Vonage Holdings Corporation (NYSE:VG)
Q4 2010 Earnings Call
February 15, 2011 10:00 AM ET
Leslie Arena – VP, IR
Marc Lefar – CEO
Barry Rowan – EVP, CFO and Chief Administrative Officer
Michael Rollins – Citi Investment
William Vogel – Merlin Securities
Good day everyone and welcome to the Vonage Holdings Corporations fourth quarter 2010 earnings conference call. Just as a reminder, 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 Ms. Arena.
Thank you. Good morning and welcome to our fourth quarter and full year 2010 earnings conference call. Speaking on our call this morning will be Marc Lefar, Chief Executive Officer and Barry Rowan, CFO and Chief Administrative Officer. Mark will discuss the company’s progress and strategic direction and Barry will discuss our financial results.
Slides for that accompany Barry’s 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 depend on assumption for 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 highlighted on the second page of the slides and 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 to comparable GAAP measures is available on the Investor Relations website.
And now, I will turn the call over to Marc.
Thank you Leslie. I’d like to begin by commenting on the year and then I’ll discuss our strategic direction and outlook for 2011.
We’ve made strong progress over the past three years and 2010 was no exception as we generated record EBITDA and cash flow, achieved the best churn performance in five years and exited the year with a fresh balance sheet.
Record high EBITDA of $156 million was achieved by increasing average revenue per user and by driving operational improvements across virtually every aspect of our business. We aggressively managed SG&A, reducing expenses by double digit percentages for the second year in a row.
We increased telephony services revenue and built market share in international calling segments, a key strategic focus over the past year. Monthly service revenue per user grew by more than $1.00, driven by improvements in rate plan mix and selective pricing actions we implemented along with enhancements to our service, and we crossed a major milestone as we generated positive free cash flow for the first year in the company’s history.
Our increasing mix of loyal, long-distance customers, combined with the company wide focus on a frictionless end-to-end customer experience, reduced annual churn to 2.4%, the lowest level in five years. We improved our customer satisfaction ratings and believe we are now among the best in the industry, and we’ve made material improvements in call quality and reliability.
During 2010, we continued to execute against our strategy to penetrate international calling segments. We strengthened our customer base as we increased the number of subscribers on Vonage World to approximately 40% of our base.
As we reported in January, fourth quarter gross line additions increased sequentially to 167,000 and were up 8% from the first quarter of the year. We finished the fourth quarter with nearly 6,000 positive net lines. Based on this progress, we expect to achieve positive net lines for the full year in 2011.
In December, we announced the completion of a comprehensive refinancing. Through the series of transactions, we replaced nearly $200 million of high cost restructuring debt, which will reduce 2011 interest expense by $23 million, or nearly half of the 2010 level. The new debt is pre-payable at par, carries far less restrictive covenants, allows greater operating and financial flexibility and provides management with a broader range of alternatives to deliver value to shareholders. This is strong progress.
Based on the solid operational and financial foundation, we’re now poised to execute the next phase of our strategy; to drive profitable revenue growth. While we continue to attract domestic customers dissatisfied with the customer service and promotional gainsmanship of large service providers, we have focused our growth initiatives in three primary areas.
First, we’ll grow share in international long distance market for both home and mobile. Second, we will meet the emerging needs of mobile and other connected device user by delivering easy to use applications that provide significant cost savings in large existing markets. And third, we will pursue additional international expansion opportunities outside of the U.S.
Let me elaborate briefly on each of these opportunities. 18 months ago, we shifted our primary emphasis from mass domestic home phone market to the international long distance market. The international long distance market is large and growing, and allows us to leverage our low cost communications platform for the benefit of ethnic and small business customers that are being charged excessive prices by large carriers, or are forced to sacrifice convenience with card based or PC only services.
We’ve had very good success with Vonage World, which includes unlimited calling to 60 countries, bundled with unlimited domestic calling and visual voice mail for $25.99 per month. Nearly one million customers are now on this plan. International long distance callers now comprise more than 600,000 or 25% of our total customer base. These customers churn at far lower rate than domestic callers.
As I discussed during our last earnings call, we’ve recently implemented an end to end Spanish language experience for our customers. From our television commercials and direct mail, to online media and through our in language sales and service, we are focused on meeting the unique needs of our targeted segments of the international calling market. We’re very encouraged by the initial result.
The Hispanic population is one of the fastest growing ethnic segments in the U.S., now comprised of over 14 million households. According to a recent survey, 36% of Hispanics make international calls and spend an average of $46.00 per month.
