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Tickers in this Article: VG, TWX, CMCSA, GOOG, YHOO, EBAY
It doesn't take a rocket scientist, or a financial analyst for that matter, to see that a company with decelerating sales growth, increasing customer defections, aggressive new competition, and soaring marketing costs will suffer operating problems.

Yes, I'm talking about that competitive voice service provider (CVSP),Vonage (VG). After an entry into the U.S. in October 2002, Canada in November 2004 and in the United Kingdom in May 2005, VG has spent a couple of billion dollars adding almost 2.06 million subscribers as of September 2006 – yet it has produced an accumulated deficit of $604 million.

During this most recent quarter, VG was able to add 359,000 subscribers. However, it also lost a staggering 154,000 subscribers during Q3, yielding a net reported subscriber addition of 204,600, which is down 20% sequentially from the net 256,000 added during Q2.

Revenue, however, was up 12% sequentially, and 118% year-over-year. That's good, but not as good as last quarter, when revenue grew 21% sequentially and 141% year-over-year.

Rising Costs Limiting Profitability
VG generated a quarterly 5% disconnect rate relative to its total subscriber base (i.e. its churn rate) – this is a massive warning sign.

Worse, subscriber revenue generation is slipping, with average telephony revenue per subscriber line (ARPU) down from Q2 2006 to just $26.33 for this quarter.

But the real shocker is that this company has no sense of cost controls. Marketing costs were up sequentially at $91 million, yielding marketing costs per gross subscriber line of $254, up 6%.

But on a net subscriber addition basis, it soared to $444.79, from $351.56, indicating a dramatic deterioration in the company's success at adding and retaining customers. With a $29 customer equipment subsidy, the VG model yields no payback from adding customers even with a four year timeline.

The long story made short is that VG's incremental subscriber revenues are falling sharply away from rising incremental subscriber addition costs. In 2005, VG burned $243 million on marketing costs alone, or about 94% of its revenue, and it is tracking for $350 million for 2006. VG used $190 million in cash from operations in 2005, and another $150 million in investments, all with no incremental revenue gains.

Surging New Competition
Although connectivity, equipment add-ons and audio clarity have been historic problems for VoIP service providers, according to the second keynote VoIP Competitive Intelligence Study of internet telephone service, recent improvements have left Time Warner Digital Phone ranked first for both reliability and audio clarity, while audio delay still plagues VG and other non-cable players.

With hindsight, VG only made sense for people with a cable modem in 2003 and 2004, but now all of the cable companies are offering VoIP phones.

Over time, both phone companies and cable companies will have high speed digital connections to homes and will offer digital TV, phone, and internet service, with Time Warner (TWX) and Comcast (CMCSA) being the leading players. And early mover Telio and newcomer SunRocket are looking to leverage new devices, such as the new Nokia N80i with Gizmo software.

New offerings from Google (GOOG), Yahoo (YHOO), and the eBay (EBAY) Skype upgrade are predicated on a coming VoIP "open standard" that will allow users to access the voice network through countless "wireless internet" or Wi-Fi networks. Instant messaging clients can also access the networks.

The bottom line? VG shares have some pretty tough looking prospects going forward – investors would do well to hold off on making the call to buy into the company at this point.

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