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Barry Rowan – CFO

Vonage Holdings Corporation (VG) Deutsche Bank 20th Annual Media & Telecom Conference February 28, 2012 3:00 PM ET

Unidentified Analyst

Good afternoon everyone. I know it’s kind of late in the day. With us today we’ve got Barry Rowan, the CFO of Vonage and he’ll kick-off the presentation with a brief slide show over the company in a video and then we’ll get into Q&A.

With that I’ll give you Barry.

Barry Rowan

Thank you, Prem (ph) and thanks to all of you for joining us today. Let me remind you of the Safe Harbor statement which cautions investors regarding forward-looking statements that I’ll be referring today in today’s presentation. For those of you in the room who are not familiar with Vonage, let me take a moment to just provide an overview of the company for you and who we are.

We are a leading provider of high-quality voice and messaging services delivered over broadband network. We have 2.4 million customers and serve residential and small and home office customers in the U.S., Canada and the U.K currently. We’ve expanded our product offering to target mobile and international callers around the world. Over the last few years, we hope you’ll see, we’ve completely transformed our business, operationally, financially and strategically.

And let me touch briefly on each of these areas of progress. Operationally, we’ve upgraded systems, streamlined processes, improved the customer experience and stabilized the customer base. We’ve increased average revenue per user as we added more value to our offer and drove structural cost reductions throughout the company. These actions enabled us to absorb the cost of dramatic growth in international long distance minutes, while improving our direct margins to 58% in 2011.

Let me take a minute discussing the operational improvements in a little bit more detail with you. Over the past three years, we increased service revenue per user by 9% cumulatively. We lowered our international and domestic termination rates by more than 25%, cut the cost of our devices by more than a, excuse me, nearly a third and reduced customer care cost for 2011 by 29% notably while improving customer satisfaction ratings. The decline in customer care cost combined with the other operational improvements helped to drive the reduction in SG&A of $87 million, that’s a decline of 27% since 2007.

We’ve also strengthened our customer base by adding high quality, lower churning international long distance callers. By lower insurance which had reached the high of 3.4% it reduced customer losses from 155,000 in 2009 to 30,000 in each of the past two years. These operational improvements have provided a foundation for us to achieve significant financial results as you can see here. We’ve reduced our cost structure to the lowest level in six years and we’ve grown EBITDA and net income and free cash flow each by about $200 million since 2007.

It wasn’t that long ago that our business was unprofitable and burning significant amounts of cash. Building on our sustained financial performance we completed two comprehensive refinancing in a span of eight months lowering interest rates from a high of 20% to less than 4%. And we cut our overall debt by two-thirds saving $43 million in annual interest expense.

In the fourth quarter reflecting our strong profitability and expectations for continuing future income, we determine it with appropriate account to our $800 million in net operating losses as the deferred tax asset. Equally important to this financial progress we’ve made meaningful strategic shift in our business. In 2009 we identified an opportunity to leverage our technology to deliver compelling value to international long distance calls and if it is Vonage World, our unlimited calling plan to more than 60 countries.

Vonage World has since grown into a flagship product representing more than 70% of new customer additions. About half of our customers are now on the Vonage World plan and 35% of our entire customer base are international long distance callers. And just this month, we launched the new Vonage Mobile platform, which leverages our success in international long distance and it became the foundation for building the mobile services business going forward.

While we have largely offset general market trends and declining home phone service, meaningful revenue growth has not materialized as quickly as we planned frankly. The quality growth is our top priority in 2012.

I would like to share a comment with you for executing on that priority. With the company now on a solid foundation operationally and financially, the time is right to accelerate the level of investment and our strategic growth initiatives as you’ll see.

In 2012, we will invest in two areas that form the foundation of our growth strategy. First is international long distance where we will continue to penetrate ethnic calling segments and grow subscribers through our retail channels including Advanti (ph).

The second is mobile services, which builds on a Vonage Mobile platform we just introduced and I will describe more in a minute. And the third is international expansion, as we plan to enter a new geographic market outside of North America and the UK

As you can see on the right side of slide, these are very large market. Consistent with our heritage, we’ll deploy disruptive technology and pricing to capitalize on these large existing revenue streams where we can make a difference.

Modest penetration of these markets represents a substantial growth opportunity for a company of our size. As our business and the industry has evolved, our conviction and the opportunities available within these markets has really only deepened. Fundamental market trends have moved in our favor including things that you’re all familiar with like availability of broadband networks and Wi-Fi, accelerating smartphone penetration, demand for mobility, and the emergence of downloadable apps. We believe now it’s the time to more fully fund these initiative and we plan to increase our investment above the level of spending in 2011 by $5 million to $10 million per quarter. This spending will increase our organizational capacity to develop products, enhance our network, and market our services.

We expect the spending to be primarily for mobile services and international expansion with some incremental investment to increase our international long distance penetration. Of course, we have tightly managed this increased spending with the same financial discipline that has characterized our turnaround. A portion of the spending will be success based allowing us to direct those or investment levels of targeted results are not achieved. We believe this growth initiatives have the potential to achieve over $100 million in annualized revenue within two to three years.