During the fourth quarter, the first full quarter in which we served our target Hispanic customers with these comprehensive programs, one-third of our prospects chose to do business with us in Spanish. This positive trend has continued through January. We see significant additional opportunity to grow our share in the large Hispanic market and will leverage our learning from this segment as we target additional under-served ethnic segments.
Mobile represents the second important growth opportunity for us. The rapid global adoption of smart phones and tablets, notably those with WiFi and 4G, create significant opportunities for internet based communication services.
We introduced our first mobile offering, an outbound long distance calling application about a year ago, and Vonage Mobile for Facebook last August, enabling inbound and outbound calling over WiFi and 3G to Facebook friends.
With these applications, we validated that we can extend our core network capabilities onto new platforms and we’ve learned a great deal about the mobile applications market. In 2010, our next generation mobile and PC products, which include Vonage Mobile, Vonage Pro and our SoftPhone, generated nearly $10 million in revenue.
Our roadmap includes making international calling plans accessible to a broad range of mobile phones, not just Smart Phones. It also includes alternatives to expensive international roaming services, lower cost domestic and international text messaging services, an enhancement to digital community calling, including the use of the customer’s existing mobile address book.
While mobile is a key driver, we also believe that a fully integrated communications experience that works seamlessly across multiple connected devices, including PC’s, tablets, readers and large screens, will likely be desired by most customers in the future.
The third plank of our growth strategy is to grow our base of customers outside the United States. This strategy is based on the inherent benefits of internet based communications, which makes distance and location largely irrelevant.
We currently have operations in the UK and Canada, and launched Vonage World in Canada last September. While it is on a relatively small base, sales have tripled in Canada since the launch. We are encouraged by the potential.
In addition to growing our existing properties, we believe there are opportunities to expand into new geographies. We will leverage our large base of existing customers in the U.S. to reach their international friends and families. Beyond this, we plan to introduce international calling services for Smart Phone users living outside of the U.S., and we are evaluating several models to expand our core services, including partnerships and joint marketing agreements.
While we are working hard to execute on our growth initiatives, our strategy also includes structural initiatives, structural cost initiatives similar to those we successfully implemented during the past three years. The past year alone, we reduced SG&A by approximately 10%, improved customer care costs by20% per line and reduced international long distance termination rates by over 25%.
Looking forward, we will optimize our cost structure through further enhancements to our online sales and support capabilities and through investment in IT systems and business strategies to further reduce termination rates.
These structural cost reductions will fuel our increasing investment in new product development and we will be adding meaningful product development resources in 2011 in both the U.S. and our new development center in Israel.
Let me close by offering a final perspective on our progress and by thanking the people who have contributed so tirelessly to our success. We’ve come a long way in a short time. Our results are a testament to the loyalty of our customers, the value of our technology and the dedication of our employees.
When we began the journey to transform the company, our market capitalization was barely $100 million, putting us out of compliance with New York Stock Exchange listing requirements and at risk of being removed from the exchange.
Today, our market cap is more than $800 million. Our business is stable. Our cash flow is strong and we have a fresh balance sheet. Our senior leadership team has brought renewed focus and energy to our business and the entire company has rallied to support our objectives.
I’m proud of our progress and deeply grateful to our employees for the tremendous commitment. And now, I’ll pass the call to Barry.
Thanks Marc. I’m pleased to review our financial and operating results for the quarter and the year with you. 2010 was a year in which our turnaround efforts begun in 2008, culminated in strong, tangible evidence of Vonage’s operational and financial transformation.
We stabilized and strengthened our customer base, reducing monthly churn from 3.1% to 2.4% and grew the number of Vonage World customers to approximately 40% of total customer lines from 23% at the beginning of the year.
We generated $156 million in adjusted EBITDA, a $200 million turnaround from the $46 million loss in 2007. We focused on driving the cash flow potential of the business throughout the year, generating significant cash from operations and we negotiated the release of more than $40 million in cash held by vendors, based on the sustained improvement in our financial performance.
We put this cash to good use, as it has enabled us to execute our two-part strategy to recapitalize our balance sheet. First, we retired $41 million of debt at par. Then, in December, we announced a comprehensive refinancing, leaving us with low leverage, ample liquidity and a fresh balance sheet unencumbered by the high interest rates and restrictive covenants of the restructuring debt put in place in 2008 at the height of the credit crisis. These results provide a solid foundation to deliver on the important strategic objectives Marc has outlined.
Let’s walk through the details of this quarter’s financial performance, beginning on slide three. We had strong results across the board. We generated record high EBITDA of $41 million in the fourth quarter, just slightly above the $40 million range we guided to in January. This is a 20% increase from the year ago quarter and up 17% sequentially.
