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Vonage Holdings Corporation (NYSE:VG)

Q1 2009 Earnings Call

May 7, 2009 10 am ET

Executives

Leslie Arena - VP of IR

Marc Lefar - CEO

John Rego - EVP and CFO

Analysts

Michael Rollins - Citigroup

Carlos Rangel - MAP

Operator

Welcome to the Vonage Holdings Corporation First Quarter 2009 Earnings Conference Call. (Operator Instructions).

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.

Leslie Arena

Good morning and welcome to our first quarter 2009 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 the first quarter and discuss steps we are taking to drive the business forward. John will review our financial results.

The slides that accompany this discussion are available on the Investor Relations website. 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 these 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.

Now, I will turn the call over to Marc.

Marc Lefar

We entered 2009 with a strategy to improve profitability and better position the company for the long-term. Our financial results for the first quarter show that we are making solid progress. Despite the economic slowdown, we improved on all measures of profitability and generated record high results in several key financial metrics.

Adjusted EBITDA grew 170% from the prior year to a record high of $21 million. We continue to increase the cash flow from existing subscribers, delivering nearly $100 million in pre-marketing operating income and our margin on an incremental subscriber exceeded $17 per month.

Throughout the quarter, we made substantial improvements in our cost structure. We implemented tighter controls on service credits and implemented cost savings initiatives, which led to earlier than expected benefits. Telephony services cost declined 8% per line from the prior year as we continued to optimize network routing and reduce vender costs.

Customer care cost declined 25% per line as prior investments in CRM and call routing software helped drive call center efficiencies and improve capacity planning.

SG&A declined 14% versus last year as we effectively managed hiring and reduced overhead expenses. The benefits from these changes are sustainable.

Gross subscriber lines increased 13% sequentially, but this was still a bit short of our expectations. The consumer impact of messaging that features aggressive but temporary promotional pricing is short-lived in today's marketplace. The importance of grade everyday value, predictable pricing and integrity in customer treatment is increasing.

Perhaps not surprisingly, given the recession, we are seeing a reduced willingness of potential customers to invest money upfront to save money down the road. Consumers want low risk, no cash out of pocket ways to save money immediately. We're making some changes to our marketing strategy to better address these realities. I'll discuss these in a moment.

Although slack dropped by $19 or 6% sequentially, $290 is still unacceptable. We are capable of delivering far better results.

Churn during the quarter was 3.1%, an improvement of 20 basis points versus a year ago. However, this represents an increase of 20 basis points sequentially. We had expected a modest uptick in churn due to seasonality and the impact of the price increase on our lower tier plan.

While we have improved our quality and reliability metrics, some of these benefits are being offset by the acceleration in the number of customers going wireless-only. For the quarter, we had negative net line adds of 6,000.

Despite the economic environment and increase in wireless-only households, the majority of defections are still well within our control. To address the change in customer receptivity to short term promotional pricing and concerns with out of pocket costs, we're making some changes in the very near term.

Beginning with our offer, we will eliminate a few of the largest barriers that have prevented prospects from signing up for Vonage service. We will eliminate start-up costs. The activation fees, device costs and shipping fees associated with initiating service will be waved. Essentially, customers can now sign up for Vonage with no start-up cost. They can start saving money and get much more value than they can from the phone or cable company immediately.

Due to the elimination of other promotional discounting, these changes will have no material impact on our financials. Of course, we will continue to provide our 30-day money-back guarantee. We will also reduce our termination fees, which lowers another barrier to entry.

We simply need to make it easier for potential customers to make the switch to Vonage and the way we do business must be more transparent. We are the Internet communications company that harnesses technology to provide great value, and this message needs to be reinforced from day one of the relationship. We haven't been doing that thus far.

As announced in April, we conducted a comprehensive agency review process and have engaged TBWA\Chiat\Day and their Omnicom sister media agency PHD to handle our messaging and media. These are world-class agencies known for creating impactful messaging for some to the world's most highly regarded brands. Our prior agency relationships are winding down and our transition is almost complete.

Our agency review process highlighted significant opportunities to improve the impact of our message, our ability to target that message and the effectiveness of how we deliver it. Today, Vonage has strong aided and unaided brand awareness. Most of the awareness is in name only.