Let me now take a minute to discuss the recently launched mobile product platform with you in a little bit more detail. We think Vonage Mobile is the most exciting product we’ve offered since the launch of our initial voice service. It builds on our success in the international long distance calling market and leverages the capabilities of our scalable voice platform.

If you haven’t yet downloaded the app, let me encourage you to do that. I will describe it here pretty briefly and then we will conclude with a brief video as Prem (ph) mentioned that will give you a little bit more information about its features.

Vonage Mobile is a free downloadable application for both iPhone and Android that lets users make free high definition calls and send free text to all the users of the app anywhere in the world. They worked over Wi-Fi, 3G and 4G wireless data network. People who don’t have the app, users get very low cost calling with pay per minute rates 70% less than the mobile carriers and 30% less than Skype.

Vonage Mobile consolidates the best features of our prior applications while adding important functionality, better value, and improved ease of use all while using the existing mobile number and address that would exist on your phone. Early response has been extremely positive. We reported on our earnings call that we had substantially exceeded our expectations of 100,000 downloads in the first week. While our original goal to reach 500,000 downloads by the end of this quarter it’s not inconceivable that we will double that goal and achieve a million downloads by the end of the quarter.

The majority of user reviews have been favorable and we plan to release improvements and new features every few weeks with expectations with Bluetooth, MMS and roaming services delivered in the coming quarters.

Now let me show you this video, highlighting some of the features new mobile product.

(Video Presentation)

Hopefully get a little grip. This is why we’re excited about this new app and really very pleased with the market success that it enjoyed in the first several weeks into its launch.

Before we move into the Q&A for those of you again who are less familiar with the story let me try to summarize the Vonage story for you. We have achieved a comprehensive operational and financial turnaround over the past several years. Our cost structure is in order and we now have a pristine balance sheet after the two re-financings I described.

Our core business generates significant cash. We are trying to utilize a prudent portion of that cash to fund new opportunities through a measured success based approach. So, we are excited about the opportunities ahead of it and thank you very much for your interest in Vonage.

Question-and-Answer Session

Unidentified Analyst

Thanks, Barry. I’m going to start with the questions. That the mobile app looks very impressive given you’ve made a substantial amount of progress over the course of the year and you’ve actually turned the business around completely from a capital structure perspective, how does this position you going forward?

Barry Rowan

Yes, I think primarily we are very pleased with progress we have made obviously on the three fronts that I mentioned you, operationally, financially, strategically. You will see some of the results there I think the numbers probably speak for themselves. We have now stable customer base, it’s not growing which remains our current challenge of course but it’s stabilized reducing the net line losses to about 1% of the total base per year. Financially, you see substantial cash flow so that gives us the foundation from which we can really focus on these new opportunities and had we not been able to clean up the balance sheet and paying 20% interest rate and so on we are just not in a position to be able to grow.

So, I think it provides us foundation of stable customer base, strong cash flow, clean balance sheet, and additionally I think on the strategic side we are able to leverage the per strategic shift that we made with the introduction of Vonage World in 2009, where we focused on not just domestic callers but international long distance callers and as you can see from the mobile app that really is the heart of the monetization strategy for mobile.

Free on-net calling and free texting is one thing that we obviously want to be able to monetize that and a year before it is off-net calling, people calling somebody in an office or somebody who doesn’t yet have a smartphone with the app downloaded, that is really the way to monetize that. So we have been able to leverage the many, many carrier relationships we have around the world that drive from the lowest cost of termination in the world and can use that in the Vonage mobile app.

So it’s that piece on the mobile side and also as I touched on we plan to expand that internationally. So we think that there is substantial opportunity in many countries in the world where the US was a number of years ago with high intra country calling for example or they can introduce the Vonage disruptive technology and pricing in multiple countries around the world. And we are working on partnerships to do that and we think that partnerships are the primary mechanism to which we would engage in the international expansion.

Unidentified Analyst

Can you describe some of the economics of your business and how it changed overtime especially over the past couple of years, given the fact that you reduced your cost structuring, taking lot of cost out of the business is now getting our cash flow; one, how are we able to do this and two; the economics of the business segment and it will be helpful.

Barry Rowan

Yes, let me talk about that at multiple levels, first at the customer economic level and then at the overall company level. With regard to customer economics, one of the reasons that we focused on the international long distance callers was not just because we thought that was a place where we could make a real contribution from a value standpoint to customers. For example we’ve done very well with the Asia Indian callers that prior to Vonage introducing its product people would spend about $75 a month on just international long distance calls to India. So, for a third of that price you get unlimited calling to India and unlimited calling within the US.

