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Executives

Marc P. Lefar – Chief Executive Officer

Analysts

Michael Rollins – Citigroup

Vonage Holdings Corp. (VG) Citi Entertainment, Media and Telecommunications Conference Call January 4, 2012 1:34 PM ET

Michael Rollins – Citigroup

Good morning. For those joining us via webcast, I’m Mike Rollins, telecom analyst at Citi Investment Research & Analysis. Our next fireside chat switches gears into the arena of Converged Communications and Voice over IP. It’s my pleasure to introduce Vonage’s Chief Executive Officer, Marc Lefar. Marc, thanks again for joining us today. Marc will start off with the presentation and then we’ll go into some Q&A both from me, as well as from the audience. Turning over to Marc, thank you.

Marc P. Lefar

Great, thanks, Mike. I appreciate it. Good morning, everyone. The first slide is our Safe Harbor statement, which cautions investors regarding forward-looking statements I’ll be referring to today’s conversation.

Let me begin with a brief overview of our progress and strategy. In the past several years, we’ve transformed the company. Since 2007, we delivered more than $200 million improvement in EBITDA and improved virtually every aspect of our business. We effectively manage our cost structure, improve the efficiency of our business operations, and stabilized our customer base as we focus on penetrating international long distance calling segments with our Vonage World unlimited international calling plan.

We’ve completely rebuilt our balance sheet. For two refinancing in the past 13 months, we cut our level of debt by more than half and reduced interest rates from highs of 20% to less than 4%, saving $43 million in annual interest expense. Our financial results reflect all of these improvements. In February, we will report our third consecutive year of positive earnings, approximately doubling that income from the prior year. This is a noteworthy accomplishment as it wasn’t a long ago that many questioned our ability to ever generate profit.

Our strong cash flow, which is one of the most compelling aspects of our business model is expected to exceed a $105 million in 2011. This cash flow can be used to fund our core business, invest for growth both organically and through potential acquisitions or to potentially return value to shareholders more directly.

Although 2011 was a rollercoaster year for the markets and our stock price is not immune to market gyrations, we finish the year up 12%. As perspective, there is only three years ago today that we were trading at $0.66 and faced the very real prospect of delisting.

Despite our progress on many critical fronts, service revenue has been essentially flat. While we’ve largely offset the general market trends in declining domestic phone service, meaningful top line growth has not materialize as quickly as planned. This is the company’s number one priority in 2012.

And let me now address how we plan to achieve that objective. Our vision is to be a leading provider for communication services connecting people through broadband devices worldwide. Building on our solid financial foundation, we’re focused on growth in three primary areas that target substantial existing revenue streams.

The first area is to focus on solidifying our core business through continued penetration of international calling segments and we’ll supplement the strategy by meeting the needs of light use domestic home phone users with aggressively priced white label strategies.

The second is to meet the emerging needs of mobile device and other connective device users. And our third growth initiative is to pursue international expansion opportunities beyond our current markets in the U.S., Canada and the UK.

I’ll describe these opportunities in more detail and our go-to-market strategies for each of them. Let’s start with a size and profile of our core business. Our strategic focus on international segment has been successful. 50% of our customers are now on Vonage World and approximately 35% regularly make international long distance calls. While churn in our international calling base has increased modestly over the past several quarters, it remains well below that of our domestic base as a direct result of the strong value proposition to heavy users.

In support of the strategy, we prioritized our marketing and sales programs accordingly. In the past year and a half, we’ve opened three bilingual sales and service sites and we’ve improved our marketing with more relevant messages and more highly targeted vehicles. As a result our base of Hispanic callers has grown by more than 50% in the past year. And the market for new customers remains robust. 10% to 15% of all U.S. households are moderate to frequent international callers using a mix of both home and mobile phones.

