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Executives

Marc Lefar - CEO

Analysts

Michael Rollins - Citigroup Inc, Research Division

Vonage Holdings Corp. (VG) Citigroup Global Internet, Media & Telecommunications Conference January 7, 2013 4:30 PM ET

Michael Rollins - Citigroup Inc, Research Division

We get started. Please note that disclosures are available at the registration desk. Good afternoon. For those joining us via webcast, I’m Mike Rollins telecom analyst at Citi. Our next fireside chat switches gears into the voice-over-IP and managed services arena. With Vonage I’d like to welcome Marc Lefar back, who has been Vonage’s Chief Executive Officer since joining the Company in 2008. Marc is going to get us started with some opening comments and video or two. And then we will get into some Q&A, both from myself and invite our audience should participate as well.

And with that, turn it over to Marc.

Marc Lefar

Thanks, Mike. I appreciate it. Good afternoon, everybody. I’m pleased to be join you today. Let me first start today with a brief summary of our progress over the past several years, for those of you that maybe a little bit less familiar with the Company. Over a 5-year period we fundamentally transformed our strategy, our operations and our financial performance. These changes have result in the swing of roughly $200 million of EBITDA and free cash flow. Strategically we shifted our primary focus to the rapidly growing unreserved ethnic segments in the U.S.

We improved our value proposition by being the first to deliver flat rate unlimited calling to over 60 countries with the launch of our Vonage world service. And we were the first to provide easy to use enhanced features like voice to text translation and mobile expansion services at no extra cost. These strategic shifts have resulted in new customers for the higher lifetime value and a better churn profile than those in the past. In addition, service ARPU increased by 7% during the period.

Our focus on operations has resulted in greatly improved cost structure. We reduced network and domestic termination costs by 50% and international long distance termination costs were down 30%. In addition, we reduced customer care costs per line by 45% resulting in $50 million in annual savings. Perhaps more importantly we’ve been able to execute the structural cost enhancements while significantly improving call quality and customer service performance.

Our core domestic and international launches since business is very stable, aided by a strong value proposition, we reduced customer churn from highs of 3.6% in July of 2009 to 2.5% at the end of the third quarter. Our expectation of the churn remain generally stable at these levels. We also have a robust balance sheet. Our two refinancings reduced annual interest expense and $49 million in 2010 to less than $3 million in 2012, and reduced interest rates from 20% in 2009 to less than 4% today.

These changes along with productions and capital expenditures of more than 10%, an $800 million in NOLs greatly increased our ability to generate substantial free cash flow. Having achieved financial and operational stability, our teams have also rekindled the spirit of innovation that is our heritage. In 2012, the U.S. Patent Office awarded Vonage seven new patents and we filed 59 patent applications, 21 of which are mobile related. We now have 18 US patents, 41 foreign patents and 229 pending patent applications. We are a stronger Company than ever before.

During 2012 we’ve seen promising results in the test markets of our flanker brand BasicTalk. The customer adoption of mobile extensions and the launches of new ethnic segment services, including our partnership with Globe to serve the Filipino community. We learned a great deal during our recent technical trial of the mobile roaming feature and I will talk a little bit more about that in a few minutes. And a number of active users and paying customers on Vonage mobile is accelerating. We remained confident in the potential of large markets we’re targeting. And we expect to increase the revenue contribution from our growth initiatives as we expand our product offerings, enhanced distribution and enter into additional international partnerships.

We continue to focus our efforts in driving revenue in three major areas. The first is growth in North American markets where we will use a two-pronged approach, we will differentiate for providing extraordinary value in international long distance, while targeting underserved ethnic segments we plan to enter the low-end of domestic market with a basic top brand. The second major area of growth is international expansion outside of North America through strategic partnerships. And the third is our focus on mobile services, which we do as a strategic enabler of the Company’s entire product offering over time.

Let me talk for a couple of minutes about our core business. During 2012, we continue to strengthen our customer base, as we increase the percentage of international long distance callers to 40% at year-end. International callers were attracted to our flagship Vonage world plan and to our expanding number of countries this is a calling plan, targeting the substantial market opportunities for customers calling Mexico and Southeast Asia we were the first to provide unlimited calling to mobiles in both Mexico and South Korea.

