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Vonage Holdings Corp. (NYSE:VG)

Acquisition of Vocalocity, Inc.

October 10, 2013 6:00 PM ET

Executives

Leslie Arena – Vice President-Investor Relations

Marc Lefar – Chief Executive Officer and Director

Wain Kellum – Chief Executive Officer, Vocalocity, Inc.

David T. Pearson – Chief Financial Officer & Treasurer

Analysts

Michael I. Rollins – Citigroup Global Markets Inc.

Greg J. Burns – Sidoti & Co. LLC

George F. Sutton – Craig-Hallum Capital Matt F. Sherwood – Cooper Creek Partners Management LLC

Jim D. Breen – William Blair & Co. LLC

Dmitry G. Netis – William Blair & Co. LLC

Operator

Welcome to the Vonage Holdings Corp. Conference Call reviewing this morning’s announcement of Vonage’s acquisition of Vocalocity. My name is Kevin and I’ll be your operator today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions) Please note that this conference is being recorded.

I would now like to turn the call over to Ms. Leslie Arena, Vice President of Investor Relations. Ms. Arena, you may begin.

Leslie Arena

Thank you. Good morning and welcome to our conference call. With me this morning are Marc Lefar, Chief Executive Officer of Vonage; Dave Pearson, CFO of Vonage; and Wain Kellum, Chief Executive Officer of Vocalocity. We’ll begin the call with some prepared remarks and then we will move to Q&A.

As referenced on slide two, I would like to remind everyone that statements made during this call 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 expectations and depend on assumptions that maybe 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 highlighted on the second page of our slides and contained in our SEC filings. We caution listeners not to rely unduly on these statements and disclaim any intent or obligation to update them.

And now, I’ll turn the call over to Marc.

Marc Lefar

Thank you, Leslie. Good morning everyone and thank you for joining us today.

Today is an exciting day for Vonage. This morning, we announced that we have signed a definitive agreement to acquire Vocalocity, an industry leading SaaS provider of cloud-based communications to small and medium businesses for $130 million. Entry into the SMB segment is a key element of the long-term growth strategy that we outlined early last year. This acquisition places us in the forefront of the large and rapidly growing hosted Voice over IP market for SMBs.

Vocalocity’s capabilities are the perfect complement to Vonage’s products and brand equities, and our companies use similar SIP-based VoIP technology presenting well defined opportunities for meaningful synergies. We expect the transaction will be accretive to adjusted earnings per share and EBITDA on a multiple basis in 2015.

As Leslie mentioned, Wain Kellum, the Chief Executive of Vocalocity is here with us today in Holmdel, and I’d like to welcome Wain and invite him to share a few words.

Wain Kellum

Thank you, Marc, and good morning, everyone. First I’d like to acknowledge the Vocalocity team and the great work they’ve done to bring us where we are today. I think I speak for the entire company when I say it’s exciting to be joining forces with Vonage. Vonage’s history as a pioneer on the VoIP business is a perfect fit with our innovative culture. A combination of our product with Vonage’s scale and high brand awareness around small business creates enormous opportunities for us to grow together, and particularly as VoIP services, for SMBs move from their early adopter phase to the mainstream. We look forward to working with our colleagues at Vonage.

Marc Lefar

Thank you, Wain. Welcome. Let’s move to Slide 4. We expect the transaction to close in a few weeks. Upon the closing, Wain will join my senior leadership team as President of Business Services. Wain will continue to be based in Atlanta, leading the Vocalocity team, and Wain, congratulations to you and your team. We really look forward to working together with you and we’ve been impressed with your results to date.

Vocalocity was formed in 2006 and delivers award-winning, easy-to-use, feature-rich products to more than 21,000 businesses. For the first half of 2013, Vocalocity grew revenues to $28 million, a 39% increase over the same period last year. Their rate of growth is more than double that of 8x8’s and comparable to that of RingCentral. In the absolute, Vocalocity added nearly 500 more net new customers than 8x8 during the first six months of the year.

Over the same period, revenue per customer per month was $229, an 8% increase over the prior year and more than 5x that of RingCentral. Although, 8x8’s ARPU is higher, their cost per acquisition was roughly double, resulting in a comparable acquisition cost to payback period. Vocalocity’s customer churn is very low at 1.6% similar to that of 8x8, and the company was modestly EBITDA and free cash flow positive in each of the last four quarters.

Moving to Slide 5. The total SMB market for voice service in North America is $15 billion and 32 million lines. Vocalocity has focused on companies with 20 or fewer employees, which represents more than 60% of the total market. The opportunity for continued rapid growth in this segment is substantial, given that 85% of SMBs still purchase voice service from traditional carriers at rates that are frequently 40% to 50% higher than those of Vocalocity. In July 2013, Frost & Sullivan study forecasted the hosted VoIP market for SMBs will grow at a compound annual rate of 27.5% over the next five years.

