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Executives

Barry Rowan – CFO

Leslie Arena – Vice President, Investor Relations

Analysts

Michael Rollins - Citi

Vonage Holdings Corp. (VG) Citi 8th Annual Small/Mid Cap Conference November 15, 2011 2:35 PM ET

Michael Rollins

Joining us from Vonage today we have its Chief Financial Officer Barry Rowan and Leslie Arena, Vice President of Investor Relation, and it would be a great opportunity to get an update on the Vonage story. They have been active participants of this conference for the last couple of years. So, I’ll turn to Barry for some opening presentation comments for about 15 to 20 minute and then we’ll go into a Q&A session afterwards. So, without further adieu I will turn it over to Barry.

Barry Rowan

Thanks Mike and thanks to each of you for coming here today. For those of you who are less familiar with the Vonage story let me begin with kind of an overview of who we are. We are a leading provider of high quality voice and messaging services that is delivered over broadband network. We have about 2.4 million customers and serve residential and small office/home office customers in US, Canada and in the UK. We recently expanded our product offering to target mobile and international callers from around the world.

Our service is delivered over a low cost high quality internet protocol based communications platform, it’s scalable and supports over six billion communications per year. One of our most valuable assets is it not only supports our current products and services but will enable us to deliver new and innovative products to our customers going forward.

About two and a half years we shifted our primary emphasis to the international long distance market with the launch of Vonage World. This unlimited flat rate calling plans to more than 60 countries bundled with unlimited domestic calling has contributed the higher average revenue per user and lower churn. Currently Vonage World subscribers represent 50% of our base and about 35% of our total customer base are international long distance callers today.

Over the past several months we significantly expanded our distribution channels and with the launch of two new mobile products Extensions and Time to Call, these steps have continued to transform our business beyond the traditional home phone business and we are really focused now on the mobile opportunity which is driving so much of consumer preference these days as you all know.

Vonage is a radically different company than it was three years ago. We delivered a $200 million improvement in adjusted EBITDA in just three years. We generated record high net income excluding adjustments of $47 million last year and these results have been from increased average revenue per user, we’ve significantly lowered expenses, we’ve improved our operational efficiency and as we’ll talk about we dramatically strengthened our balance sheet. Let me just spend a few minutes talking about each of these items in a little bit more detail.

We increased our average revenue per user 8% over the past two years and reduced our SG&A by lowering customer care cost per line 20% per year in each of the last two years. We also cut our international long distance rates by 25% during the last year and lowered the cost of our devices by a similar 25%.

We also strengthened our customer base by adding high quality lower churning international long distance callers as I mentioned. In July we completed our second refinancing in eight months leaving us with low leverage of 0.7 times and reducing our annual interest expense by $43 million to just $6 million annually. We now have a pristine balance sheet and have significantly enhanced our operating and financial flexibility through these changes.

Vonage has a very attractive business model enabled by the economics of our over the top service delivery. Average revenue per user is about $30 a month and our low cost determination results in direct margins of 68%for the company.

EBITDA margins have continued to grow approximately 20% up from 6% in 2008 reflecting continued improvements in our cost structure overall. One of the most exotic features of the Vonage business model is the high cash flow generation. We have CapEx of about $40 million or less than 5% of revenue and with that our spend levels are about one-third of the infrastructure based communications providers like telcos and cable companies as we write over the customer’s existing broadband connection.

In addition, our refinanced debt with interest rates of less than 4% results in very low interest cost as I mentioned, just $6 million per year and we have $885 million in NOL, so we don’t expect to be paying cash taxes for a long time.

The combination of these factors results in significant free cash flow generation. The $165 million in EBITDA we provided on our last quarter’s earnings call as guidance translates to over a $105 million or $0.47 per share and free cash flow for the year. You probably noticed that the stock has been trading at about 17% free cash flow yield.

Let me take a moment to discuss the balance sheet progress in a little bit more detail. Going back a little ways in the first quarter of 2010, we had $220 million of restructuring debt which carried interest rates as you can see here of 16% to 20% and contained very highly restrictive covenants. In December of last year, we announced a comprehensive refinancing replacing this debt with a $200 million pre-payable term loan with interest rates at LIBOR plus 800 and a 1¾ floor which translated into 9.75% interest.

While this was an enormous improvement we saw further opportunities to strengthen our balance sheet by refinancing through the commercial credit market. We now have a $93 million term loan with an interest rate of LIBOR plus 325 basis points and no floor. The annual interest expense is now projected as I mentioned to be $6 million at constant LIBOR rates. In addition, our restricted cash has been reduced to less than $7 million.

