We recently sat down with Jeffrey Citron, the chairman and CEO of Vonage, to talk about the future of Voice over IP, whether or not Skype is their number one competitor, Vonage's wireless strategy, and how they're responding to the recent controversy over VoIP and E911 calling. Oh, and for all the Treo fans out there, we also asked them how much longer we're going to have to wait until we see a version of Vonage's softphone client for the Palm OS.

Jeffrey CitronBefore we get into some of the specifics of what Vonage is up to right now, what's the big picture with Voice over IP?

The telecom industry is shifting dramatically, and right now you've got everyone rethinking what business they want to be in. I think many are drawing correct conclusions, others are drawing improper conclusions, and I think it's really too early to say how all of this is going to play itself out.

In my world, particularly Voice over IP, I view the issue differently than a lot of others. I think that broadband is utility. I think it's like electricity, and I don't think you should treat it any differently than electricity. If you have to regulate it, you might as well regulate it like electricity gets regulated, because broadband on its own delivers nothing. It's the services that it enables, the same way electricity is useless unless you can plug a lamp into the socket, or a blender, or a microwave, or a computer. It is an enabler of things. Broadband is enabling things like IPTV. Like Voice over IP. Streaming video. Streaming audio. Music. Radio. All the ways in which we communicate or use and consume content are being transformed by this process.

The Voice over IP industry is doing very well. The cable guys have done a great job in online services, and we commend them for that. We've done a great job, too. And right now some of the other players have to be thinking, "Well, what am I going to do in this world?"

Speaking of those other players, there are so many companies offering Voice over IP services now. Every week we're hearing about a new company getting into the game, and it seems like we're headed towards VoIP basically becoming a commodity. How is Vonage going to stay ahead of the competition when VoIP is a commodity?

Just because lots of people offer a service that doesn't make it a commodity.

What about when it's priced like a commodity?

Well, we'll go through that in a second. Some people have estimated in articles, and I don't put this estimate at all, that there are 1,100 Voice over IP providers in this country. I don't think it's that high because I can't find 1,100. I'm barely pressed to find over 100. But even if there are 100, or 1,000, there are really only six that account for 95%. So it's really one of those six deals that really matter, because those are the six that are going to drive the marketplace, or seven, or five that are going to drive the marketplace. Or seven. Or five. Now, I don't think Voice over IP is a commodity-based product, and I don't think it's being commoditized. And I don't think it's priced as a commodity.

Do you think it's headed that way?

I don't think it's headed that way. I think quite the opposite. Typically commodities themselves are very stable products. They're a fixed known quantity of something that is ubiquitous no matter where you go. So oil is a commodity. Quantity doesn't change. Oil is oil, gas is gas, electricity is electricity. Broadband is broadband.

But you could look at voice minutes themselves as a commodity.

Vonage is service. Maybe voice itself might be a commodity per se, but I don't think so. And I'll explain why in a second. But Vonage's service is more than voice. That package of what we offer is changing and growing to provide new and unique applications on a pretty regular basis. While we might think that wireline voice might be heading towards commodity status, clearly wireless voice is not a commodity, and its pricing trends aren't the same pricing trends as wireline trends. Wireline trends have really subsided at this point, and quite frankly the value that's coming is not in the area of the voice components as much as it is in way in which the voice components are accessed: mobility, video, whatever the feature set is.

But in terms of wireless now, there's a high barrier to entry compared with Voice over IP.

There's a high barrier to entry in Voice over IP now.

What's the barrier?

Well, if you want to be a top five player, you've got to compete and dislodge Vonage, Time Warner, Cablevision and Comcast. So tell me, how much money will it take to go sign up and get one million Voice over IP lines, right? Lines that are going to replace your home phone service, or replace your Vonage service or your cable service? That's a pretty big barrier.

What do you see as the cost per customer acquisition?