As was the case in the consumer market; improved quality, reliability and extraordinary value are driving the rapid shift. A comprehensive set of features tailored specifically to SMBs has resulted in very high satisfaction levels for service that is critical to the daily operations of the business, and mobility is increasingly – an increasingly important component. Vonage is now very well positioned to build market share in this segment.

Moving to Slide 7, Vocalocity’s suite of services along with Vonage’s high brand awareness further illustrates the rationale for this transaction. Vonage’s brand awareness among SMBs is nearly 80%, while aided awareness of 8x8 and RingCentral is less than 10%. In addition, since many consumer and SMB acquisition channels are similar, we should be able to reapply best practices and realize benefits of scale in our sales and marketing overtime.

This acquisition provides us with a wonderful opportunity to leverage the investment in the Vonage brand over the last decade. The acquisition of Vocalocity also supports our strategy to expand internationally by enabling us to deliver services to SOHO and SMB markets abroad. We also expect that the investments Vonage has been making to build our mobile capability can be leveraged into the SMB market.

Given the similarities of the business and our common use of SIP-based VoIP, we expect to achieve synergies from network operations. A clear example is domestic call termination, where Vonage’s costs are 65% lower than those of Vocalocity. The use of technology to service customers is another area we expect that efficiencies can be realized. We estimate recurring synergies in 2015 in the high single digit million dollar range.

Moving to Slide 8, as we step back to look at the full picture, the potential of the market, strong customer growth and satisfaction, clear competitive strengths and synergy opportunities, we believe this transaction is a compelling value, especially when compared to competitors. We’re purchasing Vocalocity at 2.4x the last six months annualized revenue. This compares very favorably to 8x8 and RingCentral, which traded approximately 6.2x and 7.1x revenue on the same basis respectively.

Let me now turn the call to Dave to provide a brief financial overview of the transaction.

David Pearson

Thanks, Marc. I’m on Slide 9 now. As Marc referenced, total consideration for the acquisition is $130 million. Under the terms of the merger agreement, Vocalocity shareholders will receive $105 million in cash and $25 million in Vonage common stock. The stock amount equates to a fixed 8 million shares of Vonage or 3.5% of fully diluted shares and is in the form of restricted shares, which cannot be sold or transferred for six months and are then subject to Rule 144.

We expect to achieve significant annual operational synergies through scale and technology beginning in the first year after close. Based on these cost synergies and current business and trends, we expect the deal to be accretive to adjusted earnings per share and on an EBITDA multiple basis in 2015. Vonage is financing the cash portion of the transaction through $30 million of cash from the balance sheet and $75 million from our revolving credit facility.

On close, Vonage will have $69 million of cash, gross leverage of 1.1x and net leverage of 0.6x EBITDA. This capital structure will enable us to continue to execute on our balanced approach to capital allocation. Accordingly, we expect to complete our $100 million share repurchase program by the end of 2014 as planned.

Turning to Slide 10, this transaction has been unanimously approved by the Boards of Directors of Vonage and Vocalocity. No regulatory approval or further shareholder votes are required. We expect to close the transaction in the fourth quarter of 2013, subject to customary closing conditions.

And I’ll pass the call back to Marc.

Marc Lefar

Thanks, Dave. So let me close by congratulating the Vocalocity team once again on their success and for having built a terrific platform from which we can together continue to grow. Wain, we look forward to working with you and your team, as we accelerate our entry into the SMB market.

And with that, I’ll pass the call back to Leslie and we can start the Q&A.

Leslie Arena

Thank you, Marc. Operator, please open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Michael Rollins with Citi.

Michael I. Rollins – Citigroup Global Markets Inc.

Good morning, and thanks for taking the questions. Just a couple of things, one is I was wondering from a numbers’ perspective if you could provide a little bit more specificity on the EBITDA or OIBDA for the first six months of 2013? Secondly, Marc, can you talk about maybe what this means strategically for the company; directionally, do you see the company more focused on SMB and maybe migrating some of the focus away from some of the other initiatives that you’ve been doing or is this sort of another parallel initiative of the company? And then finally, if I could just throw one more in, buybacks, you mentioned in the press release that you are looking to stick with the plan of the buybacks. Can you just give us an update as to where you are in the buyback program, how much is done to-date since you started the program? Thanks.

Marc Lefar

Sure, Mike. Let me pick that up. So we shared that the company has been modestly EBITDA and free cash flow positive for the last several quarters. As you know in a rapidly growing market with a relatively small company that number can change pretty materially when – depending upon the amount of customers that are acquired in a given period, given the front-loaded acquisition cost. So rather than provide a specific EBITDA or OIBDA margin upon which folks are going to model, we wanted to make sure people understood this is a profitable company, has high contribution margins and really should be looked at in this case in terms of its sustaining [indiscernible] kinds of numbers, which are in the high 60% ranges comparable to that of competitors and growing at a rate that is a faster. And when we think about the revenue multiple, we think it’s a tremendous value particularly when you consider the synergies that are involved.