For the full year, we generated record EBITDA of $156 million, up 31% over the prior year and our third consecutive year of positive and increasing EBITDA. We achieved these results through 3% higher ARPU, improved churns, which saved 170,000 customers and a focus on operational improvements that reduced marketing and SG&A costs by $56 million or 11% from the prior year.
We also re-engineered our telephone adaptors, adding more than 20% out of the cost of our devices. We generated these strong results even as we absorbed a $30 million increase in the cost of telephony services from our targeted international long distance users, an increased investment in strategic growth initiatives, including our new development center in Israel.
Moving to slide four, in the fourth quarter, we reported net income of $15 million or $0.07 per share excluding adjustments, up from $5 million or $0.03 in the prior year’s quarter and an increase from $8 million or $0.04 sequentially. We’ve now achieved seven quarters in a row of positive net income excluding adjustments.
The increases in recent quarters have been driven in part by lower interest expense, as we retired $41 million of debt at par during the year.
Reflecting one time charges of $58 million related to the company’s refinancing, GAAP net loss for the quarter was $42 million or $0.19 per share. This is down from net income of $4 million or $0.02 per share in the year ago quarter and up from a net loss of $55 million or $0.26 from third quarter, which also included charges relating to the debt refinancing.
The $58 million charge we took in the fourth quarter was very close to the $60 million we estimated in December when we closed on the refinancing. All costs and fees associated with the debt refinancing have now been reflected in our financial statements, with some of these costs capitalized in the new loan.
With the third lien notes converted into shares and replacement of the first and second liens with our new term debt, we have eliminated the need to account for the embedded derivative features of our prior debt. This had created large swings in net income as our stock price changed, creating confusion for some investors regarding the company’s actual performance.
As a result of the refinancing, we expect higher net income in 2011 due to lower interest expense and cleaner reported net income without these ongoing adjustments.
As you’ll see on slide five, total revenue for the quarter increased sequentially to $218 million from $214 million in the third quarter of 2010, reflecting our progress penetrating the Hispanic market with our Vonage World product.
Total revenue declined from $224 million a year ago on fewer lines as the positive net lines reported in the fourth quarter did not fully offset the cumulative line losses for the first three quarters of the year. On an annual basis, total revenue declined to $885 million from $889 million in 2009, driven in part by a $9 million reduction in deferred revenues from the accounting for legacy activation fees.
This non-operating issue does not impact EBITDA, and these fees were largely phased out in mid-2009 to provide more straightforward pricing for our customers.
Quarterly telephony services revenue was $215 million, down 2% year over year and up 1% sequentially. Our success in further penetrating the international long distance market led to improvements in rate plan mix, which helped to drive service revenue to $873 million for the year.
We continue to strengthen the quality of our customer base with the acquisition of customers on Vonage World. Since Vonage World was launched 18 months ago, we’ve added nearly one million subscriber lines to this plan, and as I mentioned, Vonage World customers now comprise approximately 40% of our base.
These are attractive customers, as they typically have higher credit quality, resulting in lower bad debt, and nearly half of Vonage World customers are IRV callers, who churn at a substantially lower rate than domestic callers.
Aided by the mix of Vonage World subscribers, we’ve been able to increase average revenue per subscriber or ARPU, over the past three years. In the fourth quarter, telephone ARPU rose to $29.78, a 1% sequential increase due to lower promotions and improved rate plan mix.
On an annual basis, service ARPU increased to $30.06 and is up 8% since 2008 as we’ve attracted customers on higher rate plans and selectively increased prices as we enhance the value of our offering by adding feature such as unlimited 411 calling and Vonage Digital Voicemail.
Turning to slide six, as we announced in January, we added 167,000 gross lines in the fourth quarter, up 3% sequentially and up 8% from the 155,000 lines added during the first quarter of 2010. While our quarterly subscriber line acquisition cost was roughly flat sequentially, our marketing yield improved by 5% from the first half of the year as we made steady progress, increasing gross line additions during the course of the year through penetration of targeted international calling segments.
Monthly churn was 2.4% for both the quarter and the year. This is the lowest fourth quarter churn in four years. We continue to benefit from the impact of the better churn profile of Vonage World customers and implemented improvements in the overall customer experience from network operations and customer care. As a result, we’ve had three consecutive quarters of churn at 2.4% or better.
We believe we can hold these gains in churn. Going forward, we expect churn to be helped by an increase in our base of lower churning international callers. This benefit may be offset by the yet to be seen churn impact of our no contract offer, as well as varying churn profiles of newly targeted international calling segments. Taken together, these factors result in an expectation of stable churn during 2011 at approximately 2.4%.