For us, customer acquisition costs range between $150 to $200. So you want to go get a million customers? Before you do anything, you're going to go write a check for $200 million, and that's if you're perfectly efficient. And it's going to take you two years. If you're inefficient, it might take 300 million, 400 million. Just to go get the customers. Then what about the operating costs to service those service those customers, while you're ramping up that growth. You can't just go out and acquire those customers and say that you'll figure out support later, you've got to build a support infrastructure ahead of that, and then you've got to go get them. And the question is, what are you going to offer Time Warner's customers? What are you going to offer Cablevision's customers? What would you offer Vonage's customers to make the switch from us to you? If you're going to offer a price differential you've got to go under $20. You've got to go under $15. And quite honestly, if you look at the other providers out there, there are plenty of providers. There's a whole long list of $15 and $18 and $23 that have been unable to dislodge us as a leader. And quite frankly, they have not impeded cable who sells their product at $35 and $40. So maybe there's something more to this than just the price of the service.

But what if one of those cable companies decides that they're going to approach VoIP as a loss leader and just start giving service away in order to get customers to sign up for cable TV and Internet packages?

That is an interesting proposition, but it doesn't make economic sense to the cable operator. And I'll give you an example. Today the cable industry as a whole controls about 40% of the overall market. The average price of cable Voice over IP broadband is about $40. $35 to $40. Let's use a number of thirty-five for simplicity. And the cable operates, let's say they're making about $15 per user. Now if they drop their price like $5 per user, how much market share do they have to gain to make the same amount of money? If they drop their price from $35 just to $30, they're going to go from making $15 profit to $10 profit. That means they've got to sign up 15% more customers. They have to go from a 40% market share to a 60% market share to get to the same place. Does that make a lot of sense? Probably not. And if they dropped the price from $35 an average to $25 just to match Vonage, they'd have to increase their market share from 40% to 80% to make the same amount of money. But what they're doing is they're pricing perfectly to match their anticipated market share and maximize their profits.

What if someone gives the service away just to bleed Vonage dry?

Why would they? They're going to bleed themselves dry, too. As a matter of fact, Comcast has come out, the largest operator, and said, "We're not going to compete on price." Time Warner has said, "We're not going to compete on price." Cablevision has said, "We're not going to compete on price." Because their shareholders won't allow them to cut their price to try and gain marketshare. Even if they gained all the marketshare they anticipate, they're going to make less money. It doesn't make tactical sense to them at this juncture in the marketplace. And along the way, the cable guys are doing a fantastic job of getting customers. They're not going to grow any faster by cutting the price at this current juncture.

I haven't heard you mention AT&T yet.

Well, AT&T is out of it. When AT&T came to market with CallVantage everyone said AT&T is going to put Vonage out of business. They own their own network. They're the biggest brand. They have 29 million customers. The whole nine yards. AT&T ended the year - you know the numbers. 54,000 subscribers. A big disappointment to Wall Street. A big disappointment to AT&T's management. AT&T said they'd have a million customers by the end of this year.

What did they do wrong?

Well, I don't know what they did wrong. I can tell you they did nothing right. (Laughing) And that's unfortunately, not uncommon for AT&T now, is it?

Was it a brand issue? A pricing issue? A marketing problem?

I think AT&T came to market with the wrong view and the wrong expectations. They came in and said, "We're going to offer you AT&T." And people didn't want AT&T. People wanted VoIP. They wanted Vonage. They wanted what we were. And we were able to get a large part of that market. I mean, Vonage means something to people. It's a brand. It's a formidable brand. The fact that AT&T dismissed the power of our brand, and of course, likewise, over-confident in the value of their brand, caused them some issues. You know, AT&T is a great brand, but remember brands have got to stand for something. It's got to mean something to the users. Just because I know who you are doesn't mean I want to buy something from you.

Now what about Skype? In the long-run are they really your big competition?

No, probably not at this juncture. We follow Skype pretty closely. We like the guys at Skype. We think they're doing some really cool things. We're doing some of the same things. I mean, this whole concept of free in-network calling? It's not a new concept for us. The cellphone carriers offer free in-network calling, too.