We are also experiencing solid growth among callers from the Philippines as part of the partnership with globe. Some of the recent games in new segments were offset in a short-term by the entire competitive decision of the government of Pakistan. In an unprecedented action, the telecommunication’s authority in Pakistan increased the cost to complete calls by 500%. The decision impacting all Pakistani immigrants and all foreign careers left us no choice but to remove Pakistan from Vonage world.

Although we did see a moderate short-term impact on service cancellations, this churn impact was more than offset by improvements and other calling segments. On the distribution front, our retail and community sales channels are driving strong results. Through improved productivity, in our mass merchant stores and the expansion of the face to face to sales channels, we’ve increased the percentage of gross line additions acquired through these channels from 8% at the beginning of 2011, to 30% by the end of 2012.

And in October, we launched or we believe we will be one of the series of affinity relationship with the signing of an agreement with AARP. While we focused heavily on international callers over the flat few years, the domestic-only calling segment, with 40 plus million broadband also to remain the sizable opportunity.

Over the past several months we’ve been testing a low priced domestic calling plan under the flanker brand, BasicTalk. The results of our market test and proprietary research to support our belief that this customer segment represents a large incremental market opportunity for light users and security conscious households often with poor in-home wireless coverage. Results from two market test suggests that the number of potential subscribers in this market segment, it could be as large as Vonage’s core business across all other plans combined.

Let’s take a look at the two commercials we used in our market test.

[Commercial Video Playing]

But as you can see highly competitive, it goes after the consumer skepticism for what is been a over blown low end domestic market taking that space which is reliable basic everyday service, a life safety user. We’re valuating three different pass to markets, including offering BasicTalk through a private label partnership as a standalone flanker or as a co-branded offering, you would hear more about that in the coming months.

Let me quickly turn to our second growth initiative, international expansion. Last May, we signed our first partnership with Global, in Philippine, delivering unprecedented value to the more than 3 million Philippines living in the U.S. The continued egg customers to our Philippines calling plan with globe and results were generally tracking with our expectations.

Today I hope to announce our second international partnership, but I can’t match this yet. I can tell you that we’re working for the final details of the definitive agreement for a joint venture with partner in Brazil. We expect to be in a position to provide more details on our earnings call in February. In addition, we’re in active discussions with other perspective international partners in the countries we targeted for expansion, including India and Mexico.

Our final growth initiative is mobile services. Consumers demand to mobility has become centre to all of our development priorities including enhancements to our core services, international expansion opportunities and of course standalone products. Over the past 18 months we built a robust mobile platform that has the ability to deliver high quality voice, messaging and coming very soon video communication across wired and wireless data networks for most devices running iOS and Android.

Our platform is differentiated and we enable both on net and off net calling, unlike some newer market entrants. And we don’t require the customers use a new identity like Skype. Customers already have multiple identities, communities, and phone numbers and we’re focused on enabling seamless communication across multiple identities and multiple Cloud connected devices. Even though that are not inherently voice centric.

Our patented extensions product creates a truly unified international calling capability for home and mobile. It’s been widely successful. And only 16 months, 26% of our entire customer base has signed out to use Vonage on their mobile phones. And 22% of all the international calls now originate from a mobile phone. We are also rapidly enhancing the standalone Vonage mobile app. Over the past few months we’ve been conducting technical trials of a unique international roaming product in four countries in Western Europe.

Our technical trial has provided us with significant learning and reinforced the potential for commercial feasibility. Let me show you a rough instructional video that demonstrates how the roaming fees actually works.

[Commercial Video Playing]

So we expect to expand this service and launch commercially in the next several months. Downloads of our core Vonage mobile application launched earlier in the year continue to grow. Although we’re behind our original internal expectations, we’re encouraged that downloads, usage and the number of paying customers are not just growing, but it recently accelerated as a result of some recent product enhancements.

One way to think about how far we’ve come is to consider the shift in usage behavior among our customers, in revenue terms. If we were to simply allocate revenues to mobile based upon the device calling behavior across all of our users today. Our annual mobile revenue run rate will be more than $50 million. That’s up from single-digit millions just 18 months ago.