These higher levels of gross line additions, combined with continuing low churn, resulted in nearly 6,000 net line additions in the fourth quarter. This was our first positive quarter of net line adds in more than two years.
With our expectations of continued success in penetrating targeted international calling segments with Vonage World, we anticipate higher gross line additions in 2011 than 2010 and our first year of positive net lines since 2008.
As we discussed, our strong EBITDA for the year resulted from a combination of increasing ARPU and a systematic focus on operational improvements, which has substantially improved our cost structure.
Please turn to slide seven. In the fourth quarter, cost of telephony services or COTS, declined to $58million sequentially to $60 million, as lower domestic usage and termination costs more than offset the increased international usage associated with the growth of subscribers on Vonage World. On a per line basis, the cost of telephony services declined to $8.06 from $8.36 sequentially, resulting in an increase in direct margins to 68%.
For the full year 2010, total cost of telephony services increased as expected to $244 million from $214 million in 2009 from the anticipated higher usage of our growing base of international long distance users.
We continue to focus on aggressively reducing international termination rates and lowered these rates by 25% during 2010. We also continued to implement structural cost improvements that will help to offset the rate of growth in COTS as we add to our base of international callers. Recent vendor consolidation of E911 services for example, will reduce COTS by several million annually beginning in 2011.
We expect total COTS to increase in 2011, with the increase in international callers on Vonage World, but we will also benefit from the lower churn profile of these users.
On to slide eight, our focus on driving efficiencies throughout our operations, resulted in further improvements in SG&A, which declined 7% to $59 million in the fourth quarter from $63 million in the year ago quarter and was flat sequentially.
For the year, SG&A of $239 million was down 10% from $265 million in 2009. Over the past three years, we have lowered SG&A by $83 million or 26% as we made operational improvements in virtually every area of the business.
A substantial portion of these savings has come through improvements in our customer care operations. Customer care costs per line has been reduced by more than 20% in each of the past two years. These gains have come through a disciplined focus on eliminating unnecessary calls into our care centers and reducing average handle time. These two factors improved by 19% and 16% respectively during the past year as we improved customer facing processes and increased online self-service.
We see further opportunities for gains including for example, improved call routing strategies and improved call handling efficiency. We continue to invest in IT infrastructure to assist our agents in their work and will drive more customer care to user friendly, online support over time.
Moving to slide nine, marketing expense was roughly flat sequentially at $50 million. However, we actively managed the components of our marketing to align it with our strategy of tailoring our spend across media and channels based on the buying preferences of our targeted customer segments.
For the year, marketing expense declined $30 million to $198 million, though over half of this reduction was reallocated to promotions, which are accounted for as an offset to revenue.
Now let’s move to a discussion of our CapEx, cash flow and balance sheet, headlined by our first full year of positive free cash flow and our comprehensive debt refinancing.
If you turn to slide 10, one of the hallmarks of the Vonage business model is relatively low CapEx of 5% of revenue, which compares very favorably to traditional telecom services providers. CapEx for 2010 totaled $40.4 million, in line with our guidance for CapEx to be in the low $40 million range.
We’re making these investments to support the development of new products and services, improve the customer experience and enable structural cost reductions in customer care and COTS. In 2011, we expect to invest $40 million to $45 million in CapEx, with the majority of these expenditures going toward these kinds of transformational investments.
A major financial highlight of 2010 was our substantial cash flow generation. Strong operating results combined with active cash and working capital management delivered free cash flow, defined as operating cash flow less CapEx, of $154 million for the year. Excluding $65 million in gains from working capital, free cash flow was $89 million for the year, with $19 million in cash generated from operations during the fourth quarter.
Our sustained financial performance also enabled us to negotiate the release of cash held on deposit with our vendors. We accessed $43 million in additional cash for these efforts, including $11 million just before the end of the fourth quarter.
We reduced the amount of cash held by vendors and in a concentration account required under our previous debt agreements by $73 million from its high in the first quarter, including the $43 million in cash held by vendors and $30 million from the elimination of the concentration account.
As of the end of December, just $8 million of our cash was restricted, and cash and cash equivalents included restricted cash was $87 million.
One final aspect of our cash flow worth reiterating is that we have approximately $885 million in net operating loss carry forwards that can be used to offset future income.
A combination of several important factors contribute to an attractive cash flow picture for Vonage as we look forward to 2011; an expectation of increasing adjusted EBITDA in 2011 over 2010, relatively low CapEx by telecom company standards, cash interest expense $23 million lower in 2011 than 2010 and substantial NOL’s that will shield our future income for a significant period of time.
