As Vonage goes, so goes “Residential VoIP”

Vonage invented consumer residential VoIP as most people know it. We have to give them credit for that. Many people as late as 2003 were still saying the Internet could not handle phone calls at all. I think Vonage got people past that.

In 2003, Vonage was the darling of the industry, representing the future glory of VoIP, and it was not very popular to denounce this new wonder as I did here when I declared that the essence of the entire business with all these Vonage-style services (Vonage and the then emerging Vonage-clone services from AT&T, Verizon, et al) was fundamentally flawed. I said:

When I said back then that Vonage-style VoIP was simply a local-loop alternative, using the Internet to reach the new “central office” and that, beyond that, these companies were no different that the so-called century-old telephone system and declared that these services were about as un-Internet as you can get, I was essentially blasted by the blogorati — That was blasphemy back then.

Essentially nothing has changed about what I said in 2003. It’s just that now it has become fashionable to say it. Now, the blasphemy is in not being a Vonage basher.

Stuart Henshall coined a wonderful term for these services: PoIP (Phone over IP), which I have embraced. Consumer Reports reviewed PoIP providers in February 2005 and it was noteworthy that the majority of their testers said they won’t keep PoIP because “the inconvenience outweighed the prospect of lower bills.” This pretty much sums up the PoIP business and explains why the customer acquisition costs are high and lifetime value is under water.

When investors and others asked me to summarize my thoughts on Vonage circa 2002, below is what I told them. These were pretty radical views at the time. You should have seen the way people rolled their eyes when I said these things back then.

1.The revenue strategy is fundamentally flawed

Vonage introduced their service in March 2002 at $39.99 (see press release). My position was minute revenue represented a declining value and could not provide differentiation. I said minutes would ultimately be free, or near free. We all know about SkypeOut and Gizmo offering free calls, but in fact they were not the first. Companies like Voipbuster, SIPdiscount, and others started doing it over a year ago.

Vonage has now had to reduce their price to $24.99 and eat more setup fees, greatly reducing their ARPU, while their costs have actually increased (see below). As price becomes less of a motivator for buyers, a PoIP provider’s economics get even worse, since they have to spend even more to convice customers to switch.

At that time, minute revenue was seen as the holy grail. I mean to say minute revenue was a bad basis for a business back then did not find many supporters. In fact, there are still a lot of people that continue to believe basic minute revenue as the only business.

2. Low barriers to entry will create fierce competition

Like the ISP business of the nineties, there must be literally thousands of PoIP providers now. Anyone even remotely close to the industry can name at least five. There is essentially no differentiation among them besides brand and price. There is even an entire economy now in just helping customers wade through the myriad options in the form of review sites and services.

3. Operating costs are not sufficiently advantageous

Even though it doesn’t take a lot of capital to get started in the PoIP business, it still has relatively high operating costs per user, or in other words, poor operating margins. Anytime you try and do exactly the same thing as some existing system using the Internet, and not change the architecture in some deep way, there is no guarantee the Internet-based version is going to be significantly cheaper or more efficient. To get benefits, you have to somehow leverage what the Internet gives you, not try to make it something it is not. This is where Skype was really something different. PoIP providers appear to be mostly operated by telco-heads: telco-like thinking pervades network architecture, interconnects, bundled products, pricing plans, marketing plans, etc. Whereas Skype took an entirely different approach, from top to bottom.

The result is that the operating advantages of PoIP over traditional telco are minimal, coming mostly from not building a wire plant, and (at least in the beginning) regulatory arbitrage. And since PoIP isn’t leveraging the Internet to differentiate, and instead is just saying “we offer the same thing at a better price”, it makes it easy for the telcos to leverage their significant economies of scale (100 to 1 over Vonage, easy, perhaps 1000 to 1) to achieve better operating efficiency. How bad is that: that the century old telco system can actually have better operating margins than a supposed Internet company.

4. Regulatory issues will be a nightmare

Most the VoIP industry is still playing ostrich on this point, but the writing is on the wall (or at the FCC) and we’ve already seen how PoIP providers will not be able to remain immune to regulatory burdens. As I have already said, if you’re going to stand up and say “we’re just like normal phone service” and then cry when the FCC comes calling, you get what you deserve. This impacts point 3 above and further weakens the operating advantages of PoIP.

Summary

Basically what I was saying back then was that (a) competition and other forces would drive the core revenue down, (b) as a result of that, the entire selling proposition of “cheaper” becomes too weak, (c) this, combined with other switching costs, in turn drives up customer acquisition costs, and finally (d) the operating margins will be worse than a traditional telco. There is nothing good about the PoIP business. Not many people were listening to that story in 2003.

As some of you know, I spoke with my feet, and tried to put something together that really was different and I continue to try to make a go of it.