Vonage: recipe for success?

The wonderful world of VoIP

Analysis Say Vonage to anyone in the communications industry and they say: "Oh the VoIP people." Ask if they'll make it, and you may get responses like, "well the RBOCs hate them and they have hundreds of lookalike competitors."

The salvation of Vonage is that when you ask anyone to name one of these 20 or 30 start ups that have copied the Vonage model, they usually hesitate, stammer and go to look them up. Perhaps being first into a revolutionary market, even if you don't have much in the way of breakthrough technology, may well be enough.

But the headline numbers say everything about the company that virtually invented paid consumer VoIP services across America. In 2002, the year it launched, it acquired just 7,500 customers. A year later it had 85,000. Now it boasts 300,000 accounts, each paying roughly $30 a month, which makes its run rate for revenue around $108m for a rolling 12 month period. With 600 staff that only gives them a revenue per employee of 180,000, pretty low for a technology company, but it is partly explained because it is currently ramping revenues. It is also ramping staff and said this week it will add 600 more employees between now and Q1 2005.

For those that aren't familiar with the Vonage proposition, it is simple. Consumers sign up for unlimited calls across the US and Canada for just $29.99 (it's just gone down to $24.99) and select some kind of self installable SIP devices. It can sit in front of existing phones and attach to the broadband line or it can be a softphone (a phone in software) that links through a PC or even a Linksys router with special Vonage software.

SIP stands for Session Initiation Protocol and has been endorsed by the IETF, the 3GPP, the Softswitch Consortium and by Cable Labs' Packet Cable group, to name but a few and it originally hailed from work at Columbia University and came to fruition almost a full five years ago.

SIP is nothing more than a way of packaging voice into internet packets so that all the data is there to carry out basic telephony functions through proxy servers and softswitches. It needs to identify the type of traffic, the caller, the person being called, carry the number of the caller, re-route to new addresses, negotiate what to do at termination, offer authentication where required and handle call transfers.

More advanced services such as conferencing, and fax delivery need to be supported and all of this function needs to be described in a way that internet services will understand. It's a protocol that the big US local phone companies, the RBOCs, wish would just go away. But they have increasingly taken the view that if you can't beat them, join them, and begun offering similar, competitive services.

But without Vonage and its ilk, it would just be a case of replacing one way of delivering phone calls for another, with no material change in the prices. If that is Vonage's role, just to keep the RBOCs honest, what happens to it after it's achieved that and scared voice carriers into offering voice pricing that's more in line with its current cost.

From the horse's mouth

We got a chance this week to ask Louis Holder, EVP of product development at Vonage. Holder was one of the first three employees back in 2001 when the company got its first round of funding and spent a year building out its offering.

"The key to the service is the web dashboard that we give to consumers and SoHo customers to configure their service," he says. "It gives a customer all the things that advanced telephone systems can do, which were usually denied consumers, like viewing your call record including incoming as well as outgoing calls, managing voice messages, routing calls to your cellphone." The service also allows a customer to control billing online for international calling and pay bills online.

Holder reckons that between 70 per cent and 75 per cent of Vonage customers drop their original phone line and don't bother to keep a line from the local telco. "We know that because they port their number to us. Most people buy a little $40 uninterruptible power supply to ensure the line is safe from power outages for things like emergency calls. Others use a mobile as a backup or both."

So the days when VoIP was an extra and never hurt the incumbent telcos are well and truly over. Holder talks us through the early days: "When we started we just had a single softswitch where all calls had to route through, and just one or two exit gateway back into the PSTN. We just had to negotiate gateway rates with local telecom suppliers based on volume. Now we have 25 US locations and have just bought a dedicated line to the UK and have a gateway into the UK PSTN through a local telecom company there." He won't say which telco this is through except that it's not British Telecom the local incumbent. Local incumbents tend not to want to talk to Vonage.

At the moment the UK service is only for US clients to use to call back to the US for its current cheap rate of 3 cents a minute. Later UK subscribers will be invited to join the shift to Vonage VoIP.

"Until now we have transported our overseas traffic as normal analog voice. The problem was the quality of the call when it was carried over the international internet. It just wasn't good enough. With a dedicated line we can ensure that there is enough bandwidth for our international traffic, then we can offer a flat rate which includes international dialling. But right now we just have to negotiate discount rates for termination in each country, and pay for the traffic.

"Once we have learned a little from having this line in the UK, we will branch out into Europe. That will be early next year at the latest, perhaps later this year." Vonage has to put up a UK operation, built a support desk, add a softswitch and gateway, and then put together a marketing campaign, but it looks like it will sign its first customers in the UK inside three months.

Wi-Fi future

In the meantime on its home soil it is about to try shifting its calls to hotspots and wireless LANs, says Holder.

"We have Beta tests going with a wi-fi phones and people already use our service from Hotspots with a laptop or a PDA if it has the right software on it. We've put out a few dozen wi-fi phones, from about 8 suppliers so far. We want to see how each of them deals with voice compression and how they fool the wi-fi base stations into giving the phones sufficient bandwidth. We'll pick a few to partner with in the first quarter of next year and roll them out. And when WiMAX is ready we'll offer a service using that too."