Despite having one of the strongest value propositions in the marketplace, the dominant perception among those that know us is as a provider of cheap phone service. Unfortunately, we are not getting credit for the dramatic improvements in audio quality and reliability that have been achieved overtime. Cheap is not the same as a great value.

While there is always room for improvement, our core services perform extremely well. We need to help prospects understand that. We need to move into the empty space that exists by blending the perceived reliability of traditional service providers from those attributes of top-performing Internet brands, innovation, ease-of-use, honesty and value. We are the best of both worlds. This positioning will guide our path forward.

Our messaging and our customer experience will reinforce three key pillars. We must convince customers that Vonage provides three things; one, high quality reliable service at a great price; two, innovative communications products and features that harness the power of the Internet in an easy to use way; and three, a straightforward transparent approach to doing business that gives consumers a reason to buy now. We must have promotional integrity. We must remove the barriers to switching to Vonage.

We believe these pillars are well captured in our new selling line, Vonage Sounds Good. Our price of $24.99 for unlimited local, long-distance and international calling to much of Western Europe "sounds good." Our 25 features at no extra cost, which are now called goodies, "sounds good." Clear sound quality, down the street or around the world "sounds good," harnessing the power of the Internet to deliver new integrated communications services that work across multiple devices anywhere in the world, that all "sounds good."

While it will be a couple of months before the entire campaign is unveiled, Vonage Sounds Good will launch in the next couple of weeks with a commercial that features the fairness of our pricing and the elimination of start-up costs. The broader impact of the campaign and the benefits of our new media partner on gross additions will be felt in the second half of the year.

Our strategic imperatives, which I discussed in detail last quarter, will also drive improvements in our results both in gross add and churn.

I'd like to mention some of the progress we made. Beginning with improvements in onboarding, as I mentioned on our last call, more than a quarter of our new customers will still have not registered on our network three weeks later. Improvement in the onboarding of prospects that we've sold that are still having problems getting up and running may provide the single largest lever to drive net growth over the next six to nine months.

In early April, we launched a test of the new onboarding queue in customer service. This queue provides specialized assistance to new customers. Not only are we attempting to reduce return rates in the first 30 days, but these customers also have a greater than average churn rate in their first few months. Preliminary results are very favorable and return rates for customers going through this queue are nearly 600 basis points lower than those who call into our general queue. We are ramping this program as quickly as possible.

One of our biggest challenges in the onbording process is number porting. By simplifying the complexity for the customer, we reduced the number of ports in what we call jeopardy status by nearly 5%. This simply means fewer customers will experience a delay in getting the numbers transferred. Customers get up and are running faster.

In addition, we now display real-time status of porting in our customer care system and on the IBR. This gives our agents the most up-to-date information and reduces customer frustration, and ultimately, will lower our return rate. We are also making good progress measuring call quality, improving our overall reliability and fixing performance issues before they impact customers.

Our customer care operations continue to be more efficient, and more customer friendly policies enhance tools and better training for our front-line representatives should result in noticeable improvements in customer satisfaction.

Looking to the second half of the year and beyond, we see great opportunities to enhance our product portfolio. Although the growth in wireless-only households is a challenge for all home phone service providers, it's also a large opportunity. We plan to offer mobile applications in the second half of 2009 that will allow customers to experience Vonage on their mobile smartphones. These easy-to-use applications provide seamless dialing to international numbers at great Vonage rates using either cellular or Wi-Fi networks.

We're also working on enhancements to our core voice service. Existing services will become more feature rich, and we expect to provide better integration of voice and messaging services across all devices. We're also assessing a service for small businesses that offer a bring-your-own-broadband hosted phone system for single or multiple locations.

We are also expanding our international marketing efforts to make it clear that customers can use Vonage service when they live or travel outside of the US. Beyond this, we'll begin to promote a service that allows customers to have an international number associated with their domestic Vonage line, so that inbound international calls are routed to the customer at no cost to the caller. Essentially that gives the customer an international presence from their US location.

We've also made a number of key additions to our management team. Over the past several months, we have added senior leaders in network operations, product management, customer care, product development and IT. These are seasoned executives with deep experience in some of the most successful companies in communications, technology and marketing and financial service. They are working well with the veteran Vonage team and they're already having a meaningful impact on our organization and our results.