Before I move to Q&A, I’d like to briefly touch on our balanced approach to capital allocation. Last August as a result of our strong cash flow on a conservative balance sheet, coupled with the belief that our stock represents an attractive value, we initiated $50 million stock repurchase program. As of October 30th, we repurchased 6 million shares of common stock with $14 million, leaving $36 million available for further buybacks under our current authorization.

We’ve continued purchases throughout the fourth quarter and at our current course and speed, we would complete this buyback well before year-end. We continue to believe repurchases are a good use of a portion of our cash flow. In addition to continuing our stock repurchase program, we’re actively evaluating our options to further optimize our capital structure and build shareholder value. Specifically, we’re reviewing opportunities to expand our existing credit facilities to take advantage of the low interest rate environment. Our balance sheet is strong. We ended the third quarter with total leverage to adjusted EBITDA at only 0.5 times and with net cash of $9 million.

And finally, as part of our balanced approach to capital allocation, we’re continuously evaluating potential investments both organic and inorganic that are aligned with our strategies and can accelerate growth.

So with that overview, let me move to the Q&A with Mike.

Question-and-Answer Session

Michael Rollins - Citigroup Inc, Research Division

Great. Well, thanks for that Marc. Lot to talk about. So, if we think just taking the step back, you’re making the transition from the Vonage product years ago that people are familiar with to being more of an application provider on mobile, international LD company, I think the Company think it was last year at this time or maybe even little bit before that set a revenue goal of – believe it’s $100 million of incremental revenue over few year period. How do you feel about hitting that opportunity in terms of bringing that incremental revenue in and what are – can you give the key sign posted investors and look at along the way for that growth.

Marc Lefar

So what you’re referring to is in February at our year-end annual conference call. We talked about setting a target of a $100 million in annualized revenue, two to three years up and as you heard here today while we’ve – we would like to have seem some stronger revenue during the course of 2012. There were a lot of important milestones and accomplishments that really lay the foundation of ground work for those goals. We still feel good about that kind of run rate in that same kind of time frame.

When you think about entering Brazil, which is an enormous marketplace, a very large portion of the $100 million to be potentially retired just with expansion in that marketplace over the next couple of years. We think that the acceleration in Vonage mobile and the roaming product as well as the potential for other mobile applications and the works that are (indiscernible) on our current platform also provides significant revenue opportunity and we’re excited to tell about the North American market. We think that the basic top product could be very significant and we still think the product progress in our ethnic segments as well.

Michael Rollins - Citigroup Inc, Research Division

Can you talk about the stickiness of the core business, so you’ve improved the churn rate of the core to roughly 2.5%, and you mentioned that you expect that to be stable? We see the totality of the performance. But is there something under the hood where if you look at the water fall charge that you do want subscription, that you see a certain level was stickiness for certain kind of customer in your base and then you see more turnover and maybe a push on basic you’re less focused on, or you’re trying to move out of.

Marc Lefar

Good question. The – we’ve seen very, so let me talk about stability first. In the past year we’ve seen that the trends that cause individual ethnic segments and given 10 years has remained pretty confident. So you’re not seeing below the surface any radical changes. As its always the case in service businesses, your long-term customers after a period of time their churn rate drops as you kind of have people who are kind of just comfortable an inertia it is what it is, and that pattern still exists for us. The more important distinction for us is the very low churn of international long distance customers on average that segment churns at about 1% rate and your domestic-only users churns slightly higher rate. Not surprising as utility move and shifts to mobile and the way we look to manage that is by extending the home service into mobile and providing mobile application.

We are talking just before we sat down, little about how we think the mobile market might unfold and we do see a lot of the home services moving onto data devices where you’ll actually create a phone out of a primarily data oriented device. So we’re addressing that piece of the churn profile and -- in that way. And we had seen that when we extend peoples usage from traditional home and they sign-up for other lines in other locations or mobile, their churn declines, they’re not surprised. Increased utility and churn rates decline. People spend less time shopping and there’s more sweat equity they put into investing and making the features work. So they’re more likely to stay.

Michael Rollins - Citigroup Inc, Research Division

Yeah. And you mentioned the significant portion of the (indiscernible) is actually using the mobile services today the traffic over the mobile. What do you know demographically about those that are willing to make that adoption to mobile, and then what are you doing to trying to further penetrate your basic customers?