The majority of these individuals in these households are paying 3 to 4 times the rate they could be getting from Vonage and other alternative providers. For many the issue is still one of convenience and simplicity in purchasing and use of the alternative services on their preferred device and the ability to move it back and forth seamlessly. We will focus on serving customer needs for both the home and mobile markets.

While our primary emphasis remains the international marketplace in the U.S. is still a solid opportunity in the domestic calling market. Despite the shift to wireless and a decline in usage, proprietary research indicates that there are over 20 million domestic calling households who would consider switching carriers. Many of these have said that they definitely plan to switch in the next year, that market relative to our size is still quite attractive.

In 2012, we expect sales from our expanded and direct channel will grow to more than 20% of growth line additions. This is up from 13% in 2011 and 8% in 2010. This has been driven by our new retail partnerships with Best Buy, Kmart and Sears where we doubled our presence to 6,000 locations along with the increased size of our localized street teams. We now have 60 street teams up from 6 in January 2011. These teams operate in 35 ethnic concentrated markets across 16 states, including California, Texas, Florida, and New York. Expanding our presence in these communities, these teams market and promote Vonage service at Hispanic and Asian-Indian events and community gathering places.

Looking outside of the U.S., we believe we can grow our market share in Canada, which has 13 million households and it’s a market dominated by regionally focused telcos with complicated calling offers and high priced services. We believe share gains will come from disruptive domestic pricing and by targeting ethnic subgroups such as the Southeast Asian community.

Let me now turn to the important opportunity we see in the shifts to mobile communications. In the coming weeks, we will take a major step forward when we unveil a new mobile app combining free on-net calling and messaging. This free on-net global service will also offer tightly integrated low cost international calling for those that do not yet have the application. This new app consolidates and builds upon the best features and learning from our existing services.

While a few over-the-top VoIP players have also made some moves in the mobile space during the past year, it’s our belief that the mobile user experience still has room for dramatic improvement.

I’d like to give you a look, first look at Vonage’s new app and share why we believe the new Vonage Mobile app provides the best combination of features, functionality, and ease-of-use for mobile voice and messaging and why we think our mobile experience is simply going to be better.

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Well, a couple of other over-the-top apps have delivered one or two communication features such as on-net calling, messaging or traditional international long distance calling. No one has successfully integrated all of these features into one easy-to-use application until now. Let me summarize the new Vonage Mobile features.

Vonage will be the first to use existing address book and mobile number to deliver an all-in-one app that provides not only on-net calling and messaging, but also traditional paid international calling to any another phone.

With an intuitive multi-person invite feature, customers can quickly build a large global free calling community without the need for unique user names. The mobile number is the social graph. Off-net calls to contacts who don’t have the app or are being called on a traditional home or business line can be made without ever having to leave any application, and this will be able to be done at some of the markets at most competitive rates, roughly 30% less than Skype’s pay-per-minute rates, and using in-app purchasing through iTunes and the Android markets, credits can be added to an account for off-net calls to over 200 countries simply, transparently, and instantly.

Finally, the new Apple work over Wi-Fi, 3G, and 4G exceptionally well in more than 90 countries worldwide. Looking a bit further into the year, we plan to launch a number of new services, including standalone mobile products for customers without smartphones, and a low-cost international roaming service, which allows customers to receive inbound calls on their usual mobile number while traveling out of their home country and avoiding international roaming fees.

And while we continue to view video as an occasional use feature with modest monetization potential, we are evaluating the possibility of adding this feature to our mobile app in the coming year.

Our final growth initiative is geographic expansion. The global consumer communications market outside North America is more than $300 billion and it’s growing at nearly 7% per year. This enormous market provides significant opportunities for us to expand our business geographically with disruptive pricing and services. We expect to expand our geographic footprint through partnerships, and are currently in active discussions on a range of concepts with multiple perspective partners.

These concepts range from virtual peering relationships where we exchange and terminate traffic with foreign carriers’ thereby jointly low rates and expanded international footprint between the partners. All the way to delivering full void communication services pleased to be marketed and distributed as a compliment to an existing foreign providers product suite. We expect to announce our first partnership agreement in the next couple of months.

