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Vonage Holdings Corp. (NYSE:VG)

Q2 2009 Earnings Call

August 5, 2009 10:00 am ET

Executives

Leslie Arena – Vice President of Investor Relations

Marc Lefar – Chief Executive Officer

John Rego – Executive Vice President and Chief Financial Officer

Analysts

Michael Rollins – Citi Investment Research

Operator

Welcome to the Vonage Holdings Corporation second quarter 2009 earnings conference call. I would now like to turn the call over to Ms. Leslie Arena, Vice President of Investor Relations.

Leslie Arena

Speaking on our call this morning will be Marc Lefar, Chief Executive Office and John Rego, CFO. Marc will discuss the company's progress in the second quarter and review steps we are taking to drive the business forward. John will discuss our financial results. Slides that accompany John's 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 depend on assumptions or data 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 comparable GAAP measures is available in our earnings release, which is posted on the Investors Relations Web site.

And now I'll turn the call over to Marc.

Marc Lefar

Vonage is gaining strength financially. Our business model is sound and we remain focused on addressing our operational and competitive challenges to reignite growth. In the coming weeks and months we will be increasing the value of our core offerings and we will launch new products and services to enhance our competitiveness.

The economy continues to cause many consumers to struggle financially, yet consumer expectations of quality continue to increase. Competitive intensity and wireless substitution demands that we provide even better value and innovation across multiple devices and varying forms of communication.

Second quarter financial results were strong. EBITDA, less non-cash stock compensation, reached a record high of $31 million. This is the seventh consecutive quarter of positive and growing adjusted EBITDA. We generated free cash flow of $12 million and $15 million in operating income, and the first time ever, excluding the benefit of a derivative adjustment, we generated positive net income. This is solid financial performance.

Our teams reduced the cost of telephony services, implemented process improvements in customer service operations and tightly managed overhead costs. These actions helped to drive our results and will lead to savings in the future as well.

Subscriber growth was disappointing. Net line loss was 89,000 during the quarter, as gross additions soften. In addition to the impact of increased competitive promotions, we reduced our marketing investment as we completed the transition to our new agencies and continued in the development of new advertising. Further reductions resulted from the elimination of inefficient non-media spending. These non-media reductions will provide financial benefits in future quarters as well.

The yield on our marketing and sales spending must improve and fixing this is a primary focus. Combined with the impact of enhancements to our core offering and new products, we expect to see some improvement in growth over the next several months, accelerating into 2010.

Shortly after announcing our new agency, we launched a new commercial to refresh our message and communicate an open, honest, no smoke no mirrors approach to our offer. To respond to the consumer demand for immediate savings, we have eliminated all upfront costs. Activation fees, device charges and shipping fees have been eliminated. We no longer lock customers in on short-term promotional pricing that jumps dramatically at the end of the promotional period. We believe this straightforward, everyday great value message with no tricks will resonate with customers over time.

In the next several weeks, we will launch new commercials that emphasize Vonage's quality, features and incredible value. We will also announce major enhancements to our product set touching multiple platforms including mobile, and they will be available to new and existing customers. These changes will dramatically improve the overall value of our service and will reinforce our selling line, "Vonage Sounds Good".

For the third quarter, we anticipate marketing investment in the upper mid $50 million range. We will, however, remain somewhat flexible. As programs show strong returns, we may choose to invest more heavily, if they fail to generate returns, we will not hesitate to cut them.

While improving our product and our messaging, we are also redesigning the sales experience in our telesales centers and our online store to improve conversion rates. We are bringing on new sales partners, improving the competitiveness of our story, and improving the overall speed and flow of our processes. Several improvements to the online store were implemented late in the second quarter and are contributing to improvements in sales performance. Post-sale, we are continuing to work to improve the customer experience.

Although we are making progress to reduce push factors that drive customers away, second quarter churn remained about target levels, up a few basis points from the first quarter. The quarterly change was driven in part due to an uptick in non-pay churn, a reflection of the overall economy. We are seeing some indications that this should return to more normal levels in the second half of the third quarter.

The effort to improve the friendliness of our customer policies and training among our call center representatives is ongoing. Our recently created on-boarding queue, which provides specialized assistance to new customers, continues to show positive results.