Relative to the strategic direction of the company, I do view this as transformational, but not a strategic shift. You’ll recall I actually spent a fair bit of time with you at one of your conferences a little over a year and a half ago, and we talked about the opportunity in SOHO and small and medium business, and how the core underlying technology of our business allowed us to be able to serve that market especially well and that there was an increasing level of adoption as reliability and quality were increasing and the ability to have a portal use and an easier to activate source for small and medium businesses that technology was progressing pretty quickly. And as I shared at that point in time, we said we’ll continue to look at organic and inorganic ways to get into those marketplaces.

As I’ve talked before, we have already entered SOHO and we get quite a number of inquiries for Small Office Home Office businesses, small two, three-line accounts, and that’s not insignificant amount of the inbound calls we receive, but we did not have the full platform and suite of services that Vocalocity team has built out. It’s an experienced group of software executives. We think their product is fantastic. We think that they are growing and have managed this at a rate as good or better than the leading competitors. So for us, this really becomes a natural extension and broadens our appeal to a broader group and allows us to leverage the brand that we’ve already established and invested in.

In terms of the question around, does this mean we’ll be changing our strategies in other areas, no, it does not, we continue to refresh folks who are unfamiliar with our core strategies, expand internationally. So taking the same kinds of technologies that have made us successful in the U.S. and bringing that into developing markets where the regulatory environment for VoIP is improving, where there’s good broadband access and there’s discretionary income to be able to support monthly recurring types of models, we continue to expand there. This just gives us, frankly, more addressable market, because we can tailor this platform into some of those markets overtime and relative to mobile, which is the other core area of investment, this is a perfect fit as well because much of the mobile capability and software development capabilities we build will be applicable in the business markets as well. I draw a quick corollary

I think as you know, we have 800,000 folks who have a registered subscribers of our Vonage Mobile Extensions product, meaning our existing monthly recurring home phone service customers, who are actively using mobile as an extension of their core service. That functionality and the roadmap for features for those customers is being built out rapidly as is the standalone Vonage Mobile platform and all of those capabilities are things that we think will be enjoyed by small and medium businesses and Vocalocity has already entered the market with mobile complements and we think that’s just going to grow more quickly in the coming 12 to 18 months.

And now let me turn it to Dave on the buyback question.

David Pearson

Sure. Mike, we have $76 million left under our current authorization of $100 million through the end of 2014. As we’ve mentioned, we intend to complete that authorization within the time allotted and we did in the second quarter, we bought back five million shares for $13 million. We were active in the third quarter, very active in the third quarter and we’ll be announcing that consistent with our 3Q earnings.

Michael I. Rollins – Citigroup Global Markets Inc.

Thanks very much.

Leslie Arena

Next question operator.

Operator

One moment. Our next question comes from Greg Burns with Sidoti & Co.

Greg J. Burns – Sidoti & Co. LLC

I have a question on the valuation. It seems very attractive comparative to the other public comps that are out there. So I was just wondering if there’s some significant investment that needs to be put in once the [indiscernible] the deal is closed in terms of infrastructure or maybe back-office services or anything of that nature that we should expect over the next year or so?

Marc Lefar

Greg, it’s Marc. Thanks for the question. So I’ll actually invite Wain to talk about valuation. But the specific around significant incremental investment, no, we do not anticipate any significant incremental investment in capital or OpEx to scale the business. What the team has built is cloud-based and highly scalable. It can be built on what’s largely with a variable cost model based upon the rate of growth of customers and we also see some significant opportunity to actually to take some of the cloud based approach and actually move some of the network traffic over to Vonage private cloud, which will likely get us some cost efficiencies as well and be able to scale some of our fixed cost where the company is currently on a variable cost basis.

So nothing from an infrastructure standpoint that’s significant. We would expect to make some investments in technology, particularly front-end technology to improve the throughput through acquisition channels, inbound telesales as well as front-end tools and customer service as you know, Vonage has been very successful in the last several years in driving cost out of those, while increasing customer satisfaction and as a small relatively young company, you wouldn’t expect to have the investments in those tools will be extend those from what Vonage has purchased into the Vocalocity platform. So we think that there is improvement there and it’s – as Vonage is a very low capital intensive business, because it is over the top.

Greg J. Burns – Sidoti & Co. LLC

Okay, thank you. Also just had a question about the average customer size and kind of Vocalocity’s positioning in the market, it looks like the average customer size is around 10 or so lines. Is that kind of where you are going to remain focused? I have seen a couple of other competitors in the space are looking to move upmarket. Can you give us some additional color on kind of the go-to-market strategy here and your market positioning?