In summary, our financial results for the first quarter were strong, especially in light of the challenge economic environment. Continued strong progress on our strategic imperatives should bolster margins and reduce churn in future quarters. I'm eager to implement our new marketing positioning with our agency partners to realize the true growth potential of this brand.

Although, it will take a little bit of time to turn the corner on growth, I am confident we are taking the right steps to enhance shareholder value. Our expectation for positive growth in 2009 remains unchanged.

Now, John will take us through the details of the quarter. John?

John Rego

It was a good financial quarter for us. Consistent with the initiatives that Marc discussed, we're focused on improving our cost structure and positioning the company for continued growth.

Let's start with slide three and adjusted EBITDA. Please note that we are now using adjusted EBITDA in place of what was formally adjusted operating income. It's the same measure and is defined as operating income with an add-back for depreciation and amortization and share-based expense.

For the sixth consecutive quarter, we grew adjusted EBITDA, generating a record high $21 million in the first quarter of 2009. That's up 170% from $8 million in the first quarter last year and up 4% sequentially.

The sequential growth in adjusted EBITDA was driven by top-line revenue growth, continued discipline and cost management and the benefits of scale as the majority of our cost structure is relatively fixed. We expect adjusted EBITDA to increase in 2009 as these trends continue.

Similarly on slide four, you will see we generated record high pre-marketing operating income, or PMOI, of nearly $100 million. This number reflects the cash generated from existing customer base before marketing, cost of goods sold and equipment and shipping revenue.

On a per line basis, PMOI was $12.68, up significantly from $10.66 in the year ago quarter. Incrementally, we generated $17.71 of PMOI, a solid margin of 64% on telephony services revenue of more than $27.

So let's take a look at the details behind these numbers, beginning with the revenue on slide five. Revenue was $224 million, an increase of 1% sequentially, but flat compared to the prior year. The sequential increase in revenue was principally driven by higher telephony services ARPU, which came in at $27.78 for the quarter, and that's up $0.50 from Q4.

The sequential increase in telephony services ARPU was driven by promotions mix, tighter controls on customer credits, a reduction in the period over which activation fees are amortized, mitigated by a decrease in the FCC mandated universal service fund rate. Customer equipment and shipping revenue remained flat sequentially year-over-year at $8 million.

We continue to make solid gains in our cost of telephony services. Moving to slide six, in the first quarter of 2009, direct cost of telephony services was $6.67, down from $7.26 in the year ago quarter and $7.22 sequentially due to routing optimization, supplier cost management as well as the aforementioned reduction in the USF rate.

Cost of goods sold increased to $21 million from $18 million in the prior quarter, driven by increased gross line adds and in part by the reduction in periods over which product costs are amortized. Direct margins rose to 68% in the first, up from 66% sequentially.

Moving to slide seven, we continue to reduce SG&A and absolute dollars and as a percentage of revenue, which declined for the fourth consecutive quarter coming in at $68 million. As a percent of revenue, SG&A fell to 30% from 31% sequentially and 35% a year ago. We remain focused on controlling overhead expenses and have been successful in maintaining or reducing certain general and administrative costs.

On slide eight, marketing expense for the first quarter was $66 million. That's up $4 million as planned from the fourth quarter of 2008. Cost of acquisition declined $19 sequentially to $290 as some efficiencies were realized from the prior quarter. However, slack remains well above last year's first quarter number of $216.

With the launch of our new ad agency and marketing strategy, as well as improvements in channel efficiency, we expect improvements in gross ad yields and higher returns on our marketing investment in the latter half of 2009.

On slide nine, the company generated net income of $5 million, driven by a gain of $13 million in a non-cash mark-to-market adjustment relating to the derivative liability in our convertible notes. We will make a mark-to-market adjustment quarterly.

Note that an increase in the stock price in future periods will lead to a decrease in the adjustment, which will reduce net income. Excluding this charge, net loss was $8 million or $0.05 per share, an improvement from $9 million or $0.06 per share in the first quarter of 2008.