Return rates for customers going through this queue are 5 percentage points lower than customers calling into the general queue. As a result, we have expanded the number of agents in on-boarding from 90 to 170 in July, and we plan to ramp to 300 agents in October by shifting resources. Virtually all of our new subscribers will have access to this specialized on-boarding team by the end of the year.

On the quality front, we now have data that measures the frequency and breadth of audio issues at a customer level. This data is helping us to understand which customers are experiencing a lower than acceptable level of quality and it allows us to remedy these issues sometimes before a customer even notices a problem.

This data also provides us with critical information on software defects and helps us to prioritize network expansion projects and enhancements to our call processing architecture. We are also learning from the variation in quality and churn across geographies.

In our better performing large markets, including New York and Boston, our churn rates range from 30 to 60 basis points better than some other large cities in other parts of the country. If we can bring our poor performing markets to these levels, we believe we can deliver meaningful churn reduction.

Overall, we have made solid progress on many of our strategic imperatives, including the overall customer experience. And our financial progress has been strong, but we have much more work to do to improve the efficiency of our customer acquisition engine. Our upcoming service enhancements and new product launches should provide renewed customer excitement, and I'm looking forward to sharing more specifics over the next several weeks.

And now, I'll turn it over to John to review the financials.

John Rego

Beginning with slide three, it was a strong financial quarter for us. We generated positive adjusted EBITDA reporting a record high $31 million in the second quarter of 2009. That's up 152% from $12 million in the second quarter last year and up 51% sequentially. The sequential growth in adjusted EBITDA was driven by continued strong cost management and reduced marketing spend as we transitioned our new agency and marketing plan.

Turning to slide four, the company generated GAAP net income of $2 million or $0.01 per share. Excluding the benefit of a $1 million derivative liability adjustment, that income in the quarter was $1 million also $0.01 per share. That's an improvement from a $7 million loss or $0.04 per share in the second quarter 2008.

Moving to slide five, we continued to generate substantial pre-marketing operating income or PMOI, which was $94 million in the second quarter. This fell sequentially from $98 million as a result of severance and legal reserves totaling $6 million. This number reflects the cash generated from our existing customer base before marketing, cost of goods sold, and equipment and shipping revenue. On a per line basis, PMOI was $12.36 up significantly from $11.15 in the year ago quarter.

So let's take a look at the details behind the results. Beginning with the revenue on slide six, revenue was $220 million down 2% sequentially and 3% compared to the prior year. Telephony services revenue of $215 million was flat sequentially and down 2% year-over-year on lower lines. Telephony services ARPU, however, increased sequentially to $28.18 for the quarter, that's up $0.40 driven by an increase in the universal service fund rate and the benefit from the increased rate in our basic plan to $17.99 from $14.99 offset by reduced activation fee and increased bad debt.

Customer equipment and shipping revenue of $5 million was down from $8 million sequentially and $9 million the prior year on fewer gross line adds, as well as the launch of our no-startup-cost promotion in May 2009. We continue to make strong gains in our cost of telephony services.

Moving to slide seven, in the second quarter of 2009 direct costs of telephony services per line was $6.76 down from $7.22 in the year ago quarter, driven by rate reductions and continued efficiency in routing management, also up slight from $6.67 sequentially.

Excluding the impact from the universal service fund pass-through, costs per line fell significantly from $5.10 to $4.87 sequentially. Cost of goods sold declined to $16 million from $21 million sequentially driven by lower gross line additions. Direct margins rose to 69% in the second quarter up from 68% sequentially.

Moving to slide eight, although we continue to effectively manage SG&A, we saw an increase to $71 million from $68 million the prior quarter. As a percent of revenue, SG&A was 32%, which is down slightly from 34% a year ago. Included in SG&A are costs of approximately $2 million related to the shutdown of our Canadian customer care facility and a reserve of $3 million for certain litigation items. Excluding the effects of severance and legal reserves, SG&A as a percentage of revenue would be 30%.

We remain focused on controlling overhead expenses and have been successful in maintaining or reducing costs, as customer care and compensation and benefits per line fell sequentially in the second quarter.

