement. The new CEO’s first actions were to reduce marketing spending for 2007 and announce upcoming employee layoffs to help weather the storm of legal issues currently faced by Vonage. Even if Vonage can steer clear of its legal entanglements with Verizon, the irreparable damage has been done to its brand and to the public perception that it is a company barely holding on.

The latest indication that days are numbered for independent VoIP carriers was the sudden demise of the second largest independent VoIP carrier, SunRocket, in July 2007. SunRocket created an exit strategy for its 200,000 customers through agreements with fellow VoIP providers, Packet8 and TeleBlend, to port customers’ billing and phone numbers. The situation was bewildering for subscribers and left them wondering if they were to switch to another VoIP carrier whether or not it would become the next company to go out of business.

While customers may be wary of buying VoIP service from another relatively unknown service provider like Packet8 after their SunRocket experience, Packet8 may be on a more solid financial footing than SunRocket, which managed to burn through $80 million in less than three years. By contrast, Packet8’s parent company, 8x8, reported $11.9 million in cash reserves and that the company’s “cash burn” rate declined to $492,000 for the quarter ending March 2007. Vonage announced a new promotion geared towards SunRocket VoIP customers with the incentive of two months free service and transfer of a qualified phone number for no additional charge. These displaced SunRocket users who would like Vonage’s similar low pricing will still most likely find larger service providers more appealing to meet their needs for stability and longer track records, especially if they can get phone services at competitive rates.

SunRocket customers considering their next move for residential voice might feel more comfortable in going back to their local phone company or signing up for a bundle package with their cable company like Comcast and Charter, which have been increasingly successful in acquiring voice subscribers.

Competition for residential voice has heated up since cable providers have been able to upgrade their networks to offer VoIP services and successfully sell them as part of their triple play bundles. Comcast passed Vonage as the VoIP market share leader with 2.42 million customers in Q1 2007. Combined at the end of Q1 2007, the top five U.S. cable providers (Comcast, Time Warner Cable, Cox Communications, Cablevision, and Charter) had a total of 8.4 million VoIP subscribers. While the average regular price of cable VoIP service is higher compared to Vonage and other low cost VoIP providers, the cable companies include VoIP as part of aggressively priced bundle packages of voice services along with video and broadband services. For example, Cablevision offers its triple play bundle with a year of discounted service and a net price of less than $90 a month for digital cable, unlimited local/long-distance, and broadband Internet access with 15 Mbps downstream.

Consumers were first attracted to independent VoIP providers because of the considerable savings for home phone service compared to the traditional phone carriers. Now, with the recent market events of Vonage tittering on the brink of losing the right to add customers and SunRocket closing its doors forever, customers are forced to reevaluate who they should pick for a primary residential voice line. Consumers expect to hear a dial tone when they pick up the phone, and after the recent bad news coming from Internet phone companies, perhaps paying extra through a more established service provider like AT&T and Comcast could offer consumers peace of mind that their phone will ring.

Recommended Vendor Actions

• Vonage can emphasize that it is fighting the giants (like Verizon), saying that Verizon is trying to strangle Vonage in the courts because it cannot compete with the VoIP provider on the streets. This will help to keep customer sentiment on its side. Vonage can position itself as a consumer advocate and point out that third party VoIP companies are vital to ensure sufficient market competition for residential and small business voice services.

• Packet8 and TeleBlend must move quickly to acquire SunRocket customers – many of whom are without phone service - or the customers will find another provider who is likely more well known. Rapid acquisition is especially important to counter Vonage and EarthLink who are more visible VoIP providers and have monthly plans that are nearly identical to those offered by the VoIP replacements. Packet8 and TeleBlend must explain to customers why they are less of a risk than SunRocket since SunRocket’s demise was sudden, unexplained, and without warning to customers.

• Cable companies should position themselves as Vonage alternatives and take advantage of the fear, uncertainty, and doubt created by Vonage’s legal trouble compounded with SunRocket going out of business. Like Charter has done, other cable competitors can launch promotions touting their digital voice product lines as a stable alternative to Vonage's VoIP services.

• AT&T and Verizon should emphasize their financial and network stability, and be prepared to offer their own $24.99 VoIP services (CallVantage and VoiceWing) to third party VoIP converts—even at the expense of their traditional TDM voice plans. Acquiring this type of customer will be a long-term opportunity to upsell the carriers’ growing selection of broadband and video services.

Recommended User Actions

• Before signing up for any VoIP service, consumers need to take the time to add up how much they pay for the services they currently receive and compare that to what a bundled package will cost. Bundles do not always provide the best deals; customers that shop around may find they save more money using different carriers for local, long-distance, high-speed Internet, video, and wireless.

• Displaced SunRocket customers should understand the difference between bad technology and bad financial management and not fault VoIP just because SunRocket couldn’t service 200,000 customers with $80 million in VC funding.

• Consumers who are somewhat price conscience and looking for bundled services should compare prices that are bundled with other services. They may discover that even if the voice price is more, by adding voice to an existing service like cable TV and broadband access they already buy, they save money.

• Consumers who are entirely price conscious—especially those who use VoIP as a secondary line, should consider using Skype’s service, which bests all other VoIP providers with an annual rate of $24.99 for unlimited outbound domestic calls. When combined with Skype In (for inbound calls) at $60 a year, customers can buy very cheap phone service. However, Skype and other PC-to-PC calling services cannot replace traditional PSTN voice services, since they need to have a PC powered on or a particular Internet handset as well as a broadband Internet connection.

• Customers that are interested in buying several services from Comcast need to be aware that Comcast is offering a great value in its Triple Play bundle for just $99 a month for up to 150 digital channels, 6 Mbps downstream broadband services, and unlimited local and long distance VoIP calls. Other cable companies have been marketing similar triple play bundles that make cable VoIP a real value to a household utilizing digital cable TV and cable modem broadband services.

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