So in summary, we cut our term debt by more than half, lowered our interest rate by a factor of four and reduced restricted cash tenfold. We’re obviously very pleased with these results.

Building on the progress we’ve made in penetrating international long-distance market we’re now focused on the significant opportunities ahead of us. Our heritage is using technology to disrupt large existing revenue streams by providing high quality services at compelling prices. We are now extending this approach to new market opportunities. You can see that the markets we’re targeting represent over $200 billion in annual revenue. This modest penetration of these markets represent a substantial growth opportunity for a company our size.

Our growth strategy is built on three primary planks. First is that we continue to solidify our core business, second is to meet the emerging needs of mobile and other connected device users and thirdly, its geographic expansion beyond the US, Canada and the UK where we currently have operations.

We continue to focus on building our core Vonage world customer base. As part of that, we recently expanded our retail distribution channels announcing three new retail partners, including Best Buy, K-Mart and Sears. This doubled our retail presence to 6000 stores across the country. This expanded distribution is beginning to have an impact.

In-store merchandising and training continue throughout the quarter and we’re seeing solid growth in the stores that have fully executed our program. We’ve expanded our local event teams, which now operate in 16 states with high estimated concentrations including California, Texas, Florida and New York. As reflected in our expanded distribution network, third-party retail is becoming an increasingly important component of our customer acquisition strategy.

Including our event teams, retail is now driving 15% of gross line additions, and this is up from 8% at the beginning of the year and we expect that to increase to 20% in the coming quarters. Importantly, retail is also a highly efficient acquisition channel with direct subscriber line acquisition cost in the low $200 range.

Meeting the emerging needs of mobile and other connected device users is a second core plank of our growth strategy. Consumers globally are shifting the communications to mobile devices as you know and we’re meeting their needs through new product offerings aimed at this opportunity. The addition of our Extensions product to Vonage World meets the emerging needs of mobile users and provides value and convenience to international long-distance callers. 30% of users minutes have shifted to Extensions in the three months since this product was introduced.

We believe Extensions will also help the possibility of lowering churn in a high-value international long-distance customer segments as the value proposition is significantly enhanced to be able to make these calls on your mobile phone.

Time to Call was the second product we introduced and it supports our strategies for both mobile and international expansion. It’s been downloaded in 85 different countries and provides calling to 190 countries. Approximately 400,000 customers have either registered their mobile phone as an Extension out to their Vonage World plan or downloaded the Time to Call since the launch as I mentioned three months ago.

As we look ahead, we will continue to enhance our mobile offerings with standalone mobile products. We also plan to introduce a variety of calling plans targeted at specific entry callers. In 2012 we also plan to provide an integrated communications experience that will include free app to app calling and messaging along with traditional off-net international long distance calling.

The third plank of our growth strategy is geographic expansion. Global consumer communications outside of North America is over $300 billion and growing at nearly 7% per year. International expansion is likely to be achieved through partnerships and we are in discussion with several prospective partners. Let me give you a couple ideas or illustrations of the kind of opportunities we see here.

First is something you can call an International Friends and Family product. Through a relationship with partners who also provide consumer services, we could offer low price to international calling plans for people called on our partners’ network. Secondly, we could provide Voice over IP to other companies’ bundle of video and internet access in other parts of the world. We could also partner with local companies develop communications kiosk placed in high traffic locations for people to make inexpensive calls and developing markets. We hope to announce our first partnership agreement in the early part of next year as a working – splashing out some of these opportunities.

In summary, we have made significant progress over the past three years. Our cost structure is in order, our balance sheet is stronger than it’s ever been. We recently launched several exciting new products and doubled our retail distribution as we focused on the next phase of our strategy which is to grow our business.

So thanks very much for your interest in Vonage. I would be happy to answer any questions from you Mike or other people in the audience.

Question-and-Answer Session

Michael Rollins

Great, I will start off with a couple of questions. First you talked about the opportunity for international and geographic expansion. Can you give us a sense today of what percent of the growth line adds come from international today, which is I guess separate from Vonage World.

Barry Rowan

Yeah. It’s a pretty small percentage of lines that come from our current international operations. We have operations in Canada and UK as I mentioned, so it’s less than 10% of growth line additions. Canada has grown, we introduced Vonage World at the back end of last year and saw very good results in Canada with that product, and it has some of the same kind of characteristics that US calling does and that there are some concentrated ethnic segments. In Canada we’ve done very well as you know with Asian-Indian market for example. We saw similar really solid results in Canada there.

