Leslie Arena – VP, IR
Marc Lefar – CEO
John Rego – EVP, CFO and Treasurer
Vonage Holdings Corp. (VG) Q4 2008 Earnings Call Transcript February 26, 2009 10:00 AM ET
Good day, everyone and welcome to the Vonage Holdings Corporation's fourth quarter and full year 2008 earnings conference call. Today's call is being recorded. At this time for opening remarks and introductions, I would like to turn the conference over to Ms. Leslie Arena, Vice President of Investor Relations. Please go ahead.
Thank you operator. Good morning and welcome to our fourth quarter and full year 2008 conference call. Speaking on our call this morning will be Marc Lefar, Chief Executive Officer and John Rego, CFO. Marc will review the company’s progress in 2008 and discuss the strategic imperatives to drive the business going forward. John will review our financial results. The slides that accompany this discussion are available on the Investor Relations Web site. At the conclusion of our prepared remarks, we will be happy to take your questions.
As referenced on slide two, I would like to remind everyone that statements made during this call that are not historical facts or information may be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These and all forward-looking statements are based on management's current beliefs and expectations and necessarily depend on assumptions, data or methods that may be incorrect or imprecise. Such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially. More information about those risks and uncertainties is contained in Vonage's SEC filings. We caution listeners not to rely unduly on forward-looking statements and we disclaim any intent or obligation to update them. During this call, we will be referring to non-GAAP financial measures. A reconciliation of the non-GAAP measures to most directly comparable GAAP measures is available in our earnings release which is posted on the site.
And now I will turn the call over to Marc.
Thank you Leslie. Let’s start by taking a quick look back at the past year and then I will share my thoughts on our opportunities, challenges and priorities for 2009.
At the beginning of 2008, we were facing many obstacles. We had just resolved over a year of expenses and resource intensive intellectual property disputes and the daunting task of refinancing $250 million in debt and a rapidly weakening credit market loomed ahead. We experienced a number of significant operational challenges due to rapid growth while competition from cable providers intensified. The company was in the process of a CEO search and as the year progressed, like most consumer oriented companies; we faced challenges due to the recession. Despite these challenges, we made good progress in 2008 and we are positioned to continue that progress in 2009. We completed the CEO search as I joined the team at the end of July and in the fourth quarter we successfully completed our debt refinancing in one of the worst credit markets in history.
Throughout the year we made key operational improvements and after completing the debt refinancing we focused the team’s energies on six key imperatives, the key priorities most critical for the company’s future success. In 2008, we proved that we have a solid business model as we generated $900 million in revenue and $54 million in adjusted operating profit. In 2009, we expect to improve that profitability to reignite subscriber growth and to better position the company for the long term. We will continue to build out the team and we will continue to focus upon the imperatives that I will discuss in more detail shortly. Positioning for the long term does not necessarily mean beating the cable, wireline and wireless companies in a straight-off battle, it means leveraging technology to provide the right combination of unique products and features, targeting the right customers, and providing great value that provide meaningful revenue and profit opportunities for Vonage. After six months on the job and having had a chance to review the emerging product roadmaps, I am increasingly confident in the number of unmet communications needs and the opportunity for Vonage to address them over time. As I mentioned, the company generated more than $900 million of revenue for the year, a 9% increase over the prior year. We continued to drive cost out of the business reducing SG&A by $23 million or 7% in 2008. And for the first year ever, Vonage generated adjusted operating profit which increased sequentially every quarter and totaled $54 million for the year. Excluding charges, that is a positive swing of more than $100 million from 2007.
For the year, Pre-Marketing Operating Income or PMOI, which reflects the cash generated from our existing customer base increased by 30% to reach a record-high $353 million and our net loss excluding charges narrowed significantly to $34 million from $93 million. Operationally we progressed as well. Our customer service abandonment rates dropped to 3% in December from 15% in January of 2008 and first call resolution improved by 12 percentage points over the year to 75% in the fourth quarter. And while the economic environment and competitive promotional pressure may have masked some of the improvement, our fourth quarter churn rate declined to 2.9% a 40 basis points improvement versus the first quarter. Our business provides a predictable and stable revenue stream with each additional customer generating an incremental margin of 60% [ph], it is a very appealing business. Even modest improvements in the efficiency of our acquisition engine and extension of customer life can have a large financial impact. For example, if our gross add yield during the fourth quarter improved by just 10% assuming flat marketing spend, it would generate incremental profit of $4 million in the following year. The opportunity for value creation is great.