Given our deepening conviction about the quality of the market opportunities I’ve described and as we begin to make progress penetrating new markets, we expect to increase our investment in these areas to drive top line growth. Our core business generate significant cash, we’ve planned to utilize a portion of this cash to fund these new opportunities through a measured success-based approach. We’ll provide additional information regarding our expectations for 2012 on our fourth quarter earnings in February.

And now, Mike, I’ll join you for any questions.

Question-and-Answer Session

Michael Rollins – Citigroup

Great, thanks. Thank you for the first look into the new mobile application, if you could tell us a little bit more about your experience so far in monetizing mobile, you’ve obviously being doing it now for this year may be year and a half, so talk to us about that experience and how this new application filled on the opportunities for you to monetize this platform?

Marc P. Lefar

Well, I’ve been talking about this [before].

Michael Rollins – Citigroup

At least project a little bit.

Marc P. Lefar

The folks sitting in the (Inaudible). Okay as we have talked about before Mike, our revenue is coming from non-core business are still on the $5 million to $10 million range so not huge. (Inaudible) is those are few downloader applications okay. Well, your finding is that those who download the applications will become active users. The issue becomes one of frequency of use, pricing structure, and since they’re getting penetration of those downloads.

The market has moved and the opportunity for peer-to-peer, free calling communities using the mobile social graph is one that we talked about, I too spoke with you about probably a year and half ago and that is moving very quickly. It’s our belief that based on some of the other models we’re seeing was a burn to our Facebook, voice calling that the mobile number is the social graph and if we’re able to provide a – individuals build very quickly, take free on-net community to folks that have interest.

We have seen through some of our testing and based on conversations with folks who are current existing customers, we believe we can pull through a tremendous amount of international long distance revenue off-net whether be to traditional home numbers, business numbers or to feature phones folks that do have the applications. So we think that these two things can work hand-in-hand.

1Michael Rollins – Citigroup

Voice over IP in a home broadband world where you guys have very thin applications relative to the loads of video and other things that customers do, how does you view the Voice over IP in a mobile world to deliver the quality? Is it still a fairly thin so as customers think about their data cap that this should not be an issue?

Marc P. Lefar

You got it exactly right. VoIP is very thin for lack of a technical term. You could be taking over 1,000 minutes a month over VoIP and still be using only a couple of megabytes of your transport most people packages are 20 or beyond. So it really becomes very small amount. The real trick we think is to build and [provide] full functionality of messaging and voice. So people use their mobiles to do. Keep people within the dialer, only the over the top dialer for all of the applications and then be able to monetize instantly and transparently all of those calls that cannot be completed on-net. We will do this in our technical development, some of this will be completed peer-to-peer depending up on the location and where we are doing it. We may do this through media relays and gateways where we can provide better quality.

So there is different formulas to how we provide that, but keep in mind, there is an awful lot of countries in the world, where intra-country, long distance calling is still extremely high priced. So this provides another opportunity for us both to create an on-net community but also to allow people where there is an upgrade Smartphone penetration at this point to start to take advantage of the international long distance market in countries that we normally wouldn’t even think about that will do.

Michael Rollins – Citigroup

So would you say that the opportunity internationally is even greater than domestically to monetize this platform?

Marc P. Lefar

It cuts both ways, I think over the long haul, absolutely. In the short-term penetration to Smartphones in the U.S. and people’s willingness to download applications similarity with the two predominant application stores, I think probably offsets some of that speed but in terms of the revenues and the premium pricing that customer incentive to make the switch there is absolutely enormous opportunity outside of the U.S.

Michael Rollins – Citigroup

So as you launch this product, can you give us some insight into how you are going to build awareness and knowledge for the customers to take the step of hitting the download button and installing it into their device?