The UK business we’ve had for some time, it tends to be a much more mobile oriented market. But seeing the opportunity now to expand outside the US is based on part of success in Canada and also honestly Vonage has been in a turnaround. So we felt like we had to get our own house in order – before we could really step on the gas and expand more internationally.

So, now that we’ve done that we have as you know stable customer base that reduced churn substantially, we released substantial free cash flow from the company, as we talked about, over a $100 million this year, have a pristine balance sheet that we now view that solid foundation as a platform on which we can lever our expansion outside the US.

So, we will target the markets outside the US, some primary markets and then secondary markets have kind of characteristic that we think lend themselves to voice over IP.

Michael Rollins

One of the other segments that you’ve talked about, increased passing and a couple of other calls or conferences is the enterprise segment. Can you talk about what aspirations Vonage has for its enterprise segment and, you know, what your go-to-market strategy might look like for that?

Barry Rowan

Yeah. We have not up to now focused explicitly on the enterprise segment. We do have some enterprise customers who will put multiple hundreds of customers on. For example, if they are people who are working from home, calling agents for example, we are focusing on more adjacent market, the small office/home office as I mentioned. So you’ll see us do more in that space.

The enterprise segment is not something that we would shy away from, certainly permanently, particularly as it get into more mobile offerings and products that would significantly reduce roaming charges which of course many of you who travel internationally know what those are like and just how expensive those are. So I think as we get into more of those kinds of product you could see us have those aimed at enterprise, but for that again the time being our primary concentration has been on that consumer segment and adjacent more small office/home office kinds of segment.

Michael Rollins

Thank you very much. On the slide here that we have in front of us, you talk about the strength, the cash flow generation and things, can you maybe just talk a little bit about views on stock buyback, dividend, potential debt leverage and use of your cash organically versus shareholder when they are given back money, thank you.

Barry Rowan

Sure. Yeah, now the company is in a cash flow generating position. We had the opportunity to make those kinds of decisions and to think of those ways. If you just go back even a couple of quarters, the primary use of the cash was to retire debt and even though the interest rates had down at 9.75% we felt there were still good arbitrage on that and we prepaid substantial portion of our $200 million term loan.

So, now that that is behind us there are really two priorities for the free cash flow going forward. First is helping to drive growth, so we see ourselves driving that through internal development that focus on these kinds of segments that we talked about, the mobile and the international expansion, but that may or may not all be done organically. That there could be companies that we might want to acquire that would enable us to accelerate our position in those market place. Let me give you a couple of examples.

It could be a technology that would be make by a decision that might accelerate our position technically into one of these markets that we are talking about. It could be acquiring development capability and the engineers associated with that. We opened up an R&D center in Israel for example. Now, that was not done through an acquisition but we were able to bring on a lot of engineers from another company. (Inaudible) that was previously filled Telefonica. So it could be foreign technology, it could be acquiring developers, it could also be acquiring, for example, a company that has a large user base that we might be able to help monetize through international long distances, really the primary outlet for monetization of these kinds of services.

So, it could be acquisitions and again we just gotten into the position recently where we can have these kinds of conversations on a real basis.

The second one would be the consideration of the stock buyback, and that also is on the table. You saw us reduce our cash in the last quarter in July at the part of the refinancing. So we are now building up that cash but we certainly recognize the potential of returning value to shareholders through a buyback or even perhaps the dividend. So we actively consider those kinds of things with our board and certainly would prioritize the cash flow uses in those ways between growth and potential return of value to shareholders.

Michael Rollins

I just want to turn back to the mobile opportunity, 400,000 downloads in three months sounds pretty good. Can you walk through how the mobile app will work for a user? And then the second thing is if you were to look to say a year from now, maybe two years from now what you – how you see your revenue mix shift evolving from where it is currently to mobile international.

Barry Rowan

Sure. So let me first take the first question about how the apps work and how they will work going forward. There were two apps initially that were introduced. There is an extensions product, and the way that works is if you are an existing Vonage World customer or if you are a new Vonage World customer, you go to the website, you can register an Extensions product, virtually all the people register a mobile phone but it can be an office phone or another phone that you choose to call from.

And then if it’s the feature phone you hit basically a virtual calling card. So you enter the number that you are calling, a pin code, excuse me, dial an 800 number, the pin code and then the enter the number that you are calling or you can speed dial it and just press the number, just press the one number and accomplished that call which many people just call a few numbers, you know, they are calling their friends and family in India or Mexico or something like that.

If it’s a smart phone then you simply download the app on that and it’s a one touch dialing. So you go to your contact book and find that person, click on them and it will automatically reroute it over the bondage network, and clearly that’s the third route and the easier route from the customer standpoint.