Marc Lefar

Sure. Sure. So I know it’s been quite popular with some of the competitors in the space to speak to the word upmarket, bigger is better. Bigger is better if you can serve them well and you can do it cost effectively. The reality is that 62% of all the revenues in SMB within companies that are 20 lines or less. As you would expect, Vonage coming from a consumer orientation and we serve up to two and three lines, we get those calls on a regular basis and Vocalocity’s success along with what is still a very under penetrated market. While we will certainly fish in the ponds where there are bigger customers, we can get them efficiently. We like the market that Vocalocity is focused on and average customer lines in the high single digits on average, feels pretty good to us. We know it’s a very cost effective acquisition and we think that we’ve got a product suite that will allow us to grow market share pretty rapidly in that under 20 segment.

Greg J. Burns – Sidoti & Co. LLC

And in terms of sales, is it all direct? Did you have any kind of indirect sales channels?

Marc Lefar

Yes, I’ll just give a couple of high numbers and let Wain provide some additional commentary. There are resellers of ours representing about 15% of total distribution. Digital is a large portion. SEO and SEM representing about 45% of new customer acquisition. Customer referrals based upon the quality the platform are also quite large at about 26%, 27%, and then there is direct mail and outbound telesales that are also high single digits and there’s some web aggregators, they’re also high single digit percentages. Wain, do you want to talk a little bit about what’s been most productive for you and kind of the direction of your distribution shift or mix shift; what you expect over the next six months or so.

Wain Kellum

Sure. As Marc said, largely, we are a direct company. Two years ago, our indirect revenues were about 8%, and as Marc said that’s more than doubled over the last two years. And so as cloud becomes pervasive and early adopters move into mainstream, people that were traditional telecom resellers are looking to sell cloud solutions. We expect our distribution strategy continue to evolve where indirect will account up to 40% of revenue in the future.

Marc Lefar

Thanks, Wain.

Greg J. Burns – Sidoti & Co. LLC

Okay. And just lastly if you can just talk about kind of the Vocalocity’s differentiators or how you separate yourself from some of the competitors you mentioned on the call, and when you are out in the market, who you are seeing mostly and who are you competing against when you are up for a deal?

Wain Kellum

So Vocalocity, largely we compete with the installed base of the copper line. So our typical sale is somebody coming off of a traditional telephone system. So that’s the predominant market that we sell into. When we compete directly with an alternative hosted PBX provider, the people that we compete with are people that you would expect to see, our primary competitor is 8x8. So if we just picked one competitor statistically that we see more than anybody. We compete less with RingCentral and if we look at our ARPU versus RingCentral, as Marc had pointed out in a slide, there is a substantial gap in the marketplace. One of the advantages that we see as being part of the Vonage team is with their brand recognition in the SOHO market. We think it opens up avenues to a substantial part of the market we never could get to in the past.

Greg J. Burns – Sidoti & Co. LLC

Wain, do you want to take a minute. We were impressed when we did benchmarking versus some of your competitors at some of the dashboard tools to allow real-time status of usage for all extensions and while the competitors have some dashboards as well as some call monitoring ability, we were just impressed with the simplicity and the ease of use and we know that you get fairly frequent penetration of that use by your customers. Can you talk a little bit about maybe the philosophy and how you sell that versus an 8x8 and a RingCentral?

Wain Kellum

Yes, our product roadmap is driven by a pretty simple concept. We try to build tools that help our small businesses, sell harder and service better. So what we would like to think is every one of our customers if you call them and said why did you pick Vocalocity over the competitive alternative, they would way Vocalocity gave me tools that help me sell more revenue or service my customers better. And then as Marc said, that benefit turns into very specific features that we provide; call recording, analytics, are your best sales people the one that make the most phone calls, are they the ones that spent the most time on the phone, how does your best sales person’s call activity compare to your worst person’s call activity. It’s hundreds of features that combine. They give our customers a competitive advantage in their business.

Greg J. Burns – Sidoti & Co. LLC

Thank you very much.

Leslie Arena

Next question operator?

Operator

Our next question comes from George Sutton with Craig-Hallum.

George F. Sutton – Craig-Hallum Capital

Thank you very much. I am, this morning, a bit surprised at the valuation, I guess. I would be a big congratulator for Vonage. I think you got a superb transaction price, but I am scratching my head, as I think many are, relative to the valuation. I’m wondering if you could address what type of a process this sale went through and also could you address the patent side of the equation? Obviously, the competitors you named have a pretty large number of patents and I’m wondering how Vocalocity sits there? Thank you.