Moving to slide 11, let me talk for a moment about our comprehensive debt refinancing completed in December. In connection with that refinancing, we entered into a $200 million five year term loan facility, which replaced the company’s restructuring debt carrying interest rates ranging from 16^ to 20%. The new lower cost facility bears interest at LIBOR plus 8%, with a LIBOR floor of 1.75, and is pre-payable at par, allowing us to retire debt with cash flow from operations at any time.
As a result of the refinancing, and the retirement of $41 million of the previous debt at par during the year, we will achieve substantial interest savings during 2011. Total interest expense is expected to be drop by nearly half from $49 million in 2010 to $26 million in 2011. With the cash portion of interest declining from $42 million to $23 million, assuming constant LIBOR rates.
Based on our anticipated continuing strong cash flow from operations, we expect to make an initial pre-payment on our debt by the end of the second quarter of this year. As part of the refinancing, the remaining third lien notes were converted into 8.3 million shares of the company’s common stock, resulting in 222 million shares outstanding at year end. Fully diluted shares are approximately 245 million, assuming the current stock price.
We exited this refinancing with a strong balance sheet. Total leverage is 1.4 times debt to EBITDA and with net debt of $140 million, or .9 times, we have ample liquidity of $79 million in unrestricted cash. Importantly, we also eliminated the highly restrictive covenants contained in the prior debt agreement and now have substantially more flexibility to deploy cash generated by the business.
Moving to slide 12, as we look forward to the coming year, let me reiterate our expectations for 2011; adjusted EBITDA higher than $156 million achieved in 2010, higher gross line additions in 2011 than in 2010 and positive net lines for the year, growth initiatives, meaningfully impacting revenue beginning in the second half of 2010, monthly churn of approximately 2.4% for the year, CapEx in the range of $40 million to $45 million.
In summary, we are very pleased with the progress we have made during this important year of our financial and operational turn around. With a clean balance sheet, our cost structure in order and a growing customer base, we have a solid platform on which to build for the future.
Thank you again for your interest in Vonage. And now, I will turn the call back over to Leslie to initiate the Q&A session.
Thank you Barry. Operator, please open the line for questions.
Thank you. (Operator Instructions). Our first question comes from Michael Rollins with Citi Investment. Please go ahead.
Michael Rollins – Citi Investment
Hi. Thanks for taking my questions. A couple of things I just wanted to ask about. The first was, if you look at the cash flow from operations for 2010 and you compare it to EBITDA less cash interest and cash CapEx, there’s a fairly substantial difference. I think I’m calculating for 2010 like $74 million versus $194 million of cash flow from operations, so it did suggest that there’s a very substantial working capital benefit, maybe some other benefits in 2010. How should we be thinking about that difference between the EBITDA less cash interest and taxes versus what cash flow from operations should look like for 2011 if we pick apart the guidance that you provided. And then the second question is I could, is a more fundamental question. If you could talk a little bit more maybe about Vonage World and the ILD base in terms of the percentage sales rates, whether its gross adds, whether its upgrades of existing customers, and where do you think you can – and 2011 in terms of the proportion to what I guess you would characterize as a higher value international customer. Thanks.
Yes, Mike, it’s Barry. Let me take your first question, and as you very accurately point out, we released substantial cash flow in 2010 from operations as well as working capital. About $65 million of the cash flow from operations was generated through working capital as we aggressively managed that during the year. Coming into the year, there were reasons to have working capital managed more conservatively. As we went through the year, we saw opportunities to release that.
As we look forward to 2011, we certainly want to be clear that we do not expect that kind of continuation of working capital benefit in 2011. I think the expectation I would set for you is that we would expect working capital to be basically neutral for 2011, but there are some quarterly variations of cash intensity. For example, the first quarter tends to be a little bit more cash intensive as bonuses are paid out then for example.
But on an annual basis, I think we would have an expectation that working capital should be basically neutral going forward. So if you take as a result the EBITDA expectations less the CapEx less the interest expense that we’ve guided to, no taxes obviously, that would get you to a free cash flow number for 2011 post debt service.
Hey Mike, it’s Marc. Let me take the second question on Vonage World. So for perspective, as a percentage of gross line additions, Vonage World represents about 80%, a little bit north of that of our total inflow of new customers.
Within that Vonage World number, roughly 50% or more are active users of international long distance. Difficult to forecast forward what that percentage use would be. We expect it to be roughly consistent. We are seeing that in our Hispanic ethnic marketing efforts. We’re actually pleasantly surprised by the number of domestic only customers we’re getting, which suggests that segment really has been under served.