What is Skype's real business and who are they really hurting right now? That would really answer your question. So we're not losing customers to Skype. We do consider Skype to be an ancillary service. It's an adjunct to your telephone, it doesn't replace your telephone. What other kinds of ancillary telephone services are out there that are simple to Skype? The closest analogy I can give you is the calling card business. Lots of people in the calling card business. Lots of telecome companies offer calling card services. And that's really what Skype is. A little more sophisticated. A little more electronic. But it's still a calling card. It augments high cost international rates with a lower cost alternative route. And they're taking a lot of business away from the calling card industry and the calling card industry is going to suffer because of Skype's success. Now Skype hopes they can transition their ancillary calling card business into a replacement business. And by the way, so does every calling card company. I don't know if it makes any difference. And they're going to have a challenge to go from being a cheap calling card to - I'll give you an example. If you go to sign up for Skype and you go make 1,000 minutes worth of phone calling outbound to non-Skype users you're going to pay more for your Skype service than you would for Vonage and all the other Voice over IP competitors.

So you're not worried?

You're always worried in this business about what's going on, but today, Skype's business is a calling card business. We are always concerned about with Skype is, what are they going to do next? Where are they going to try and go with this? We've articulated where we're going to go, and Skype's articulated where they're going to go. The question is, Can either of us do what we think we can do?

Now no matter what happens, the Bells have to be very worried. Not just from Vonage but from Skype and from the cable operators, who are all each executing really well. Think about how much money AT&T must be losing in the phone card business because of Skype.

Now Vonage isn't losing anything, because if you actually compare Vonage's international rate to Skype's international rate, it's the same. (Laughing) Actually we're cheaper in a number of markets, it's actually a little cheaper than Skype. And no inconvenience of their credit card system. I'm sure you read those articles about what's going on with their credit card costs.

They have been having some trouble on that end.

Well, billing isn't easy. (Laughing) Listen, anything free is always easy. Paid? That adds a little extra layer of complexity.

I wanted to ask you about the WiFi phone that we reviewed last month—

Yes, we've got a new version coming out. We're going to update the old ones.

What is your strategy related to wireless? Because more and more people are deciding that they don't even want a land line in the house, they're deciding to just have a cellphone and nothing else. How does Vonage grow if the trend is away from people having any sort of land line in the house, whether it be a broadband VoIP line or a wireline.

That trend is very misunderstood. That isn't a trend. Yes, people are switching services to cellular. But it's a very, very small segment of the population. Most people today, and as people get older, use their phones in very predictable, social patterns. I want, as an individual user, a phone attached to a physical location. I also want a phone attached to me, as a physical person. Some users don't need a phone in a physical location. There are a lot of them out there. And those are the people who are most likely to go to cellular only. But those people will, over their lifetime, change that position. An example would be you. You're a single guy, right? You don't need a fixed line in your home. You probably do just fine with a cellular. When you get married and have your kids, when you go drop your dry cleaning off, you don't want to leave your phone number for your cell phone anywhere. You want it to be your home phone number. When you own your own house, you don't want the plumber calling you to schedule an appointment when you're in the middle of this interview right now. You want that call to go to your house and a message left on your voice mail.

But there's no denying that an increasing number of people, especially young people, are getting used to the idea of not having any kind of wireline at all and doing everything with their cellphone.

Yes, but those habits will change. Young people today don't do the things that married people do. They don't do the things that homeowners do.

But is there evidence to support this? It seems like we're seeing a definite increase in the percentage of people who don't have any sort of land line.

You are seeing an increase in that area. Well, obviously Vonage is causing part of that because our lines don't get picked up anywhere. So we may be adding to that trend. But there are lots of people who—in fact I was having dinner the other night at a restaurant in New York and the waiter was talking to me little bit about Vonage since he recognized my name. He was a cellphone customer only, and was thinking about getting land line service because of a variety of issues. We talked a lot about why he would have it, and why he wouldn't have it. There's always going to be that issue there. That said, Vonage believes that we should not limit our view just to the hundred million people who are going to have wire lines in this country. We want to expand our view to open up and tackle a new market known as wireless. And we want to see if we can do this in a very different way. We have some novel ideas about what might happen in the world over the next few years.