Marc Lefar

So the customers are using Vonage extensions are almost exclusive international callers. These are folks who are trying to reach different time zones. They have been calling from their small business or from their home phone, and the way the product works, it allows you to simply register another line, your mobile number, download the application and with that you can then simply access your Vonage plan.

So we’re trying to actually create the environment where people don’t think about it as a location based device. If you buy a service plan that service plan you can now access from all of your devices from anywhere as long as the broadband connected. And what we’re finding is; people shift usage from their home to those devices. And in terms of ethnicity we see that it actually is pretty proportionate across our ethnic penetration.

We see slightly higher adoption among Asian Indians. We think that’s probably because their SmartphOWNED option is a little bit higher than some of the other ethnic segments. But when you think about it relative to our base, more than half of all of our international callers are now making those calls on their mobile phones. It’s really not yet a product for domestic-only users, but that is an opportunity we see down the road.

Michael Rollins - Citigroup Inc, Research Division

You touched on the idea that you could use these applications on any device and the convergence that you can provide across the growing number of devices that people have is interesting and it’s something I know in different forums that you’ve talked about different pieces and ideas of this strategy. How far away are we from Vonage being able to have a more holistic -- we’re going to just be your communication application across whatever you want to do, and is that really where you’re heading?

Marc Lefar

Yes, that’s where we’re heading. In terms of the timeframes; the technical capability we largely have today. The technical capability is; you’re building for an operating system you need to have a phone number or user name, be able to authenticate that in the cloud, be able to connect that device and do it on-net and off-net; that core capability exists today. The propagation across lots of different flavors of devices that is work to be done over the next 12 months. I think the real breakthrough is going to happen now with some basic market dynamics that we’re going to see over the next two years.

I believe what we’re going to see in a world where voice-over-LTE, which has done a flavor of void is the way carriers package their services. We’re also going to see, there’s always going to be people that will whole sell LTE data. And you’re going to see a continued propagation of standalone data devices. So we’ve already got smaller iPad’s; we’re going to see micro-mini iPad’s; we’re going to see phone’s to get a little bit larger, you have a Samsung Note, you got Amazon Fire, well think about those. You can buy those today with the data plans for $20 or $30 bucks, not the $80 usually bundled by the carriers. What they’re doing essentially in smart is you bundle the voice ARPU in with the data ARPU and then you let people pick the size of the data plan they want. But make no mistake about it. They’re not going to allow themselves to compress and rerate.

The problem is that the market dynamic which is devices are not being bought as mobile just because they’re false. They’re mobile and their data device is primary. Software makes them a communication device. So the whole idea is, a company like Vonage can very much let you take your data device, lets you have a $30 rate plan, and now take the application, we can charge a quarter or not, that’s business model specific and now you can have voice messaging and video and you can use that for [a traditional] phone number [Audio Break] five years out, I am highly confident that you’re going to see that model unfold.

Michael Rollins - Citigroup Inc, Research Division

Another area that I just wanted to explore with you is the core business and you face competition from a variety of voice-over-IP players for a while. magicJack the one that you’re targeting in our ads as well, and now you’re going head-to-head …

Marc Lefar

Do we talk any magicJack?

Michael Rollins - Citigroup Inc, Research Division

Well I assume that’s what you meant, but it was magic.

Marc Lefar

Okay.

Michael Rollins - Citigroup Inc, Research Division

So, if you look at now the ad’s and focus on BasicTalk going after that type of a product and that type of a customer need. What does that mean in terms of your business; the ability to grow in that segment but also the risk that you have customers who use you today and they might just say, oh I can move over to this product for a cheaper price and kind of watch some of your revenue in the process.

Marc Lefar

You’re touching on a couple of different issues, very important ones. We start from the view of; what do customers want? What's already out there in the marketplace? And you never want to hasten revenue migration or cannibalization on your own base. But we’ve been out there in a marketplace where there have been other people out there trying to do a preparative time. So the idea is, you either have to compete in that market and do it smartly on your own or watch while somebody else steals the business.