Marc Lefar

Yes. So, let me take the last point first, and I’ll let Wain comment on process and I’ll give from a Vonage perspective what we think is a – why I think it’s the fair value. First on the patent front, obviously, we have reported pretty aggressive patent activity on our own with patents that have been granted in the last year. We’ve already exceeded this year the granted patents that we had in all of last year combined and have tremendous intellectual property in the VoIP space in many different aspects of that. So relative to the patents that are held by some of Vocalocity’s competitors, this is actually one of the reasons why I think that Vocalocity and their owners should feel good about combining forces with Vonage because they get a little bit of shelter from the competitive environment over the next several years.

In terms of valuation, let Wain speak to the process, but it’s a competitive marketplace and based upon the overall size, the company has been growing extremely rapidly. But I think the practical reality is an IPO for a company of this size would be a bit of stretch and the company is just probably looking at 18 to 24 months before having the kind of scale to be able to do that and the marketplace moves very quickly and given the kind of penetration that we expect to see happen in the market over the next couple of years, our assessment is folks felt like it was the right time to be able to tie to a company that could get efficiencies and had some market power and if you recall, the transaction does include a significant stock component.

So for those investors that have been in Vocalocity, they have been there for a long time and have done very well on this investment. They have a chance to reap the gains. For those folks who want to continue to share on the upside, they have that opportunity as well. Wain, any perspective that you are interested in providing?

Wain Kellum

Yes. We have received ongoing interest in the company for a while. So, the Board decided to hire representation. We hired William Blair. We ran a competitive process. We got to a price point that we think is fair, otherwise the Board wouldn’t have approved it and the shareholders wouldn’t have accepted it. But given that we have several alternatives of deal structure, the component of the offer from Voange that included stock that we consider has material upside over the next coming periods as we integrate the companies and grow faster, was really the thing that threw our thoughts towards Vonage is by far is the best offer on the table.

George Sutton – Craig-Hallum Capital

Okay. I certainly appreciate the perspective and congrats to both.

Marc Lefar

Thank you very much.

Leslie Arena

Thank you. Next question operator.

Operator

Our next question comes from Matt Sherwood with Cooper Creek Partners.

Matt F. Sherwood – Cooper Creek Partners Management LLC

Hey, guys. Congrats on a great deal here. Just had a quick question, just trying to sort of understand the accretion commentary. If you look at $75 million of debt, the interest expense on that’s like $2.5 million and you’re talking about single to high single digit million synergies by 2015. So assuming some of those come in 2014, do you think, even in a breakeven business this thing would be accretive maybe earlier than 2015, so just curious how to look at that?

Marc Lefar

First, Matt, it’s Marc, thanks for the [indiscernible]. Dave speak to the specifics, but obviously, relative to guidance, things can always happen faster and I’ll let Dave talk about the basis upon which we’ve evaluated these numbers. But there is also a business that we want to expand and grow and as we over the next couple of weeks embark on our planning process and then after closing, build specific go-to-market plans that give customers and prospects tangible reasons why this combination is something that’s compelling with as much open market share growth as there is, we want to be able to invest what their company has built and potentially some of those synergies in that first year to be able to accelerate revenue growth and so relative to guidance, we try to do our best to deliver against all of our commitments to you.

We feel like this is a reasonable and you would have asked us for some timeframe, when will it be accretive, that’s the base level guidance and to be candid, until post closing and being able to put together real operating plans for 2014, it’d be premature this thing being sooner than that. Dave, you can talk about the basic mechanics for the 2013 number if that’s helpful.

Dave Pearson

Sure. I think Marc summarized and you cited the correct factors and the correct inputs. I’d say on the EPS one, there is that [indiscernible] if you are looking at it the right way, really does depend on market conditions and operating decisions as Marc cited.

Matt F. Sherwood – Cooper Creek Partners Management LLC

Great. Okay, then just a quick question here on the – you guys referenced 39% growth in the first half. Under Vonage’s umbrella, this is just as the law of large numbers as a growth rate, do you accelerate or do you think under Vonage’s umbrella there’s a potential for the growth rate to accelerate? Just without giving guidance, like how do you look at the 39% growth rate relative to the potential for future growth if things play out how you expect?

Wain Kellum

The market research we did as part of our diligence we conducted our own proprietary research among small medium business to understand the appeal that the Vonage brand brings as well as how well known the leading competitors happen to be and it was enormously clear to us that while there is this movement to adopt cloud-based hosted VoIP, because of the functionality that exists and also the extraordinary value, most small businesses, frankly, really have no idea, they basically come out, they’ll do searches, they don’t have a tip of tongue name that they are going to go look for and when they hear about or recommended by another business they are familiar with, they’ll do search and they’ll see who comes up and then they start to inquire.