Can you talk a little bit more about what that wireless strategy would be? There's the WiFi phone, but what else is there beyond that?

The WiFi phone is really a test to prove out the technology and viability. It's still clumsy and its interface is a little difficult. And the reason why we've done these tests is so we get that feedback to try and streamline, and mainstream the product.

It seems like very much of a niche product.

Right. And it's going to be that way for a little while. The question is, is what happens in the world of wireless broadband? If you can tell me what happens to wireless broadband, I can tell you what happens with wireless VoIP. Now there're a lot of interesting discussions going on right now. The city of Philadelphia is a very interesting project. And obviously we're going to be involved in this project because Vonage's phones may have the capability of providing seamless service throughout the city of Philadelphia when you walk around. Now is that a replacement for your cell phone? Probably not for most people. But for a teenager? Yeah, it could be.

Is Vonage actually working with the city of Philadelphia on this?

We are working with some of the providers today in talking about how this project might work. There's also another WiFi project going on in the city of San Francisco. And this is really for emergency services personnel. And so what the emergency services there want, of course, is to build a backup network based on the WiFi network and Wi-Fi Voice over IP to operate communications in the event of any kind of big disaster. That's another really interesting approach to the technology in service. But I don't think we should stop and think about WiFi as the end-alll, be-all of wireless broadband. I think we have to think as technologists about what might happen in the next few years. I think the most exciting technologies we're seeing is really in the area of WiMax and OFDM. If that technology is deployed, then these Wi-Fi phones will be multi-mode phones for both WiFi and WiMax. They'll be multi-mode in the sense of being able to respond and handle multiple different kinds of wireless broadband connections. And that might provide a new secondary-like cell network. And will it replace cell networks? No. Not for a long time.

You're testing a standalone WiFi phone, but how much demand do you really see for a standalone device?

Until we know what the WiFi coverage is going to look like, it'd be very hard to know. Here's the thing that's interesting. WiFi and WiMax will continue to grow. So today's niche very well might likely be tomorrow's mainstream. It's our goal to be early enough to be able to gain as much share as possible on that trend. Now with that said, we're also scoring dual-mode where we can do Wi-Fi or wireless broadband and cellular. Whether that's GSM or CDMA, or if you're in Asia, PHS. We think that that's another option, we'll just have to see how that goes.

What do you think about Motorola and Skype's arrangement where they're going to preload Skype onto some cellphones? Oviously in many cases it's up to the carriers what actually ends up on cellphones, but—

I don't think that's going to come to fruition in the US.

Does Vonage have any plans to try and get its softphone preloaded on any cellphones?

No. We don't. We're going to take a very different approach. We want to partner with the carriers to develop a service and revenue for the carriers that makes sense. Skype is looking to bypass that product.

Are you talking with any carriers right now?

We're talking with them. I think at this point we're talking every carrier in the U.S. Some are receptive. Others are a bit concerned. But net/net people are interested in this because we bring a new kind of customer to their network, and obviously that's an attractive offering for them.

You already have a softphone for Windows Mobile, where's the softphone for the Palm OS?

If the Palm OS were a little easier to work with it might be here already.

Is it a problem with PalmSource? Is it palmOne?

The horsepower to do this isn't there on many of palmOne's devices. Much of the Palm devices out there don't have the capabilities that we would need, and the ones that do have the capabilities we need, that's what we're focusing in on our efforts.

Any sort of time frame on when we might see a softphone for Palm? This year maybe?

This year. I think there's a good chance this year you'll see an expansion of the softphone client. Not just in the area of being able to run on other operating systems, but I think we're going to continue to invest in additional softphone capabilities from different vendors, so you might actually see another vendor or two make available. Just like consumers have a choice of devices, you'll also have a choice of software to go along with the services.

What about Symbian?

We're working with Symbian. We're working with the actual manufacturers themselves.