Now what’s been interesting and somewhat surprising to me really the low end magicJack [rumor] completely non issues a year and a half ago. magicJack did make some nice product improvements, the product they launched a year ago in November. And say what you want about the business model, I’ll just speak to what the consume reaction is. We really have not seen -- that much -- the churn from magicJack of our core base is very small relative to where our major churn factors are and other competitors and it has actually declined over the last nine months. So they may start traction. I can't speak to what their throughput is. It sounds like they’re making some real revenues through some real market penetration and our research says there really is a marketplace for this low end device or folks who are thinking about cutting the cord. They’re even thinking about us as a prospect on our core business, $30 bucks a month -- they’re already in light use, they really like it as a complement to their wireless phones and that’s why they’re buying. So we think we can go after the market and there’s much more incremental than there is a cannibalization risk.

That said; we’re also not doing this with the primary Vonage branded product, because that would create this gigantic suction. So we think through some private label partnerships we’ve got at least one very large mass merchant who’s very interested in distributing this for us as well as online distribution that under a separate brand and whether we use a power buy or we co-brand with a mass merchant or a large digital retailer, that the ability to essentially scrape will remain, they have a lot of the traditional $50 home phone service segment while making sure that we kind of become very aggressive with the low end folks who are still relatively small compared to us. That’s really a market that Vonage should own and we’ll go after it pretty aggressively and we’ll manage the cannibalization risk very carefully in our market.

Michael Rollins - Citigroup Inc, Research Division

Is there a way to think about, of the customers that you have today on Vonage, the traditional service. What percentage of them take either international service which you say was 40%, but add on top of that, the one number calling multiple numbers or some of the advance voice mail, the email services that you provide, is a way of just thinking about what percentage of your customers use advanced or premium services on Vonage?

Marc Lefar

Sure, so I think the – I get these numbers pretty close. We provide voice mail to text translation. We started doing that shortly after Vonage world launch. We provide that included in the basic package and we have about 60% of our base uses that on an active level and then another 60% -- about another 60% also use things like SimulRing where your product, your home phone will ring multiple cell-phones or other devices. Those are pretty high penetration rates from quotient features and we do see different folks are using those features actively. Their churn rate no surprise tends to be lower than the average. Those 60% numbers I haven’t looked at what the overlap is, but I suspect it’s quite high.

Michael Rollins - Citigroup Inc, Research Division

But they’re not available on the BasicTalk?

Marc Lefar

Correct.

Michael Rollins - Citigroup Inc, Research Division

So that’s a differentiator between …

Marc Lefar

Yeah, BasicTalk is truly going to be inbound and outbound with the number. The box will not have an Ethernet port. It’s single line device. We actually reengineered our cost structure at a new device just for BasicTalk. We’ve got the cost of the device extremely low and the features said is basically going to be call forwarding, call waiting, it will port numbers, they won't charge in the charge for porting and your 911 services. So it’s super strip down basic feature functionality.

Michael Rollins - Citigroup Inc, Research Division

And moving on to the other topic; when I think about the Vonage model and I think about what you done actually in the U.S. there was a backdrop of robust broadband penetration that was an enabler for the U.S. customer to adopt the Vonage service if they wanted to. When I think about these international markets and investors do, I don’t know if they’re familiar with what broadband looks like in Brazil or in India. How should we think about the revenue opportunity relative to, do you look at something like broadband penetration to gauge the market? What are the factors that you’re looking at to develop that revenue opportunity as you expand these strategic relationships?

Marc Lefar

Absolutely. Broadband penetration and disposable income as well as smartphone penetration are three of the primary filters along with the favorable regulatory environment that we look at and we’re evaluating the market. And of course we look at overall market size and the pricing umbrella, and how high is pricing, what's still being priced. So we’ll take a look at things like, is the equivalent of intra-country long distance still quite high. If they’re charging $0.10, $0.15 a minute to call from city A to city B, that’s a real opportunity in a market where there’s a broadband penetration. In Brazil when you look at the top 16, 17 markets the most densely populated markets you have broadband penetration that is nearing 40%, 50% and growing quite quickly. We think over the next five years you’ll see the same kind of trends there next going India, a little slower than Brazil, but still quite high probably patterning where the U.S. was eight, nine years ago.

Michael Rollins - Citigroup Inc, Research Division

And as you look at the Philippines, relative to the plan that you laid out in terms of opportunities; where are you in that plan as a sort of case study into these newer countries?