Vonage on WiMAX, if it is allowed to piggy back on the service, will effective shift into being a mobile phone company, and it would eat into the lunch of the WiMAX operator, unless it deliberately partners with Vonage.

In fact it wouldn't be insane for Vonage to begin building a network with a WiMAX partner. But any new general purpose WiMAX networks are going to stand or fall based on a triple play - offering voice and later mobile voice, entertainment on demand and high speed internet over the same infrastructure. If one of those key components were taken away by Vonage, the economics of the business might not hang together.

A new wireless network could identify and block Vonage packets if it so chose. Currently that's not illegal in the US or anywhere, as far as we know. But the disincentive is to upset and lose customers. The right way around this would be to offer a service that is the same price or lower when in a bundle, as the Vonage service. That's fine for a new broadband wireless network, but for the RBOCs who have existing revenues to protect, it would be a disaster if they were to have to match Vonage pricing.

A similar bundled service from the RBOCs is currently available for something like $60 a month for the same phone services, but without the web dashboard control. That means if any of the RBOCs decided to embrace Vonage pricing, they'd have to give away roughly half of their voice revenue. Suicidal at present.

It is for this reason that the RBOCs are so hostile to Vonage, with Verizon in particular trying to get Vonage regulated out of business, and throwing up issues like the exhaustion of number availability and the weakness of 911 calling on VoIP and raising issues about the taxation of such a service.

The FCC is on the verge of ruling on how VoIP is to be treated, and obviously the investors in Vonage, have 200m reasons (they have invested in total $200m to date) to lobby for the FCC ruling to be lenient.

Michael Powell, the chairman of the FCC thinks personally that services like Vonage should be managed US wide by the federal authorities, while others have suggested that local taxation and regulations should apply. He promised the VON Conference only a week ago that he would preside over a minimal, well-harmonized regulatory environment when applied to VoIP services.

Perhaps the administration, whoever is in power by the end of this week, will have a different view, given that the RBOCs can make powerful allies and even more powerful enemies, even for a President. We shall see.

Seeing the light

Certainly the love of big business is not alien to the Bush administration and last week's ruling over exemptions from unbundling for fiber networks, reeks of his administration's involvement. At least one RBOC in the form of Bellsouth is less worried about its phone traffic and more concerned with connection. It has begun to offer broadband lines without the consumer having to be a local phone customer, something that Vonage sees as enlightened.

Another danger for Vonage are free VoIP services such as Skype which claims that about 30m people have downloaded it. "The free Skype model has been around for years," says Holder, "with Skype now and before with Dialpad and Netphone. The problem is that people don't want to be tied to switching on their computer every time they want to make a phone call. And people that want things for free are the hardest types of customers to later convert to a paid service."

Well at least 30m people are unsure enough to try it out. But then again to use Skypeout, the service which goes through a PSTN gateway, customers are paying the same kinds of prices that Vonage customers are paying.

So it's swings and roundabouts and free calls are only to other people who have Skype through a PC. As the Skype founder Niklas Zennstrom is fond of saying, "Even a Skype user has to order pizza and call his mother once in a while," and that means gatewaying to the PSTN.

Vonage is still in growth mode and if it continues to attract customers at the same rate as it has this past quarter (around 100,000 accounts a quarter) in will take it around 18 months to make it to 1m accounts and a revenue closer to $360m. But so far it's not profitable.

Holder says that its cost of acquiring customers isn't going up right now. "AT&T went and copied our business model when it launched CallVantage, and that has broken down a lot of barriers for us. Right now all it has done is educated the consumer that VoIP is safe. Then they look around for the best service and find us."

But he doesn't expect things to stay that way forever: "At the moment we use a lot of internet advertising, because the right demographic for our customers have high speed internet lines already and they spend a lot of time surfing. We also do some TV advertising and some radio and print. But we know that the cost of acquiring customers is going to go up as it gets more competitive in VoIP."

So what will Vonage do once the world catches up with it and there are literally hundreds of VoIP programs around for unlimited global calling for under $30 a month? "Well that won't be for a few years and although we understand that is coming, it is up to us to move our offering on to make sure that it stays one step ahead."

One way it can do this is by taking its offering to bigger businesses, which it also plans to do next year, partnering with IP Centrex services and IP PABX device suppliers.

Next stop: Europe

In Europe where Vonage is on the verge of launching, staying one step ahead is easier said than done. The UK and France are building out IP only networks in order to savage their costs, perhaps halve them, ready for a VoIP onslaught that they figure is best to trigger themselves. There's also more local loop unbundling and so more competition from ISPs and unbundlers.

And we would think that all Vonage investors will be on the edge of their seats come the US presidential election, because that and the FCC's deliberations, could well decide the company's long term future, within a matter of days.

Copyright © 2004, Faultline

Faultline is published by Rethink Research, a London-based publishing and consulting firm. This weekly newsletter is an assessment of the impact of the week's events in the world of digital media. Faultline is where media meets technology. Subscription details here.

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