So that’s the extensions product and the way that works, the time to call product is different that is you buy a call. So you’d buy a 15 minute call or you can call up to100 countries for $1.99 or less, and so you buy a 15 minute call and you can – and then you download the app you get one free call and then you can make calls that way.

As we go forward, as I mentioned where we see the opportunity is to offer an integrated calling capability where there would be on net calling so if you download an app on your phone and your friend downloads an app on their phone you can make those calls for free.

And honestly that’s not that hard to do, there are many companies doing that, startup companies doing that, the real trick is the interoperability between the internet and the public switch telephone network. So the other part of that would be not just calling on net but being able to call a traditional phone number. While there are more and more smart phones obviously in the world still a lion share of the phone are not smart phones or people lining to call traditional landline.

So we see the need to offer an integrated calling capability of on net and off net and you will see us also add other capabilities like messaging to that for example. So that’s where we see it going. As we show it in the slide you see it’s over a $200 billion market and I think the opportunity is for pricing to come down on that market certainly. And if I won’t some of the traditional telcos do that, some of them have the capability many do not, but there is a huge economic incentive for them not to, and that is by lowering the prices to match this next generation technology they are going to re-rate their whole base. So by doing that they are going to lower the prices for the entire base.

So they will in our view be contend to have, the multiple entrance continue to nibble around the edges if you will to a few billion dollars but for companies like us it’s significant, and we think that it’s not going to be a winner take all kind of a proposition, it will be companies like us who can offer the kinds of products that we are talking about and dramatically lower the rates of calling.

So just one more point on that if you get off the airplane at Heathrow you pay $1 a minute or more depending on where you are calling, there is no technical reason for that as long as they have Wi-Fi. So, for example, we are able to lower the cost of calling by 70% to 90%.

Unidentified Analyst

I just have a question about the brand. Obviously the company has been restructured, you have done a great job of lowering the cost capital, starting to contemplate giving some of the money back to shareholders, but I am just curios about how you brand Vonage in the market place today. It seems like it’s a new company with new opportunities, what are you using in traditional press, online, etc to get the message out.

Barry Rowan

Yeah, that’s a great question, let me answer that in two parts. First is that Vonage has a very strong brand. It has I think over 85% brand recognition in the US and there is lot of brand equity in Vonage. While the company went through some real difficulties financially the company did –and it even had some difficulties in customer quality in the early years that it was growing so fast, but there is tremendous brand equity and positive brand equity in the bondage name. We spend on the order of $200 million a year in marketing, so that’s significant layered in over time, and at one point it was over $300 million that clearly created a meaningful brand equity.

The way we go to market is a combination of factors and the fact that it’s shifting to match the strategic direction of the company. So it’s a combination of things. We do a general market television course, many of you have probably seen our ads on TV. But in the last couple of years, we have gotten increasingly sophisticated about the way we deploy the marketing powers and as many of you know, our CEO Marc Lefar was Chief Marketing Officer at Singular so that clearly is one of his real areas of competence.

The ways that we deploy that are general market. But we also for example, in 2010, targeted the Hispanic community. So we put in a full end-to-end Spanish language experience with Spanish language call centers in Costa Rica and Chile, Spanish language IVR, Spanish language website and we started advertising in Spanish. So we targeted the vertical market there. We also will match the marketing media with the way people choose to buy. For example, the Hispanic market tends to respond better to direct mail. So we will use direct mail for them. We also use of course banner advertising and internet-based advertising. But we’ve also now as I talked about are increasingly deploying more traditional kinds of retail channels in the Best Buys in the world, you saw the gross buying addition percentages growth of 8% in the beginning of this year to 15% in the third quarter, and also what we call street teams which is perhaps an unorthodox sort of a way but we’re setting up a table at a fair, a Hispanic fair, a Filipino fair for example, some of these ethic segments that we’re targeting and they’re on a full commission basis. We’ve seen some very good success with that. So it’s kind of guerilla marketing in the areas that are target rich opportunities.

Michael Rollins

When Vonage has talked about mobile on a couple of different occasions, we talk about the opportunity to eat into roaming, particularly international roaming. Is the bottleneck a combination of the bandwidth that customers have available relative to what it can compress the voice down to, or are there other bottlenecks for you coming up with a savvy product to save roaming dollars for people?

Barry Rowan

Yeah, I think the real challenge in roaming is not just the outbound calling but it’s the inbound calling. So how do you enable somebody to call you when you’re roaming and have it right at the phone. So, that is a non-trivial challenge technically and we have some very bright engineers who work on those kinds of things. So we see that as really the opportunity in roaming where you can have somebody who can then really replace their phone service and be able to be confident that they can not only make much less expensive outbound calls but then receive these calls on their phone and not pay the very sizable roaming charges.