Gross line additions for the quarter were 227,000, up 26,000 sequentially. The company lost 6,000 net lines in the quarter, as churn increased sequentially to 3.1% from 2.9%, driven in part by seasonality. We believe that the current economic conditions as well as increase in the number of wireless-only homes have had some impact on our business as well.

Turning to the balance sheet and cash flow on slide 10, the company generated $7 million in cash from operations. We expect cash from operations to be positive in 2009. Capital expenditures and software purchases totaled $7 million. Unrestricted cash at the end of the first quarter was $45 million, and additionally, the company has $40 million in restricted cash.

Finally on slide 11, we are pleased that on April 24 the New York Stock Exchange accepted Vonage's plan of compliance for continued listing on the Exchange. We submitted a plan for the New York Stock Exchange, which included a discussion of our operational and financial initiatives and the projected impact of those initiatives on the company's results in 2009 and 2010.

As a result of the plan acceptance, Vonage's common stock will continue to be listed on the New York Stock Exchange. The company will be subjected to quarterly reviews by the NYSE to ensure progress towards its plan to restore compliance with continued listing standards.

Operator, let's open up the line for some questions.

Question-and-Answer Session

Operator

(Operator Instructions). We'll take our first question with Michael Rollins with Citigroup.

Michael Rollins - Citigroup

I just had a quick question for you. I was wondering if you could talk about the usage dynamics of your customers these days. Is there a lot of deviation around the average, and if you could share with us what that average is and how it's been moving overtime that would be great?

Marc Lefar

We've not shared specific usage dynamics and wouldn't share those for competitive reasons, but we've not seen significant movement in the average usage. We have seen on the lower end rate plans, as you might expect, folks who purchase those for backup lines or in the case of wireless-only for emergency relief or the confidence of having 911 services. We do take a look at usage behavior as a predictor of churn.

So, while the averages haven't change, we do spend time trying to understand the dynamics of usage and we can use those as a key indicator to go bring proactive offers to customers where we start to see significant declines in usage that may in some cases be an indicator of a preparation to leave, and we'll try to address them directly with alternative offers that might be better for their needs.

Michael Rollins - Citigroup

As you look at the marketing strategy evolving over the next six months, what would be your ideal target in terms of the percent of your gross adds that come in from Internet, the percent that come in from telemarketing and those that would come in from direct or indirect retail?

Marc Lefar

At a high level, if we look at our numbers today, we're sitting at roughly 60% in telesales, 30% coming online and about 10% through other channels. We are looking to drive that number to the Internet over the next 18 months to get to the point where, frankly, I'd like to see those numbers flip.

There is no reason why in our category if we do things simply in many of our features sets and functionality as well as the integration of tools in the PC itself that we shouldn't be handling most of our sales and an awful lot more of our service online. I don't see a huge shift in that mix over the next three to six months.

I would envision that mix to be relatively stable, perhaps with a few percentage points shift online. I would expect to see a more material shift in that mix in the next calendar year as we do retrofitting of the actual online platforms.

Operator

(Operator Instructions). We will take our next question from Carlos Rangel with MAP. Please go ahead.

Carlos Rangel - MAP

I want to ask if you are seeing impact on the advertising spending in terms of a reduction in cost or a better negotiating position, given that many players are pulling away from advertising.

Marc Lefar

We are seeing and benefiting from some of that in the first quarter. Keep in mind that the media buying strategy historically has been very much on a remnant and low end portion of the marketplace. So our price efficiencies there have not been as great as some folks who might be buying primetime and seeing lower rates on average.

We do anticipate significant efficiencies with our new media buying agency across the board, both in terms of how we implement our media plans as well as what the actual buying power of Omnicom's Media Group allows us to deliver. So, we should be able to get some additional benefit from lower pricing.

It's a modest benefit to-date. The fact remains that the broad market for advertising is soft. That should provide a buying opportunity for folks who are going after what I'll call more traditional mainstream media buyers.

Operator

(Operator Instructions).

Leslie Arena

If there are no more questions that will conclude the call. Thank you very much.

Operator

Once again, ladies and gentlemen, we would like to thank you for your participation. You may now disconnect.

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Source: Vonage Holdings Corporation Q1 2009 Earnings Call Transcript
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