I wanted to ask you about Vonage and E911. Vonage has been in the news a lot related to this issue, and not always in the most positive light.

Well, I think people don't understand what's really going on here.

What is the underlying issue that's causing the problems for Vonage's integration with E911 system?

Let's talk through the problems. We've already handled successfully nearly 200,000 911 calls. That's a lot of 911 calls. We've had two or three incidents that are disconcerting to us. Now irrespective of the two or three incidents, no incident is a good incident when it comes to 911. And clearly no matter what happens, we're going to continue to roll out for national E911. But when you look at the two problems that we've faced so far in the public press, one has been the issue over a user who did not register his services that fully knew that he had to register it. And that's a problem. So to resolve that issue, we're going to be changing some of our processes and systems.

Two fundamental changes. One, when you sign up for the service, you're going to get E911 unless you explicitly say you don't want it. We think that's helpful.

You'll automatically register the user's billing address as their location?

You have to tell us or you're not getting it. And that'll be very clear. But two, even if you tell us that you're not going to get it, and you dial 911, we're still going to send the call to an ERC, an emergency response center, who will still ask you to identify who you are and what's the nature of your problem, so in the event that someone says, "I don't want it," and dials 911 we still could handle the emergency call. And I think that's a very good way of handling the user error problem and the expectation problem. And those are changes that we were doing in response to what's happened, and also quite frankly, just to better serve our customers.

The second problem, which is the problem that happened I think in Florida, where a call was registered, we knew which emergency service center to send the call to. We sent the call there over the emergency line, and an operator didn't answer the phone. An interactive voice response system did. Right? And that was what happened in Florida. Now, I've got to tell you honestly, I could have never possibly anticipated that the emergency services center would ever have voice mail.

Is that what a person would get if they called 911 on a land line?

No, it's not. Well, it could actually. It depends. And we'll go through that, but I want to talk about this problem we just had which is quite interesting, because I think it's really odd that that would ever occur, so what we're doing to stop that from happening is in the event that we need to transmit a call ever to a Public Safety Answering Point, the emergency center, whereby we think that call might be intercepted by an IVR system, we're going to send it back to our ERC center and make sure that we have a human operator answering that call. That's what we're rolling out right now.

Now, beyond those two problems, when you send a call to the PSAP, it's very interesting on how the call gets there. Now it depends on where you are in the country, and where we are in our rollout base. In Rhode Island, the IP call goes directly to the PSAP in IP, and that works great.

In New York City, for example, when you dial 911, that call will go to the emergency service center in New York City. It will travel over dedicated facilities - not the PSTN. In Chicago, for example, the call will go over a 10-digit phone number, but it'll show up to the operator exactly the same way it would in New York. No difference. The difference is how you access the network. Today, where we have agreements we access the network over dedicated facilities like New York and Rhode Island. Where we don't have dedicated facilities, we try to access 10-digit numbers, which is exactly how wireless has done it. And it's exactly how the satellite guys have done it for a very long time. And our goal is to migrate off of that ten digit solution. Which by the way, over 200,000 911 calls have gone over it. So we're quite pleased to have a dedicated facility, and that's a complicated problem. Now to get those dedicated facilities we do need the help of people who own the infrastructure. And Verizon has agreed to do this with us.

It's the Baby Bells that generally control that infrastructure?

They control about 90% or 80% of it.

Are they reluctant to grant Vonage access? Do they say it's a cost issue and that they want you to share the cost with them?

No, no. It's interesting. Every Bell will make a different excuse. Verizon is the one that is to be most commended. Verizon says, "Let's put all this crap to the side and let's figure out a way to make this work." And Verizon actually has multiple solutions, depending on the market. And they work really well, and our goal is now to roll it out territory-wide. Verizon makes available to us the same things it makes available to a combination of wireline entities and wireless entities.

So we've gone to the other RBOCs and said we want these same things. With Qwest we have an agreement in principle, but we're still working on details. Bell South and SBC have been very reluctant for every reason under the sun. Bell South's made some progress and they're starting to come around, but still not there yet. SBC keeps issuing press release after press release of how they're going to offer this, but they don't offer us the complete solution to do all the pieces like the wireless guys have so we can do it all real and right.