Marc P. Lefar

So we will use a combination of traditional PR, non-paid media and media. We have firm relationships with all of the usual suspects, we will have beta trial where we will have, we expect several 1,000 people based on the up and running and using this in a closed environment before the actual launch date. And at that point in time as I pointed out I don’t think you’d see it on the slide. We’ve created a very interesting multi-invitation vehicle. So, you’ll be able to click by one or by many and do multiple SMS and/or e-mail invitations to all of your friends internationally or domestically to be able to create a viral push for that download.

So just based on the friends and family of Vonage, you can get a pretty significant number, you multiply that by the thousands of people through an address book. And then don’t forget to think about the long-term implications of what’s the value of those many hundreds of millions of mobile numbers that you now have in the database with access that are tied to personal characteristics of people.

So when you go three, four, five years out, we think okay, with the international revenue market that’s going to get compressed. You now have something that is a very large social network tied together globally by people’s mobile address books. And that’s an opportunity that we think we’ll pay dividend down the road.

Michael Rollins – Citigroup

What are the things that you have done with some of your other applications is tied to a social network. You know Facebook there is others out there like Linkedin, which that is a more professional network. What’s your interest or opportunity to try to leverage this platform in a social networking or professional networking contacts?

Marc P. Lefar

You know, it’s – I’ve taken a lot of grief for this one who is, I bet that the Facebook connect product is going to be a lot bigger that it was and it wasn’t I was wrong. The simple fact of matter is some of these social networks are people where there is a certain kind of distance that people want to keep from those individuals and their contacts, and Facebook friends are not the folks that folks want to call on a regular basis via voice. The beauty of IP communications is we can deliver voice messaging whatever service you want via an IP identity.

But I think the markets prove itself out and the reality is, it is the mobile phone number that the carriers initially own. That is the social graph certain people want to message and voice. We now at a point where we can borrow that number out of any IP network and connect people and set a completely different rate card, complete different experience, that’s much more tightly feature centric than what the carriers can provide.

So we believe that it’s the mobile number that will be first. We do believe, however, that once that moves forward there will be some, whether it be a LinkedIn or Facebook or these small communities where it’s the university, CellZapp directory on every college campus, where people want to be able to call people based upon their user or e-mail address on a college campus or within an enterprise where if you work for General Electric you want to be able use that ID as opposed to a phone number because those may not to be loaded directly into the address book. We do believe that federating those different user identities along with the phone number is absolutely a place whether there is expansion. But we do believe that the first and foremost we have to drive this mobile number as in social graph.

Michael Rollins – Citigroup

You mentioned also that if it is an investment needs to push forward into this platform and into this arena, it’s sounds incremental maybe to the investments of 2011, is this I know you want to probably wait guidance for the fourth quarter call. But can you just give us a sense, are we talking when you say investment, more OpEx or are we thinking more in terms of CapEx or are there implications for both as well just sort of conceptualizing about 2012?

Marc P. Lefar

Good question and yes, we’ll give little bit more specific guidance in February. But keep in mind our business is very low CapEx compared to facilities based carriers. We do not expect to significantly increase CapEx, many of the kinds of products and services we’re talking about, do not require significant capital and expenditures. Those that do basically are replacing expenditures made in prior year, so in terms of CapEx within the range where history has been is not outlandish. The approach we’re taking is one of success-based investing. We have told folks and we didn’t do as much of this year as we like. We want to grow top line revenues. We prove we can generate cash, stabilize their customer base, and we’ve offset some pretty strong headwinds in the core domestic marketplace. We think we can do better this year.

As we penetrate both our international markets with partners as we penetrate some of these new distribution opportunities, as we see some of our advertising particularly in light of new bundled price increases and some of the step that Cable and Telco guys are doing. We won’t hesitate to invest smartly experiment, succeed, and accelerate investments out of OpEx as the way to drive top line revenues. But you can expect for us and you know me for a while, these are all sales and marketing investments where we can test and learn, so we have the ability to ramp these based upon the revenues that we see coming through.