Marc Lefar

Its resulting to the slightly different twist on the business deal, I mean that most of the revenues that come out of that venture are coming out of the U.S, that’s are most of the ability to pay is, Filipinos living in the U.S. and wiring money back. So while the partnership was robust in terms of exchange of value to be able to drive revenues, we didn’t have to go penetrate the Filipino market directly in the Philippines. These other markets are many orders of magnitude there. We look at the size of Brazil and the size of the telecom market there as well as what is extremely high pricing. We view that do that as many tens of millions of dollars of annualized revenue opportunity for us? We think Brazil can be very, very large and there is a lot of opportunity to come in at the low mid end. Mexico is a little bit more competitive and we see India has still got a regulatory environment a bit slower in terms of broadband penetration, smartphones but also a very large market place that has outsized pricing that we think is right for compression.

Michael Rollins - Citigroup Inc, Research Division

I have little time, couple of minutes to see who has question from the audience, there’ll be a mike roaming around. In the meantime, I appreciate the update that you gave us on the return on capital pace, that you’re currently on with the share buyback and; how do you look -- you mentioned the idea of raising debt through a facility. How do you look at the net debt leverage targets for the Company, and is the Company willing to lever up for the specific purpose of buying back stock. Would you think that leverage needs to be something of a more strategic nature?

Marc Lefar

Well as I said, we’re taking a very balanced approach to capital allocation in total. And when I talked about looking at additional facility, this is real opportunistic given where interest rates are. We’ve got positive net debt to date. We’re not talking about taking, even after this additional facility that we’re evaluating, I think folks would look at that and go, we’re not an asset based Company. So just in terms of how you’re going to put something together, we very much want to have dollars available for the range of users and whether that is inorganic growth in the small and midsized kind of range where it becomes to fund additional investments in the core business, to return additional value to shareholders and additional buybacks, all of those for general corporate purposes would be the opportunity for that debt and we think about it in terms of setting up perhaps a revolver that is there if we need it, but without getting too specific on we think the ideal targets would be, our goal here is not to highly lever the Company in anyway other than to get to what would be more traditional reasonable levels given our strong cash flow.

Michael Rollins - Citigroup Inc, Research Division

Any questions from the floor? Last question for you Marc, so when I think about the strategy on mobile and on international LD; how do you see the mix of consumer versus business in the future because clearly a company’s enterprises who are sending employees globally or who ask their employees to have really international client list from that base. It seem like back of the really needs benefit and one that company’s would be very incentivized to pursue, is that something that you’re looking at in terms of a shift in the mix of distribution where it makes sense to be more business focus going forward?

Marc Lefar

It’s a great question. When you think about business lets think about the sub-segment. So, I agree 100% and we do think that over the 12 to 24 month period enterprise mobility CIOs and CFOs who are talking an application based approach to putting that on to company issued phones, even those were bring your own phone and employees come into the company, frequently they’re being asked to load software for security reasons on to their devices. The ability for those to have international calling outbound or have international travelers to radically reduce their corporate expensed by using over the top services is great.

We have talked with a number of Fortune 500 CIOs, CFOs who are very interested trialing things with us. Things that we need to develop to make that come to provision really speak more to security needs and enterprise sales maybe just takes a longer period of time. We’re not have distribution to do that, so we may end up doing that through a partner and what really gets sexy for these companies is when you can tap into the corporate directory and actually load that as part of the application, so not only do they get voice messaging and video, but other collaboration tools as part of that suite. So, when you start talking about it, they get excited. But everybody wants to kind of add more complexity to it. So we’re going to build that baseline platform, and we do think that over the longer term that is the direction the large enterprise will go.

Small to medium business kind of a different animal altogether. In that one, midsized business distribution is hard and is not a skill set that we have today. It’s an area that we consider. We certainly would look at; we think that over the next few years there’s probably going to be some consolidation in that market. We’ve got a lot of $30 million to $100 million revenue businesses and we’ll continue to track and see that market. It’s not one we’re going after directly in the short-term and as you know we already compete in the small office, home office business and we’ll continue to do that with enhancements to our core product selling through retail and retail like channels including our feet on the street.

Michael Rollins - Citigroup Inc, Research Division

Well, Marc that brings us to our time. Thank you very much for joining us today.

Marc Lefar

Thank you for having me Mike. I appreciate it.

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