By Brian Lund (TMF Tardior)
June 1, 2000

Internet telephony service provider Net2Phone (Nasdaq: NTOP) dialed in its earnings for its third quarter yesterday after the bell. The results verified the notion that the company has a great deal of potential, but also significant uncertainty surrounding its business model. For now, it is executing its plan very well. Here are some of the key points:

• Revenue growth strengthened, bounding up 22% sequentially to $18.9 million.
• Gross margins shrunk four percentage points to 42%, still quite high for the industry.
• Sales and marketing costs remained at the same high level as the previous quarter, representing 59% of total revenue.
• Net losses expanded 31% over the second quarter to $14.5 million, or $0.21 per share, one cent better than analysts had expected, according to First Call.

Net2Phone acquired a great many customers this quarter through its various marketing deals. During the quarter, the company arranged distribution through Real Networks (Nasdaq: RNWK) and priceline.com's (Nasdaq: PCLN) new long-distance service. These agreements increased customer rolls 43% sequentially, from 575,000 at the end of the second quarter to 825,000 in the third. The priceline deal brings 1000 new customers a day, according to management.

Minutes of usage, however, rose only 17%, since many customers came aboard toward the end of the quarter. Revenue growth exceeded minutes because more expensive international calls accounted for a greater percentage of total usage.

That is a trend that the company hopes will continue, since international calls are higher margin. Management indicated that it may be willing to offer free domestic PC2Phone calls, should the market trend that way, in order to build its customer base without sacrificing too much revenue.

The cost of customer acquisition at Net2Phone is already pretty high, however. The 250,000 new customers this quarter didn't just cost the $11.1 million, or $44.53 each, that the company spent on sales and marketing. Net2Phone carries a substantial amount of prepaid contract deposits on its balance sheet that derives from up-front payments it has made to its partners, such as America Online (NYSE: AOL) and Yahoo! (Nasdaq: YHOO), for marketing and distribution. This is money that Net2Phone has already paid, so it is subtracted from operating cash flow.

At the end of the second quarter, prepaid contract deposits amounted to $18.8 million, $12.6 million higher than last year's fourth quarter and $9 million ahead of the first quarter of 2000. It will be amortized over the lives of the contracts. Net2Phone did not give prepaid numbers for the latest quarter, and it is not public knowledge what future payments the company will have to make to its marketing partners in accordance with these contracts.

It's difficult, therefore, to know how much customers cost Net2Phone. That's too bad, since, as Bill Mann recently discussed, customer acquisition costs are a useful metric for an unprofitable company.

It is also not terribly clear how much each of those customers will be worth to the company. Yesterday, federal regulators eliminated $3.2 billion in fees that long-distance telephone carriers pay to local phone companies. As a result, the landscape will become more competitive. AT&T (NYSE: T) and Sprint (NYSE: FON) will offer a plan without any monthly minimum usage charge. Net2Phone may see new pricing pressures as a result, domestically and internationally.

Still, Net2Phone is the big dog in its neighborhood. It has lots of backers, including AT&T and British Telecom, who recently took a $300 million stake in the company. Net2Phone will have $575 million in cash after that deal closes -- enough to cover the $18 million in prepaid contracts, and then some. It has years of experience in the budding Internet telephony business and is convinced that it can develop numerous revenue streams from that source.

There's a lot of potential here, with all of the associated risks. Investors need to study the situation very closely before jumping on board.

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