Michael Rollins – Citigroup

You also referenced that you expanded the distribution in indirect side and you expect to go from I think you said 13% in 2011 to 20% in 2012, does that mean also that [growth adds] with this expanded distribution should also significantly improve in 2012 and be an obvious help to the customer metrics becoming positive?

Marc P. Lefar

Certainly, we expect to improve the top line revenues and that’s why we’re focused on. If anybody want to translate gross line additions depending, think about mobile, how you account the GLA versus the revenue stream, a casual user or a prepaid user. So I don’t want to oversimplify it in terms of a gross line addition number, but top line revenue is what you’re going to measure us on. We do anticipate that growing, we’ll see that across multiple components, we would expect to see that across our core business, International segments as well as international geographic expansion as well as mobile, over the course of the year and into 2013 and beyond.

Michael Rollins – Citigroup

What’s the pricing environment like for the traditional services in with the expanded distribution at some of your competitors, whether it’s the magicJack in retail or the Skype online, are you seeing some pressure on the pricing for the traditional residential business?

Marc P. Lefar

Our core business, we saw that pressure a couple of years ago when we restructured and focused our business primarily on the International Calling segment. Our value for the Vonage World plan is still exceptional for those folks that make moderate to frequent international calls and there’s still a large marketplace to penetrate. The trick there is expanding it to mobile where a larger portion of the calls are now being made.

In the Domestic Only segment, we certainly see pressure there, we have for sometime. And while we’ve not seen anything frankly from Skype based upon magicJack’s recent announcement that appears that they’re doing pretty well at least in the first quarter. Our product testing would suggest that it’s nowhere close to same quality that we have, but for folks who are looking for a cheap alternative, but don’t care about 911 services, that are not as concerned about reliability, it’s certainly an alternative.

We’ve certainly heard more enquiries in our call centers about magicJack and we believe that there are opportunities for us, I mentioned White Label. There are a lot of distribution partners that would love the part of this very large safety security market. It doesn’t require thousands of minutes of domestic talk, and we think the opportunity to establish new price points with new distributors under their name using our network of quality is something that will help us come back from those low-end competitors.

Michael Rollins – Citigroup

The company as you showed on the charts earlier has had a very substantial turnaround in terms of you’re pushing the company into positive free cash flow generation. And one of the biggest questions is still what should Vonage do with that cash. How is the Board evaluating, how much debt to keep in the company, how much to leave on the side for opportunistic expansions of your business plan versus actually taking some cash later buying back stock or even paying dividends?

Marc P. Lefar

Well first keep in mind that it’s only been a few months so we’ve had the luxury of being in this position where there is some cash in the balance sheet that did need to be used to get ourselves out of exorbitant rates. So this is the last five or six month phenomenon. The Board looks at in a very much a balanced way and this is not about a hand ringing, gee, when are you going to finish your analysis. This is much more about – we have been very clear that our strategy and our conviction is that we can drive top line revenue growth and do that it in a profitable way going into existing markets.

We have a number of products. You have seen some of those here. I have talked about some of the international expansion. And we want to be able to take a balanced approach to how we invest. We also believe that there is opportunity, some that we have looked at, some that we continue to look at for smart acquisitions. These are those that would meet one of three criteria, either one they significantly advance our technology through intellectual property that will help us along our roadmap from mobile to international.

Second, that they have some very talented resources, the premium on exceptional software development particularly in Android and iOS, is that a premium and there are many venture funded companies out there that, the core concept isn’t there, but it got great talent. It can be an inexpensive way to acquire that kind of talent and bomb them to our business.

And third for those that actually have product concepts that could accelerate community or that have communities that we could monetize exceptionally fast because of our relationships those three areas would meet the criteria for us for potential acquisition. Of course it has to pass rigorous return on invested capital criteria we’re not out there just to buy communities for the sake of buying communities. And then we look at that along with returning value to shareholders much more directly through the potential of buyback and dividends.