So it’s difficult to be precise, but I think it’s reasonable to guestimate that it would be about half of the mix of those coming in would be on Vonage World rate plans and if we then account for the churn differentials between the higher churn rate of domestic only customers in our legacy base, offset by the lower ILD churn profile, we expect to finish 2011 somewhere north of 50% of our total customer base on Vonage World.
Michael Rollins – Citi Investment
And just two other quick things. First, I just want to correct myself. I think I was comparing the $74 million of EBITDA less interest to CapEx. I misspoke. I said it was versus the cash flow from operations of $194 million. It should be compared to the free cash flow that you guys reported on slide ten as $154 million, so I don’t want to confuse anyone by myself mixing up those numbers. And then Marc, just one other thing. Back to mobile and the application environment, can you talk a little bit more about your latest thoughts in monetizing further mobile and the apps and as you think about the levers for growing revenue better, particularly in the back half of 2011, how important is the contribution from the mobile and application side versus just all the blocking and tackling that you’re doing in terms of international long distance from the core of what you’re selling today?
Let me try to break that down for you. As we’ve talked in previous earnings calls and some of the conferences that we’ve been attending recently, we’ve talked about our focus being on going after existing large revenue markets; those that have what we consider to be outsized margins being charged largely by the incumbent carriers, wireless carriers where the technology fundamentally does not require the cost to deliver those services can be greatly reduced through the use of technology.
We think there is a lot of artificial barriers and the penetration of Smart Phones, open OS, WiFi access and 4G, and customer’s willingness to download applications, provides a lot of opportunity for disruptive kinds of products and services.
All of those need to be very easy to use from a consumer standpoint, but as we look out over the next few years, it is our very strong belief that the markets of international roaming, which is in the mid $30 billion range today, S&S, which is in the U.S. alone, $28 billion. We estimate it will be more than 2X that on a global basis, as well as just international long distance calls being made from mobile as enormous opportunities for pricing compression and where good margin can still be made by simply using software based solutions over broadband.
We have not specifically broken out the contribution of individual mobile applications, nor will we. It is our firm belief that the international long distance market, which is largely established and from some proprietary research, we feel tells us, that 57% of everybody that makes international long distance calls in the U.S., are exclusively using either their mobile carrier for that ILD and/or their wire line traditional service provider.
What that means is there is tremendous opportunity here that has not been touched by any form of VOI player or calling card user at all. You can also equate that to their pricing as anywhere from four to five times to popular destinations, what we might be able to provide. We’re already providing Vonage World, and we can certainly extend to a mobile environment.
Many of the social community applications, many of the discussion points around leveraging existing address book and how we bundle text messaging and international roaming, may well include ILD outbound types of calling services.
For competitive reasons, I’d prefer not to get into details on exactly how we will build each type of application, which element will be monetized, but rest assured, our technology teams approach is going after these large revenue streams where existing customer behavior already exists and it can be more easily ported into a mobile environment.
So we think that the monetization is really quite straightforward. It’s charge less for a high quality product that people are already buying today.
In terms of your last point around the blocking and tackling of ILD versus the mobile application specifically, it’s both. We’ve obviously been successful in driving the blocking and tackling in ILD. We think doing more of that into ethnic segments and to actually expanding that onto mobile phones for outbound, is probably the most straightforward of the applications and probably more predictable in terms of the rate of penetration, in terms of trends.
You can see value proposition, ease of use, penetration of different devices. That’s probably going to give you a little more visibility than perhaps cracking into some of the newer markets like international roaming and domestic and international text messaging.
Michael Rollins – Citi Investment
Thanks a lot.
Next question operator.
Our next question comes from William Vogel with Merlin Securities. Please go ahead.
William Vogel – Merlin Securities
Yes, thank you. I was wondering if you could elaborate a little bit on the run rate, the extent to which it’s been established for the 25% improvement in termination costs that you talked about. I know it’s an ongoing battle with the various correspondent entities around the world, but could you help us get a little sense of the extent to which that run rate has been established already an will just continue or just how it will relate from 2010 to 2011.
Let me take a first swing at that and I’ll turn it over to Barry to maybe talk about how we’re handling it going forward. Up until the last year, we had never really had a formalized supply chain organization. We established that just before Barry’s arrival and he’s helped to enhance the skills and effectiveness of that organization.
Now that we have a substantial level of minutes that are available, we can retire those across multiple carriers. We have a pretty robust process, a request for proposal process where we’ll literally put our minutes out to bid with certain levels of SLA’s across different major countries, so a significant portion of our total international long distance termination is constantly being refreshed and rebid.
