The future of VoIP provider Vonage (News - Alert) Holdings Corp. continues to look bleak, particularly now that a research analyst with Citigroup, one of the underwriters of Vonage’s IPO, has cut the rating on its stock to “sell” and predicted that the company will go bankrupt in two years if it loses its appeal of the patent infringement suit brought against it by Verizon (News - Alert).

In a research brief sent to investors Tuesday, Citibank analyst Michael Rollins said Vonage – the largest and most successful VoIP provider in the US - could undergo “a financial restructuring or bankruptcy in the 2008 or 2009 timeframe,” if it loses its court battle with Verizon. He downgraded the stock from “hold.”

Verizon slammed Vonage with the patent infringement case in June 2006, alleging initially that Vonage had infringed on seven (later reduced to three) patents related to VoIP technology. Earlier this month an eight-member jury ruled that Vonage must pay Verizon $58 million in damages as well as a 5.5 percent royalty rate on any sales going forward. Vonage immediately appealed the decision and the case is expected to go on for at least another year.

While still far from the $197 million in damages initially sought by Verizon, Vonage shareholders saw the stock drop nearly 4 percent the day after the decision. It was a major blow to the company, which had already seen its stock take a beating after its IPO in May 2006. Vonage’s shares – which started at $17 and now stand at around $3 - have fallen more than 80 percent since its debut.

In addition to having to pay Verizon $58 million plus royalties, Vonage now faces the possibility of a judge imposing an injunction which might require the company to shut down its service. Vonage shares toppled nearly 26 percent last Friday after the injunction decision, even though the judge ruled a final decision on enforcing the injunction would not be made for two weeks.

Vonage has requested a stay on Verizon’s request for an injunction, which would postpone the decision. Most legal experts are saying Vonage will likely get its stay, in order to facilitate review of additional (sealed) court documents which it has presented. Meanwhile, Vonage could come up with a “workaround” solution which would allow its service to continue to operate without violating any of Verizon’s patents. (One can be relatively sure that the company is working on one, if it does not have a workaround already.)

Many analysts are speculating whether Vonage will be able to survive the financial damage, should it lose its appeal. The basic question is whether it can turn a decent profit while at the same time paying Verizon for use of its patents. Because the VoIP market is so highly competitive and the rates offered are so low, it is not a technology which delivers high profit margins. In addition to the $58 million, plus royalties, it must pay to Verizon, Vonage will also have to pay some hefty legal fees for its court battle. Furthermore, the company has more than $250 million in debt.

And then there’s the matter of Vonage’s aggressive marketing. The VoIP provider’s success has been largely dependent on its ability to reach the masses through television commercials and other expensive mediums – and it might not be able to continue to do this and pay Verizon at the same time. At the same time, if Vonage’s growth slows due to a lack of marketing that could spell the end for the company. The company was expected to spend upwards of $160 million on marketing in 2007. Its past spending on advertising has been considered a major factor in the adoption of VoIP by consumers in the U.S.

A lesser issue - but perhaps also a potential back-breaker - is whether Vonage’s phone service maintains the same quality following the implementation of technical workarounds. Vonage has long prided itself on the quality of its service, and if the workaround cause glitches or disruptions, it could lead to customer defections. Through the use of workarounds, Vonage could avoid having to pay the royalties to Verizon, going forward - however, there is still the question of how much time and money it will take to develop these workarounds - and how well they will work.

Although Citigroup has reduced Vonage’s stock rating to “sell,” Deutsche Bank AG and UBS AG, which also underwrote the IPO, have not. The research department at Deutsche Bank has kept its “hold” rating while the research team at UBS has stayed with “neutral.”

On Monday Vonage Holdings Corp. Chief Executive Mike Snyder said the market is overreacting to the court’s decision last week to issue the injuction.

“To paraphrase Mark Twain, the rumors of Vonage’s death have been greatly exaggerated,” Snyder said in a company statement. “Friday’s events represented one small step in what is sure to be a long legal battle.”

Snyder said the market’s reaction showed “an unfortunate lack of understanding of the judicial/appellate system, a lack of appreciation of Vonage’s resourcefulness, or, perhaps, both.”

Vonage has gone great lengths to reassure customers that it will be able to continue providing service while dealing with the strong possibility of a protracted legal battle.

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Patrick Barnard is Assignment Editor for TMCnet and a columnist covering the telecom industry. To see more of his articles, please visit Patrick Barnard’s columnist page.