But given the current state of things, I’d say nothing is off the table, and it’s a balanced approach. But for 2012, our goal is to make sure that we have adequate funding to be able to drive growth and then it’s not one or the other it’s possibly, we have possibility of doing multiple activities with that cash.

Michael Rollins – Citigroup

Okay, time for couple of questions from the audience if anyone has one. Just while the microphone is getting around. This year if I look at some of the shift in strategies within the sector companies that were focused historically more on the residential markets has bought or built their way to be more focused on the corporate market. Is that something that Vonage is also looking at and maybe as a tool to get very quick adoption of some of these value enhancing services for customers?

Marc P. Lefar

It’s a great question, Mike. While we have been very disciplined about our strategy for the last three years, fix the fundamentals, get ourselves to place, we’re generating free cash, get our balance sheet cleaned up, build the fundamental architecture, so we could expand into these new markets these new products. Our lifeblood has been a consumer marketplace and that’s a lot what our management team’s expertise comes from. However, as we’re seeing particularly in the mobile space and in some of the international long distance opportunities, whether it would be through partnership or either potentially getting indirectly, we get a lot of increase from small, medium businesses who want our services. And we do consider the potential to expand SOHO will certainly be an opportunity for us for growth in 2012.

Those distribution opportunities they purchase much like consumers, so it’s pretty easy to take those existing services and modify them. But as you get into more medium businesses, whether it would be through partnership, considered joint-ventures or acquisitions, it is something that we’re beginning to turn our attentions to and consider that for additional growth opportunity as well, but it’s a secondary priority to the strategies that I outlined today.

Unidentified Analyst

(Inaudible)

Marc P. Lefar

Okay, so for folks who couldn’t hear, I think, the question was fundamentally about the comparison of the mobile app to Skype, what are the big differences? So keep in mind, Skype requires, you’d have a Skype username that you know in order to have those contacts work. They do not have the ability to do off-net calling from within their existing applications using the phone number. You have to actually leave the application, go into dialer to be able to complete that. They also do not have to give you the ability to real-time add credits to that account.

So you have go through a web, and do web, it’s very much a PC-based environment user experience. Go there, go add credits, if you did make off-net calls from your PC, which is a small percentage of their folks, we think that are much higher in mobile. You have to go to that browsing experience, add credits, have your credit card hand if you don’t know you have that setup, allocate those credits and have that populate.

Even then when you want to make those calls all you can see your Skype friends, if you want to add a Skype friend that isn’t already part of your PC environment, you have to go into the directory and look that up or add them or know the user name and god forbid you actually make an off-net call and find that person in your address book, you’re back out to the application again.

So the user experience is fundamentally different across almost every facet with. We believe it’s really important to get adoption to keep people inside the application for both on-net and off-net calling. And that’s a fundamental change that we don’t see happening. Skype is heavily invested in the Skype user name. Could they try to find ways that are hybrid and bringing the phone number in and showing your combination list? Sure, but then you got two different entries for every single customer for Skype and the mobile number and we just don’t think that’s the way the world is going to work over the long-term for mobile voice and messaging.

In terms of network, Skype’s quality is solid. We think that ours is every bid is good, but be better in some places than ours the architecture is a little bit different. Keep in mind that their architecture for the PC is very different than it’s for mobile.

Their PC architecture uses every PC, it’s got Skype running on as of a note in the network. That doesn’t translate directly to mobiles late from the same challenge that we do in terms of making mobile work given the vagaries of 3 and 4G. But we think that relative to the smaller folks that are out there doing it, we and Skype are very comparable and head and shoulders above the rest.

Michael Rollins – Citigroup

That brings us to our time line, Marc. Thanks again for joining us today and sharing your new thoughts with us. Thank you.

Marc P. Lefar

Mike, thanks for having me, I appreciate it again.

Michael Rollins – Citigroup

Thanks.

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