Not only is the business model solid but the market opportunity for digital voice remains robust. Penetration among broadband households is still below 30% and now more than ever consumers are looking for great value and good quality. Over the past several months, we made strong progress in defining our priorities, establishing clear accountability, and instituting operational rigor. 2009 is about execution. To that end, we have implemented six strategic imperatives to focus the company’s resources and drive future growth. Each imperative is supported by a set of tactics, these are the action plans aimed at improving specific elements of our customer experience. I touched on this at a high level last quarter. We would like to provide some additional detail on the work that is underway.
The first imperative is to dramatically improve the on boarding process and early life customer satisfaction. We need to deliver a frictionless experience from the time of sale to the customers’ active use of our service. This is a large opportunity for us, let me put this in perspective. After responding to our advertising, asking all their questions, making a decision, placing an order and passing credit authorization, more than a quarter of our new customers will still not have registered on our network three weeks later. These customers represent the vast majority of our returns yet these customers have never even had a chance to use our service. Our gross additions yield can be greatly improved by simplifying this experience, so we have kind of impacted the tab on our business based upon our 2008 gross line adds, just a 25% reduction in the current return rates will generate an additional 50,000 gross lines.
To simplify the early life experience, we have defined three initiatives. First we have to do a better job of setting expectations with customers when they order in our sales channels. Second, we must ensure seamless coordination of shipping, number [ph] porting and installation support. This includes improving our processes and those of our telecom partners to expedite porting as well as improving our shipping logistics. And third, we must provide dedicated support through specialty representatives who will handle technical questions and help complete the installation process. Together we expect these initiatives will significantly reduce return rates.
The second imperative is to improve distribution and marketing effectiveness. 2008 SLAC was simply not acceptable exceeding $300 in the fourth quarter. Critical to this imperative is improving the quality of prospects and the understanding of our services through improved advertising and media tactics. We must improve the conversion rates in our distribution channels and we need to shift our distribution mix to the most efficient partners and channels. We have already made some improvements in our advertising by simply being more clear about what we do and how we do it.
Vonage replaces the home phone, it works over your existing broadband and it delivers phenomenal value. For heavy international users, the value is even greater and highlighting additional useful features like SimulRing, tightly integrated PC and home phone services, voice mail delivered as e-mail to your PC or smartphone, and voice to text translation will help to differentiate our services. Our recent commercials and media enhancements, although not fully deployed until very late in the fourth quarter, are receiving positive customer response as exposure begins to build. After a week pre and post-holiday season, business in February has improved and advertising testing has shown a 10 percentage point improvement in the level of interest in learning more about Vonage compared to prior commercials. Early days were encouraging.
Our work with our telesales partners to more directly aligned compensation with quality sales is also showing early positive signs and improvements in our online marketing and shopping experience are driving better close rates. We expect these improvements to lead to higher gross add yield and lower sequential SLAC. To accelerate improvement, we recently initiated Search for new agency partners to handle our messaging and media. We are encouraged by the quality of the early thinking and have confidence that we can further improve both the impact and efficiency of our messaging. We expect to bring this agency review process to a close by the end of the first quarter.
The third imperative is improving the quality and reliability of our network, our products and our support platforms. We must ensure that our major platforms are up and operating reliably. While service quality has improved significantly over the years, customer standards have also increased. Many of the customers that leave us for competitive reasons are also highly likely to have experienced some kind of problem with service quality in prior months. We believe we can materially reduce churn and increase net adds by implementing several initiatives in this area. We must also minimize defects in the products we launch. We have already taken major steps to fix existing defects and we are implementing further automation of our testing capabilities to ensure that future services get to market quickly with a high standard of quality.
The fourth imperative is to develop new products and product enhancements that meet the needs of specific customer segments and that create a habit of frequent usage. At a basic level, we do ensure that our core service provides all the comparable features of traditional home phone services including outbound caller ID and auto connection for 411. Beyond this, we are working to identify and find new and developing market opportunities. This includes for example expanding our international scope to broaden the distribution of Vonage services outside the US, UK and Canada. By pursuing distribution partnerships and direct distribution arrangements, we can expand Vonage’s footprint to capitalize on heavy international usage opportunities where demand exist today. We can also do a much better job of tailoring our products and pricing to US based customers with strong international communication needs.