On slide nine, marketing expense for the second quarter was $52 million. That's down from $66 million in the first quarter and $65 million a year ago. We reduced marketing spend as we transitioned to our new advertising agency, while eliminating redundant spending.

Our cost of acquisition increased $73 sequentially to $363 in the quarter, as our gross line add efficiency fell. Gross line additions for the quarter were 144,000. We expect improvements in gross add yield as we begin to see benefits from product enhancements and expansion of our marketing campaign. Churn increased modestly to 3.2% from 3.1% in the first quarter, as economic conditions and competitive pressures offset some of the operational gains made in the quarter.

Turning to slide ten, the company continues to generate cash. We reported strong free cash flow of $12 million. Cash from operations was $19 million. We expect cash from operations to continue to be positive in 2009. Capital and software expenditures totaled $8 million. Unrestricted cash, at the end of the second quarter was $56 million and additionally, the company has $40 million in restricted cash.

Leslie Arena

Now, operator, please open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Michael Rollins – Citi Investment Research.

Michael Rollins – Citi Investment Research

I was wondering if you could talk about just a little bit more in the sales productivity side, what are you seeing sort of early in the third quarter in terms of directionally where the productivity is going. And then also, as you think about the marketing strategy, where is your target CPGA or cost of acquisition over time and within that context I would be including the subsidy of the device.

Marc Lefar

So we're not going to be giving any third quarter guidance specifically, Mike. What I'll tell you is that conversion rates, as I mentioned have been improving modestly, as we've been able to implement some changes to the online store, so we're getting better throughput in terms of folks hitting the main page, what actually comes out the other side we've seen meaningful increases there.

We are still seeing softness in the economy, however, and we've not had the new advertising from our new marketing campaign or full-blown spend back to normal levels on the media front, so it's difficult to calibrate where we really expend gross adds to come at in the third quarter at this point. It's a little early yet.

Relative to the CPGA question, as you well know, that is completely driven by our gross add yield, so it really ties back to what kind of improvements do you expect to get. We're disappointed with the gross add yield that we've seen in the second quarter, it was worse than we expected. We did expect some softness due to pullback in marketing investment due to our transition.

But with the lower spending, I would see on [flak], which we traditionally report, we expect that we should be able to get back in to the mid $200 range over time. And as we've discussed in the past, we've moved to an approach on CPE where we are no longer charging for device, we take that as a full subsidy. So, on the device front it really depends on our costs, which we are in the process of driving down.

Again, I don't want to talk to forward-looking programs because we're in the process of trying to think about how do we take costs out of those items that we have to subsidize. You can use historical numbers to get a rough surrogate.

Leslie Arena

And I think, Mike, from a comparability perspective on this CPE subsidy because we have now no upfront costs, you'll see the CPE subsidy increase, but we gain on the revenue side. So you can't make a quarter-to-quarter comp as you could in the past because of the change in our methodology, but we'll help walk you through that.

Michael Rollins – Citi Investment Research

One other conceptual question, in the last quarter or two we've see a real drop in cable telephony net adds as a category, and I'm wondering if you think that in some respects that's helping you? Are you seeing any change in the competitive environment from cable, or do you think you're actually being hurt maybe by the same things that the cable sector is seeing in terms of their productivity on cable telephony?

Marc Lefar

That's a good question. My sense is that, if you look at the absolute penetration of homes past and the availability, I think at the last range we looked at Comcast is still well below 30%, Cablevision is probably leading the pack I think it was probably in the mid 40s. That's still, in my opinion, pretty doggone low when you look at the leverage folks have into those households.

I think the excitement level, the novelty and frankly, just the initial rush you get as people come new into the market with their campaigns, has basically run its course. There's still a significant amount of under-penetrated market that has economic reason to switch that isn't happy with the cable alternatives, and we think that that is ripe for us to be able to leverage.

We need to be able to get our voice heard, we need to make sure that we're differentiated and we need to be able to clear up the clutter on what is the real price value equation that folks get from a triple play versus us. If we do that successfully, I think there's a large number of new subscriber opportunities for us.

Leslie Arena

Okay, next question, Operator.

Operator

(Operator Instructions)

Leslie Arena

Okay, Operator, we'll wrap up the call. Thank you.

Operator

That does conclude our teleconference for today. We'd like to thank you for your participation.

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