SBC finds that E911 is a competitive advantage over Vonage and they want to extort that competitive advantage. I've got to tell you, the last thing anyone should be doing in this country is using E911 as a competitive advantage and risking people's lives. It's not the right thing to do. Remember, these Bells were given 911 as a public trust. Originally given by Congress to AT&T and then by AT&T through divestiture to the Baby Bells. And they should really honor their public trust commitment. Verizon has. We're very pleased about that.

How much does this damage the Vonage brand?

Every carrier in America has had E911 problems over their lifetime. You know. The Bells. New York City for example when they had their outage. The wireless carriers. This is really the first time Vonage has been negatively affected by something that it was trying to do to benefit the customer. And we felt a long time ago that we were taking on a risk by going out and offering 911, but we felt that being able to save 200,000 lives was worth it, knowing that there might be something that might happen that we can't anticipate. The Texas issue is one where we had user error that we wouldn't have anticipated and, of course, we're fixing that. The issue in Florida is another. We never would have anticipated hearing a recorded message on an emergency helpline and, of course, we're going to take action by moving those routes from our system and routing to our emergency response center.

This will be an emergency response center that Vonage will be operating?

The center is actually similar to what OnStar has, for example. We're not going to do it ourselves. We're going to use something similar an On Star or Tyco or EVS, we're contracting a company which has the facilities infrastructure to take the call, has the experience how to handle that call, access the caller's location information, and then get the call transferred to fire, police, medical.

How does your customer base break down geographically? Is it primarily people on the coasts?

Initially we had a propensity towards early adopters, who tend to be slightly more technical savvy. We've clearly crossed the chasm to late stage adopters. We hear this in our customer inquiries our calls, our installations. The rate of customers needing help with installation has gone up because even the simplest of tasks have become complicated for people who are not familiar with the terminology or the equipment.

In terms of the geography breakdowns, we've got a high concentration of people in New York, New Jersey, California, Florida, Chicago, Texas. But we have phenomenal penetration in lots of rural markets. There's been a lot of great stories about how we've attracted a lot of rural customers, because really, rural customers don't have a lot of options. A lot fewer than you have here in New York.

Are you seeing a growing percentage of people who sign up for the service and then take their adapter with them overseas?

We don't know exactly how many people take it overseas permanently, but we look at our database and at any point in time there's a good 5 to 10% of our boxes that are not in the U.S. based on IP addresses. But they're moving. They come back to the U.S. and then go back out again.

So they're being used by people who are traveling a lot?

We know for sure that lots of people are traveling with their service, and that's one of the great advantages of Vonage is that it allows you to actually do that. You actually pick up your box or your Wi-Fi phone or your router. Some people are traveling and staying there for a few weeks. Some are for a few days. Some for months. I know people that go out on these assignments to other parts of the world for a few months, and what a great thing to be able to take your phone service with you when you're in India for three months working on a project. And then you come back home, and you take your phone service with you. It's pretty phenomenal.

Recently Vonage raised another $200 million in venture capital. Is that money going to be put towards customer acquisition? Is the consumer VoIP market that competitive that you need that kind of money?

No. We're very fortunate. We had an opportunity to raise $100 million last year. A majority of that money is still in the bank today. And we've been able to execute our own strategy really well. So we took this opportunity to go out and you know, increase our balance sheet, strengthen our capital position by raising $200 million. And we feel confident that we can deploy that capital effectively and get a great rate of return to our investors, both existing and new. What we're going to do is we're going to attempt to expand our marketing focus here in the U.S. to acquire customers. We're going to attempt to expand our presence in the U.K. and Canada. We're going to invest that capital to build up new products, features, and services, and we're going to look at other overseas expansion opportunities.

Is there an IPO in the works?

You know I can't comment on that question, but I will thank you for the courtesy of waiting til the end of the interview before you asked that. This morning I got asked that on the third question. (Laughing)


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