So it’s really about a first to the customer and being able to provide that compelling story. So we think that the Vonage brand can add an awful lot of help. Until we really build out our 2014 integrated plan, I’m not really in a position to suggest a higher growth rate than what the current course and speed has been. Obviously higher numbers are easier to attain on smaller businesses, but we fully bought this company with the expectations of material growth over the next couple of years. It’s been part of our strategy all along. I’ve been talking about SOHO and SMB now for the last two years.

I think those who have been with us for a while know that when we had to make a change in some of our billing and platform approaches that delayed us a bit for our ability to enter the market and we decided that this was the right company at the right valuation to be able to move us into a market leading kind of position very quickly. So there is no change in our strategy. We’ve been excited about this marketplace for very long time and this gives us a chance to make up for lost time if you will or to jump in and be able accelerate it.

Once we get into the market doing business together and we actually can put the Vonage brand along with these platforms into the market, I will be able to give you a much better perspective on how fast we can grow.

Matt F. Sherwood – Cooper Creek Partners Management LLC

And just one final last one, if you sort of look at Vonage, it’s running at an $820 million run rate. This is $55 million. You are talking like $875 million of revenue and just – this can grow 40% just this alone. That’s another $22 million of revenue next year. You talked about a $100 million run rate by the Q4 from some of your internal initiatives. So even if the core business declines marginally like it’s been doing in terms of top line, I mean, this company seems like there’s a good path to being sort of a mid-single digit revenue grower. Is that – am I looking at this correctly?

Marc Lefar

I think the basic business logic that you walk through makes sense. I want to clarify that when we talked about our growth strategies, we had organic plans for small medium business that are part of those numbers, some things that have been shared, some things that have been – have not. This obviously provides some overlap with some of those activities. We are not changing guidance in this particular call. We’ll provide updates to guidance as appropriate at our traditional quarterly end conference calls, but your notion of does this provide an accelerant for revenues over the next couple of years and do you have more visibility to that than you probably would have before, absolutely. And in terms of the ranges of revenues, if you kind of do that math and take the 40% growth rate that Vocalocity is driven and layer that on top of our current business, yes, the mathematics holds up and we do think that can lead over the next couple of years to some consistent and meaningful improvements in our top line.

Matt F. Sherwood – Cooper Creek Partners Management LLC

Thanks.

Leslie Arena

Thank you, Matt.

Matt F. Sherwood – Cooper Creek Partners Management LLC

Okay.

Leslie Arena

Our next question operator.

Operator

(Operator Instructions) Our next question comes from James Breen with William Blair.

Jim D. Breen – William Blair & Co. LLC

You talked about sort of the sales channels now, will that change appreciably as you merge the two companies together? And then just in terms of the sales structure, will that change at all internally with the employees that you have? Will you be adding some or will there be some sharing across the platform?

Marc Lefar

We will letWain and I, Mutt and Jeff is a little bit, one of the things that was appealing to us was there is great overlap in the channel that currently exist. So inbound telesales basically stimulating lead generation from a range of sources whether it be referrals, online or direct, not direct mail, direct marketing efforts and bring those into inbound telesales capability, that’s one of our largest channels at Vonage and it’s a significant one for Vocalocity as well. So we don’t expect that to change, we expect that to be significant as well.

Vocalocity has had some successes in outbound telesales, perhaps more so than Vonage. So we think there might be some reapplication of what they’re doing well and we’ll be experimenting with that. And then referral marketing is one that we think is a very interesting opportunity as well. With over 2.3 million customers, a lot of our customers that are tech-savvy international companies, we know that we already have a lot of folks who have run small businesses using Vonage and those people know small businesses.

The relative scale of our existing customer base and brand and the ability to create referral programs that drive traffic to our new partners, we think is pretty exciting and could be a significant accelerant in channels. So customer referrals could be an even bigger one. And then digital, for this scale business, the small business folks really are looking and searching for information from a whole lot of different sources and digital marketing and all its forms, that skill set is critical and obviously you can scale that when you got that capability in the consumer environment as well. So we see a lot of opportunity there.

Wain is in a much better position to speak to the shift of our channels and some of other exciting developments they are seeing work for them that are probably less applicable in the consumer market. Do you want to talk a bit more about that, Wain?

Wain Kellum

I do, we’re proud of what we’ve built and Marc did a really good job walking through metrically that no company in our space has done a better job of balancing growth and profitability than Vocalocity. But there are three areas that we’re really stuck on. The company had not made progress on. And if you look at [indiscernible] 48% of their revenues are outside of the United States and Vocalocity had no traction there. If you look at where Vocalocity was in the SOHO space, although we have a fair amount of customers; thousands of extensions that are single line extensions, that market is really driven by our branding play as opposed to our traditional lead sources. Then when we looked at what RingCentral spent on branding, we were never gone to be able to move to that level of spend.