So the 25% we think is quite stable, and I’ll call that in the bank, notwithstanding the fact that certain regulatory environments and regulators have the ability to at various points in time take unilateral price increases that could affect any U.S. based carrier. We do have an established process. We constantly take all of our minutes, put them out for bid, and ensure we’re getting best competitive rates, and as our volume increases, as you would expect, we get better economies of scale, and it’s our belief that we have pricing that is unsurpassed relative to other providers of international services.
We also believe that in some of our core countries like India, we are probably among if not the market leader, among the top handful of folks that are actually bringing minutes to those terminating providers.
We have not provided specific forecasts forward for how much additional reduction in cost rates we expect to get, but as I mentioned in my opening comments, we are pursuing more structural kinds of programs that would allow us to take advantage of the minutes that are terminating on our network, the ability to wholesale minutes and the ability to actually move minutes on network by providing points of presence or even consumer level adaptors where high traffic connections go peer to peer.
So we do have a number of tactics in mind to continue driving costs down. Barry, do you want to add anything else to that?
Yeah, I think you’ve covered it well. I’ll just add a couple of quick points. I think really it’s been a two-step strategy in driving the costs down as Marc pointed out. The first one is to really be aggressive on negotiating rates and our volumes have clearly enabled us to do that very well, and you’ve seen a lot of the benefit of that.
The second piece is really looking at structural cost reductions as Marc described. So it’s not just pushing hard on carriers, but it’s really looking at where we might make investments in IT infrastructure for example, that gives us more sophisticated capability.
We certainly have traffic going back and forth between a number of carriers so as we look at that traffic and can take more sophisticated looks at that, it will enable us to really look at where the natural owners of telephone numbers are for example, and see how we might be able to benefit from that as we continue to invest in those IT systems.
And we also are looking across the board not just international. As I mentioned in my part of the discussion, we have consolidated E911 vendors for example, so we are looking at cross the board ways to be able to drive the cost down and certainly have been successful with that internationally as well as domestically based on the increased volume that we’re carrying.
William Vogel – Merlin Securities
Great, Barry and Marc, superb job in executing and superb job in really getting that competitive advantage that you have on an increasing basis out to folks who just really I think are now resonating with your marketing offer, so job well done.
Thank you, William.
Next question operator.
Our next question comes from Mike Latimore. Please go ahead with your question.
Great, thanks. Good morning. Just on the cost of telephony services one more time, Barry did you say that the biggest impact sequentially in the quarter was on the domestic side, and so if that’s right, basically do we think about international telephony service per line kind of stable with domestic coming down. Is that what happened? Is that the trend that might continue?
That was what happened in the fourth quarter. We got some benefits on the domestic side, and I think it’s important Mike to break out usage and rate as you think about both international and domestic.
So clearly we expect usage to go up for the international callers as we add more people on Vonage World and as part of what makes them so sticky and leads to lower churn with people who are using the phone internationally is that they do use a lot. They churn lower, so we expect usage to go up.
We are continuing to work at driving ILD rates down on a per minute basis. Domestic usage across the country really has been declining over the last number of years, so we do see some benefits from that. We continue to work as I said on the domestic cost side of the house and have made progress there.
So I think looking forward to 2011, the reason obviously that we guided for increased costs overall is that we expect it to be driven by higher international usage, but then offset by the work we will continue to do to bring rates down both internationally and domestically.
And then at least in the near term, is the focus going to continue to be on Hispanic and Indian communities or are there other ethnic groups you would target in the first half of the year?
Both the Asian Indian and Hispanic communities are our top two ethic segments. Hispanic actually has just recently caught up to Asian Indian and will likely surpass in the first half of the year. I expect for the foreseeable future, those will be the two largest segments; the Hispanic market just because it has been so underserved and is so large in the absolute.
There are other additional ethnic segments that we are pursuing. We’ll be launching a couple of standalone rate plans for ethnic markets. I’ve talked in previous calls that one of the markets we think, although it’s somewhat small, actually does represent one of the top five outbound calling destinations from the U.S., and that’s the Philippines and you’ll expect to see something on that from us in the near future.
Great. And then in terms of the guidance for interest expense for the year, does that assume this pre-payment as an aid in the end of the second quarter?
That guidance that we gave you is based on the existing debt that’s outstanding Mike, so again, I don’t want to overset expectations there, but if you just take the current debt levels at LIBOR. And I’ll just add one clarification too. We said assuming constant LIBOR. There is a 1.75 floor on the $200 million debt facility, so clearly with LIBOR rates where they are, it would have to go up substantially in order for us to increase the actual interest rate on that debt. So it was important for me to clarify that as well.