A second opportunity includes developing a full featured offering for small businesses those of up to 10 lines. The integration of traditional phone service and PC based features including flexible messaging and easy-to-use call management features meet many of the needs of this underserved segment. Much of the functionality of our recently introduced Vonage Pro offering can be tailored to meet these needs. Additionally, we believe the timing is right to take advantage of the penetration rate of smartphones, devices with WiFi and increasingly open networks by providing branded mobile applications. Executed in a consumer-friendly way, we believe the market for downloadable or pre-loaded applications that provide seamless international calling and those that allow the use of WiFi even for local calling provide good opportunities for the Vonage brand over time. We are also reassessing the positioning and feature set of Vonage Pro to determine the optimal segments and enhancements for this product. The personal computer is becoming a fixture in kitchens throughout the United States and the penetration of laptops continues to increase. The ability to provide a truly integrated and portable voice and messaging experience when they can leverage a single phone number in multiple locations across multiple devices while accessing contact lists and sophisticated calling features like on the fly conference calling and multi-person voice messaging holds great promise.
The fifth imperative is to continue to optimize our cost structure. Although we have made great strides in the past year, there is much more that we can do to take cost out of the business. One of our key initiatives is to reduce the overall calling rate of our customers while driving other contacts to self service and web-based services. We receive roughly 10 million calls per year into our call centers. We are digging deeply into the root causes of these calls and re-evaluating the best way to handle each. This work has made it quite clear that many calls can be completely eliminated with better customer communication up front and the use of self service IVR and web-based solutions can eliminate even more.
A 10% reduction in calls handled by live reps could save between $6 million and $8 million annually. Other initiatives underway include the implementation of more sophisticated route and rate management tools that will immediately allow us to optimize our costs and quality across our carrier partners. International call termination costs are another area of optimization and our focus on aggressively managing SG&A will continue.
The sixth imperative relates to enhancing the productivity of our organization to improve the talent management, employee development and management tools. We have a strong can do culture advantage. Our employees work hard and care deeply about the business. We must further develop our people and we will be putting training programs, further development and succession planning programs in place to ensure that we build, retain and recruit top talent. We made solid progress in 2008, we significantly improved our financial results, we restructured our debt, we improved our operational performance, and we stabilized customer attrition despite a weak economy and strong competitive pressures.
That said, our net additions and cost of acquisition fell well below expectations and while there is no silver bullet, we do have very clearly defined strategies and tactics to address these performance gaps. I am confident that strong execution against the plan will deliver meaningful progress during the course of 2009 and beyond.
Now, John Rego will take us through the details of the quarter and the full year results. John?
Thank you Marc. Beginning with slide 5, we are pleased to report that the company reported its first quarter of positive operating income. Operating income for the fourth quarter 2008 was $3 million up from a loss of $9 million a year ago and $3 million sequentially. We expect operating income to continue to grow throughout 2009.
Similarly on slide 6, you will see the benefits of scale and the value generated by our existing customer base. We delivered a record high Pre-marketing Operating Income or PMOI in the fourth quarter. This number increased to $92 million up from $81 million ex charges a year ago and $91 million sequentially. This is the eighth consecutive quarter of growing PMOI. On a per line basis, PMOI was $11.70 up significantly from $10.52 ex charges in the year ago quarter. Incrementally, we generated $16.33 of PMOI driven by the fact that over 50% of our cost are relatively fixed in nature. This translates to a 60% margin on telephony services revenue of more than $27. PMOI is a proxy for the cash flow generated by existing customers and excludes marketing, cost of goods sold, and equipment and shipping revenue.
Looking at revenue and earnings on slide 7, the company reported revenue of $222 million, a 3% increase from the fourth quarter of 2007 and a decline of 2% sequentially. Revenue declined sequentially due to a decline in telephony services ARPU resulting from the fall in currency value of the Canadian dollar and the British pound and an adjustment in international revenue which totaled $0.33. Excluding these impacts, sequential telephony services ARPU increased by $0.09. Net loss ex certain charges for the fourth quarter of 2008 narrowed to $10 million or $0.07 per share that is down from $12 million or $0.07 a share a year ago. GAAP net loss for the fourth quarter which includes a $31 million debt extinguishment charge was $41 million or $0.26 per share.