And so as we contemplate of what our strategic alternatives were and we looked at Vonage’s scale globally and we also looked at Vonage’s brand recognition in the space, it became fairly attractive that we would be able to do things from a distribution standpoint that we have are not. Lastly, Vocalocity really doesn’t have any strategic relationships like our competitors do. And now being part of a company that is by far the biggest VoIP provider in the world, it’s realistic to think that if we put resources around strategic relationships, we would start to see some material results. So we think that distribution strategies are going to widen up substantially as part of Vonage.

Jim D. Breen – William Blair & Co. LLC

And just on the cost structure, right now, you have the run rate of mid 50s in terms of revenue on Vocalocity. I was just wondering what some of the termination costs would be sort of as a percentage of that? And obviously given the traffic that Vonage pushes through, there’s going to be some synergies there, I was also wondering on the equipment side, is there any potential overlap in terms of just buying power for some of the equipment that you are selling at Vocalocity? Thanks.

Marc Lefar

Yes, let me take the first, take the crack at that. Let me answer the second question first. Really from an equipment standpoint, we don’t see any synergies. Our consumer oriented device is very different that the actual handset console or range of consoles that Vocalocity will put into small businesses. So we don’t expect any hardware savings there. On the network side, for competitive reasons, we are not going to give lots of detailed specifics, but suffice to say that our scale domestically is much larger and I share that our cost to telephony services termination is one-third of that of Vocalocity.

So certainly there is two third 70% savings that we think that we can implement, there is some modest investment to make that work, but that was one of the key things that became imminently clear when the diligence activity and the folks who are running networks got together. There are some other areas within network operations that we also think will be synergies and some duplications that can provide some cost improvement as well.

Jim D. Breen – William Blair & Co. LLC

Terrific. Thank you very much.

Leslie Arena

Next question operator?

Operator

Our next question comes from Dmitry Netis with William Blair.

Dmitry G. Netis – William Blair & Co. LLC

Hey, guys. Jim is my counterpart on the telecom services side, so excuse the back-to-back William Blair questions here. But anyway I want to extend congratulations on the transaction as well and thank you very much for providing so much transparency into the metrics to be able to track your progress. That’s pretty refreshing to see. So the two-part question here is I’d like to touch on the gross margins and given that the termination fees you’ve discussed are being so much lower, where the gross margins are today on Vocalocity side and where do you think you can get them given the synergies? And then the second question, maybe I’ll just throw that out there is on the – all the features that the platform has today. It sounds like your ARPU is pretty comparable or just slightly – a tad slightly lower than 8x8’s. 8x8 has got a pretty vast number of features built into their platform. So I just wanted to hear where Vocalocity is in terms of some of the UC features such as mobility, maybe call recording and presence and all the integration possibly with CRM systems, et cetera. If you can discuss where that is or what the roadmap of that is, that would be great. Thank you very much.

Marc Lefar

Dmitry, thanks for the questions. Dave, if you don’t mind, we’ll take them in a reverse order and Wain and I will hit the features and ARPU stuff and then I’ll turn it Dave to comment on gross margins to the extent that we can share that detail. Just to clarify, so there is no misunderstanding, 8x8’s ARPU is higher than Vocalocity nearing 2x, their acquisition cost is also roughly 2x what Vocalocity’s happens to be. So in terms of efficiency, it’s very, very comparable and we are pleased with the level of loyalty that the Vocalocity team has gotten, which says that people accept these products, they are using them and there is very low switching. In fact, for what churn is there, roughly 60% of all the churn that occurs are business failures if not going to a competitor. So we are very impressed with the platform and the use of the features that we are seeing.

Relative to the array of features, more features that nobody uses isn’t necessarily a great thing. It adds complexity and some times frustration for folks. So it’s less about the list and much more about those that are unique and easy to access and use. When we did our diligence and research with small businesses, you come down to about eight to 10 features that are used regularly and are extremely critical and your ability to access those, use them and modify them on a fly or on the fly is more important than the that comprehensive list and we have seen portions of the roadmap, so we believe that there is additional features that’s including some interesting things in mobility that the Vocalocity team is working on that will more than meet the needs that beat competitive offering for the segment that we’re targeting.