And just one last question. You mentioned some investments in product development. I guess can you help quantify that and also maybe clarify whether that would show up in OpEx or CapEx?
So the primary investment really is in people. You’re talking largely about software development. Any additional CapEx that we would incur is included in the $40 million to $45 million guidance we’ve already provided. We’re not providing specifics on how many people we’ll staff except that we fully expect to be able to exceed last year’s EBITDA and absorb the current year expense of those additional engineers that we’ll be adding both in the U.S. and in Israel.
Next question operator.
Our next question comes from Uri Miller. Please go ahead with your question.
Good morning. One of my questions was already answered, but my second question one, is there a leverage target that the company wishes to achieve or do you think you’ll just continue to pay down the entire $200 million of debt over the course of the next few years with cash flow from operations?
We have not established formally a target that we have stated publicly. Clearly having this refinancing behind us now gives us more flexibility to think about the balance sheet in successive improvement areas. Let me tell you how we think about that.
The way we think about it is clearly at 9.75% interest now, there is a reasonably substantial arbitrage benefit from being able to pre-pay debt as we get comfortable with cash flows and also having enough for operating cash as well as cash on hand where we could do acquisitions and that kind of thing for example.
So the first piece would be to pay down debt at an appropriate level based on our expectations of cash needs. As we go forward and kind of taking a page out of my previous life, as a company, assuming sustained financial performance, which we have certainly guided to, that we would expect to be able to borrow at lower rates over time.
So the way we would see that playing out would be to be able to take advantage of that over time and we would look at the interest rates and terms structures we’re able to achieve and have that help drive the overall capital structure.
I think if you look out for the next year, we would expect to continue to have the debt in place. We can repay it as we pointed out, expect to make an initial prepayment by the end of the second quarter of this year, but then we’ll actively look at what kind of financing we should put in place and at what level we should have that financing in place.
The other thing to think about is the difference between actual debt and debt capacity, so I think clearly at our leverage ratio where it is, we have substantially more debt capacity that we could take on if we thought that was necessary. So again, we don’t have plans to do that, but I think it’s an important piece of the whole picture as we think about it going forward.
Next question operator.
Our next question comes from William Vogel. Please state your question.
William Vogel – Merlin Securities
Hi. Just very quickly, have you seen any material competitive response from major incumbents during the course of the last 18 months since you folks have launched. In particular, has there been any sort of counter measures in the Hispanic market, any win back programs of any materiality that you’ve been able to observe?
Barry Rowan Well Bill, we live in a competitive environment. We clearly see promotional domestic pricing from the bundles. That’s been something that we’ve seen for the last few years. We’ve not seen that accelerate or decelerate in any significant or material way from what the trends have been the last couple of years.
On the international front, clearly you’ve seen a couple of folks like Metro PCS offer some alternatives for international long distance calling on the mobile phones. We don’t see and have not seen any material impact of that on our business. Again, it’s a very large market and our market share is still relatively small, so we wouldn’t expect to see it.
I would say that many of those require you to make some hard choices like only having a single carrier as your provider. It doesn’t include all locations within a country when you’re calling to it, and it’s difficult to use in terms of knowing exactly what rates you get. You don’t have a flat rate to every place in all places in those countries.
I would anticipate that we’ll continue to see some price sensitivity particularly among the smaller players where there’s not a pent up revenue and margin base. We saw some pricing from some calling card folks. We launched the Asian Indian market. People tried to match offers with smaller range of countries for promotional periods of time, but not of that really had a large material impact.
For the large carriers, the folks who have the dominant share of the international long distance market, we have not seen significant moves. Occasionally you will see promotional products or bolt on enhanced service offerings, which will buy down the rates, but they’re still largely uncompetitive with what we and some of the IP providers would offer.
One of the reasons I think for that, and I’m speculating, but having been there in my previous life if believe it to be true, is the re-rate cost. There are such large revenue streams and such extraordinary margin sitting on the books that the traditional Telco’s, it becomes very difficult or risky to take material price declines that would require 50% to 60% reductions to even begin to be competitive because of the kind of cash that it would drain from the operations.
So we think it’s going to be – never say never – but quite a while before we see any dramatic response on the ILD front.
William Vogel – Merlin Securities
OK.. Thank you so much.
Thank you operator. We’d like to conclude the call.
OK, ladies and gentlemen thank you for your participation in today’s conference. This does conclude the conference. You may now disconnect. Good day.
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