As part of the debt refinancing, we completed a tender offer for the company’s existing convertible notes while simultaneously issuing new notes. For accounting purposes, a portion of these transactions are viewed as an exchange which requires that we record the difference in valuation of the new notes compared to the old notes as well as any fees paid to lenders who exchange their debt as debt extinguishment cost. Debt extinguishment cost negatively impacted EPS by approximately $0.19. So, let us look at the details behind the numbers.
Beginning on slide 8, average monthly telephony services revenue per line was $27.28, that is down $0.14 in the year ago quarter and $0.24 sequentially. The sequential decline was principally driven by the aforementioned currency impact and international revenue adjustment. These items mask ARPU increases driven by lower promotions and tighter control over credits. While we expect pricing to remain stable in the fourth quarter we did increase the price of our lower tier residential offer to $17.99 from $14.99. Customers on this plan represent roughly 20% of total lines. The $17.99 price point continues to be extremely competitive in the marketplace and enables the company to generate additional value to support growth. We believe we may see a minor increase in the level of churn for these plans once all customers receive their revised billing this month.
Moving to the drivers of direct margin on slide 9, in the fourth quarter of 2008, direct cost of telephony services was $7.22 up from $7.11 in Q4 ’07 and $7.20 sequentially. We continued to aggressively manage costs and believe per line cost can fall an additional $0.05 to $0.10 in 2009. Cost of goods sold was $18 million, an increase of $1 million from the fourth quarter last year and a decline from $21 million sequentially reflecting the decline in gross line additions and lower promotional activity. Direct margins of 66% were flat year over year and sequentially.
Moving to slide 10, SG&A of $69 million reflects an $8 million or 10% decline ex charges from the fourth quarter 2007 and a $4 million or 6% sequential decline. As a percent of revenue, SG&A fell to a record low 31%. Our intense focus on cost reductions has enabled us to decrease SG&A both in absolute dollars and as a percentage of revenue. We will continue to aggressively manage these costs.
On slide 11, marketing expense for the fourth quarter was $62 million down $3 million sequentially and $1 million from the fourth quarter 2007. The cost of acquisition or SLAC rose to $309 from $272 sequentially and $223 in the year ago quarter. We expect SLAC to decline in the first quarter of 2009 and anticipate that marketing spend will be in the mid $60 million level on a quarterly basis throughout the year. As Marc discussed, we believe that current economic conditions have had some negative impact on our business hampering both our ability to add customers as well as impacting customers’ ability to pay. We have seen a slight decrease in prospects as well as an increase in the number of customers whose credit and debit cards fail on processing. Our credit and collections group have thus far been able to resolve these payment issues to successfully process payments.
Gross line additions for the quarter were 201,000 down from 284,000 year over year and 238,000 sequentially on a lower marketing spend. The company lost 15,000 net lines in the fourth quarter ending the quarter with more than 2.6 million lines in service. Churn for the quarter was 2.9% down from 3% sequentially. We continued to see stabilization in our underlying care metrics with first call resolution of 75%, customer satisfaction of 85%, and abandonment rates of 3%. We believe these results have allowed us to offset some of the dampening effects of the economy.
Turning to the balance sheet on slide 12, cash, marketable securities and restricted cash at the end of the fourth quarter was $86 million. Cash used for operations was $6 million and capital expenditures in the quarter totaled $6 million. The company completed its debt refinancing in the fourth quarter of 2008 and I would like to briefly go through the cash interest and interest expense charges in the fourth quarter and discuss what those charges will look like going forward. Interest expense for the quarter totaled $13 million, which is a blend of the interest on the old convertible notes of 5% and interest on the new notes ranging from 16% to 20%. In 2009, while there are variable interest components, quarterly interest expense is expected to be approximately $13 million which includes $5.2 million cash interest and non-cash or pick interest of approximately $4.5 million as well as other charges.
In summary, we have made sound financial progress this year and are looking forward to continued progress in 2009. And now operator, let’s open up the lines for questions.
Thank you (Operator instructions).
Okay operator, if we have no questions, we will conclude the call.
Okay, it appears we have no questions at this time.
Once again that does conclude today’s call, we do appreciate your participation. You may now disconnect.
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