Lot of those key features that are basic, that everybody has to have and deliver well, are a lot of the flat rate calling for local long distance, extension dialing; so limited number extension dialing, outbound caller ID with a business name, access to your mobiles, the types of call forwarding with mobile. You can only make calls from your mobile phone number with your business number as your caller ID and eFax. Those are some of the key things and I’d invite you to compare kind of the ease-of-use of Vocalocity’s access to those services to competitors. I don’t think anybody does it better. Things that I think are really interesting to us around what makes it unique and Wain started to talk about it and maybe you should get into more detail with this group. We were really quite impressed with a lot of – really talked about in terms of how you can make businesses have more – have their sales people more successful. And some of the dashboard tools and call monitoring ability for small businesses and0 medium businesses to be able to really understand what their sales people are doing, understand how they are serving and caring for their customers, who is actually making all the calls, how much time they are spending with customers, the ability to actually whisper in on those calls as a secondary party or to be able to barge and break-in to provide additional assistance and put that in the hands of small and medium businesses. Not to say that any of those haven’t been in some flavor done elsewhere, but the quality and ease-of-use of those impressed us when we were doing our diligence. And Wain, if you want to spend a little more time talking about that feature set and then we’ll come back to the gross margin question.

Wain Kellum

Sure. Dmitry, good to talk to you. Since you followed 8x8 for so long, you know their product set fairly well and what I would suggest is that Vocalocity is very similar with really one primary difference. We just started the company much, much later than 8x8 have and so when we started, it was clear that cloud-based computing was going to become pervasive. So we could build a cloud-based architecture that gave us redundancy and resiliency of data centers in Northern Virginia [Indiscernible] customers would just automatically be separated to Portland or Atlanta or somewhere else and it’s the way you would build things from scratch and then the standards of usability of interface changed a lot. So we were able to build a system that even Bob at Bob’s Plumbing Company could build fairly sophisticated call recording rules on his own. So a wrapper that a small business centers can take full control of this strategic communication platform with an elegance and ease-of-use. And then as you would expect they also want full suite of integration. So at Vocalocity, you would see sales force integration and SugarCRM integration and Intuit QuickBooks integration for customers that use that, LinkedIn integration for recruiting customers that use LinkedIn as strategic tool. And so you would see a fair amount of parity just in an easy-to-use wrapper and I think that’s why even though we really launched our product in 2007, we’re growing much faster than 8x8 and even adding more customers on a gross basis, as Marc pointed out in his data that he shared.

Dave Pearson

And Dmitry, it’s Dave, on your last question regarding service margin or gross margin, I think the best way to answer that and I think the data points people would have familiarity with is 8x8. We estimate their service margin at about 85% and their PMOI margin at about 77%. In each case, there is about 10 percentage points of a difference between 8x8 and Vocalocity right now, with Vocalocity having a lower margin by about that amount. And we do believe, per Marc’s comment, that termination and other synergies that there is no reason for that gap to exist and in fact that Vonage has scale advantages that Marc referenced versus some others in the space.

Dmitry G. Netis – William Blair & Co. LLC

Guys, thank you very much for that insight. I really appreciate it. Maybe last question just to wrap things up here. As far as the, Wain has – it’s probably for Wain actually, as far as the lead aggregators you guys use and the lead conversion rates, how do they compare or just talk about basically what the plans are? Clearly, Vonage’s brand and direct sales efforts will generate a significant amount of leads, but on the current lead aggregator strategy, where you are in terms of that conversion rate and where do you think that’s going to wind up in the future? Thank you.

Wain Kellum

Yes, and so if you look at Vocalocity’s lead sources, lead aggregators represent a meaningful, about 20% some slow into our business as far as what we close, that’s a fairly finite number on their ability to get qualified leads so they can pass over and sell. And so, as Marc said that, the big opportunity here and [indiscernible] you know the huge part of the market that’s running on copper lines, and if you look at the number of small businesses that represent it’s millions and millions of small businesses and those millions of small businesses are not on Google searching for small business phone systems today. So, if you look at number of unique searches in a month of key words that we care about that we might sell a phone system to, in the U.S. that number is going to be less than a 100,000.

So representing a very small portion of the small businesses that could get a substantial benefit, sell harder and service better while cutting their phone bill in half, and so moving into areas like direct mail, and outbound and alternative distribution strategies to get to the part of the market that’s not online searching, are things that we’re probably more interested in, because all the lead aggregators are really a fixed inventory every month of what they can catch and provide on the Internet.

The other thing that happens is as you get bigger and get more brand and we’ve seen this to Vocalocity as we become a more substantial company with brand, we are able to do techniques that allow us to catch the lead before they get to a lead aggregator. And in that regard, as Marc shared the Vonage brand recognition, nobody has a better brand than Vonage in the space as far as being recognizable. So I would expect the lead aggregators as a percentage of our total bookings to accelerate their decline, because they’ve been declining for three or four years. I think it will accelerate the decline as a percentage of what we book every month.

Leslie Arena

Hey, operator. We have time for one more question.

Operator

(Operator Instructions)

Leslie Arena

Okay. If there are no more questions, thanks everyone for joining us today. Have a good afternoon.

Marc Lefar

Thank you, everyone.

Operator

Ladies and gentlemen, that conclude today’s presentation. You may now disconnect and have a wonderful day.

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