So that’s directionally where we see the real market challenge and opportunity, so we think about it holistically in being able to offer an integrated mobile application that works in the U.S. or outside the U.S. We’ve certainly taken those steps with time to call – you know, you see that’s downloaded in 85 countries through the iTune store. So people are now able to access that product from virtually anywhere in the world and can make those kinds of call to anywhere in the world, as I mentioned 190 countries but that’s where we see the opportunity, to be able to call from anywhere to anywhere at the lowest prices available.

Michael Rollins

When you look through your customer data, if I remember it just represents the lot of tools, to look through spending patterns, churn patterns on an aging customer basis, what do you see in terms of – you talked about ARPU growth recently. So what do you see in terms of sustainability of ARPU performance just given that there’s competition for a variety of the different home replacement services as well as international services?

Barry Rowan

Yeah, if you’d asked me, and I’d been at Vonage, it will be two years in March, if you told me that we could actually increase ARPU I would have been surprised. I was within the cell phone business for a number of years and certainly the ARPU compression is just a characteristic of most of these kinds of markets. So the fact that we’ve been able to increase ARPU over the last two years by 8% is meaningful and I think that history has something to say about the future. The way we’ve been able to increase ARPU is we’ve been able to increase the prices for increased value in the product. So for example, we added unlimited 411 directory assistance calling and added a charge for that that was very value add to us as well.

But secondly is the mix, so as we sold more and more Vonage world customers at the highest priced plan you get this unlimited calling to U.S. and 60 countries. That has driven up the ARPU as well. Going forward, the ARPU will be comprised of some different mixes I think too Mike. But, even with Extensions, you see that we had very good success with Extensions. As I mentioned, it’s free to register one Extension, we had other people say, “Wow, I’d like to have a second Extension”. So we started offering that, some six weeks later you can buy a second extension for $4.99 a month. So that’s obviously a low ARPU product, it’s still a line but it adds to the stickiness of the customer base.

And as we introduce for example a stand-alone mobile product where you wouldn’t necessarily have to have a device in your home but you could just have a supplemental ILD calling service, that those ARPUs might be lower. So what we really look at are the margins overall and we’ve been very pleased to maintain a direct margin in the high 60s, a 68% kind of range. That’s by the way have been, there are two moving pieces in that, that are important to recognize.

One is that our international long distance minutes are going up very significantly with the number of international long distance users and of course it costs more to terminate a call generally outside the US than inside the US, although intra-state pricing is pretty high.

So we’ve been able to offset that increase in cost of international long distance cost of service by as I mentioned 25% reduction in international long distance rates in the last year. As we move forward it will be continuing to take the rates down for domestic charges as we move to more of a curing model. So, the way we look at that is holistically looking at ARPU we will see different kinds of plans that has lower ARPU but what we really manage obviously is the relationship between that ARPU and the cost of delivering the service.

Michael Rollins

So in our final minute, curious if you could – you know, you’ve been there now for some time at Vonage. You showed us the progress operationally in balance sheet. As you’ve been there and you’ve got to study the industry more, what would you say is the most differentiated parts of Vonage’s asset in technology base? What really sets the company’s platform apart from your competition and maybe where some of the industry is going over time?

Barry Rowan

Yeah. Well, when I came to Vonage, it – I had to look at it pretty carefully, honestly, and had a whole bunch of different things to look at. There were three reasons I came. One is the business model; I could see its ability to release significant cash flow. Second were the people from our board on down, a very top-flight group of people, very capable. And thirdly, was the opportunity to take the technology and aim it in some new directions that I thought were really going to be some rising tides that would lift all boats. There are some real fundamentals there.

So, I think that Vonage’s distinctive as I’ve come to immerse myself in it more is this. And that is if the inter operability between the internet and the public switch telephone network. It’s not easy to do both. There are people that can provide services on net and internet kinds of services, there are traditional telcos but where the magic happens, where the real value is, is in being able to do both. It’s being able to transport communications on the internet, take real advantage of the lower cost associated with that by riding over the top. Also, get the benefit of those lower cost at the wholesale level as we’re able to add much more flexibility in the way we manage routing traffic for example. So it’s that interoperability between the internet and seeing the ability to monetize these kinds of services that we’re talking about that I think is real sticky.

Michael Rollins

Well, thank you again for your continued support of the conference and for your thoughts today. Thanks very much.

Barry Rowan

Thanks, thanks very much for coming.

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