So, it clearly has been a very attractive value proposition from the customer standpoint and from our standpoint, the subscriber economics have been more attractive than the domestic callers, but they are different in that a domestic call has lower cost of termination as you would expect, it’s cheaper to terminate the calls in the US than outside of the U.S., but that higher cost of termination associated with the international long distance subscribers is more than offset by lower churn. So, people who are making international calls use the product very extensively and usage drive satisfaction which results in lower churn.

So, on the subscriber economic, we have been able to replace higher churning, domestic-only callers with lower churning, highly valuable international long distance callers with the introduction of Vonage World which as I mentioned now about 35% of our overall customer base are international callers that are characterized by these better economics.

And then if you go beyond the customer under the cost structure of the company itself, that’s clearly a phase where we’ve had I would say a maniacal focus on operational improvement and as I tell people in the company this is not taking the cheese slicer approach to the cutting cost. We take 10% out of everything. This is radically changing the way we do business from customer care operations to setting up or more enthused to driving lower calls in the care by improving the end-to-end customer experience, and then looking across the entire P&L from where we can drive those changes. Another example of that is in the carrier operation inside of the house. So cost of telepathy services, our single largest line item as you would expect and we’ve substantially increased the number of minutes to support the international long distance callers that I described, but offsetting that significant growth in minutes has been a very aggressive approach to reducing those termination costs.

So, we took international long distance termination cost down by over 25%. We’ve reduced domestic termination costs by over 30%. And we’ve invested in next generation call adding capability that enables us to move to more of appealing relationship for example with carriers. So that takes significant cost out of the US calling and US termination and world going forward. So, it’s a summary of really the three things we talked about; customer economics, significant structural cost reductions in the overall P&L and then of course the refinancing that cut our interest expense from $49 million annually to $6 million on a go forward run rate.

Unidentified Analyst

Thank you. You have talked about CapEx spending of roughly $5 million to $10 million per quarter, as you do that what should investors expect to see return on their investment from that CapEx and how this is going to position going forward.

Barry Rowan

Yes, just to clarify what we said is we expect to spend $5 million to $10 million in operating cash per quarter out of the EBTIDA cash flow stream. So we have achieved EBITDA running at about $40 million per quarter so we’ve been at over $40 million now for five quarters in a row. We thought that it was a prudent use of that cash, some portion of that cash to drive the organic growth opportunities that we described particularly on mobile and in international expansion. So let me talk about how or where we are going to spend the money on so your question on what we will see it coming out of there. Then the reason that we have given a range of $5 million to $10 million a quarter is that, that investment includes both startup investments and increasing the size of our development organization for example.

We put a development organization in place in Israel last year so we are expanding that development there, a very high-tech development capability there particularly within the communication space. So we will be increasing the size of the capability in Israel, increasing the development team in the US. We are staffing up the international expansion team including business development capabilities to be able to engage in these partnerships. So that constitutes some of the startup investment, which is on the order of half of that $5 million to $10 million a quarter.

The balance will be more expansion oriented capital so to give you an example of one of the kinds of opportunities we would pursue internationally is international friends and family product. So you could imagine us teaming up with company outside the US that has very high cost of calling to that country, we could have a bilateral arrangement with them or we have very low cost of terminating between us and by doing that we can then offer to some of those that calling to that country for the customers of our partner in the country have low rates. So by doing that we would be making some initial investment but as we establish those relationships part of the expansion capital would be for acquiring those customers. They will certainly be attractive on a net present value basis that we pay for acquiring those customers and subscribe our acquisition cost. So that’s the nature of the spending that we have earmarked during the course of this year. What we expect to get from it, we certainly would not be making these investments if we didn’t feel very strongly about the size of the opportunities and the significance of the markets we are going after.

So we think that it’s not unrealistic to think that these growth initiatives and increased international long distance penetration here, the whole mobile services business and international expansion outside of our current geographies could add more than $100 million in annualized revenue within two to three years. And those that we expect to be at attractive margins as well even with the pricing that you see for Vonage Mobile 30% below Skype and 70% off of traditional carrier rates we are able to make acceptable margins on that and still price it for penetration.

Unidentified Analyst

Right. That’s great Barry. Barry, again going back to some of your success, given the fact that now you do have free cash flow, you have a much less restrictive balance sheet than you had in the past. What do you plan to do with the excess cash? Are you thinking about re-investing it? Have you thought about perhaps dividend? How do you think about that?

Barry Rowan

Yes I know, it’s a very important question Prem and we get it often from investors and prospective investors and I would just say it’s an unusual question for us given the history of the company. So it’s a relatively new position for us to be in and that we have cash on the balance sheet and have been building cash on the balance sheet. We did use a substantial portion of our cash to pay down debt previously when that interest rate was in the 9.75% range. It certainly made sense to do that from an arbitrage standpoint. Now that our interest rates are at LIBOR plus 325, we think the arbitrage is certainly not as attractive as it was. But I think that’s relatively new to this position.

We are also at what I would describe as a kind of strategic inflection point for the company. We have I think done a very good job and get high marks for the turnaround that we’ve done operationally, naturally that you’ve seen. But now the challenge really is to grow, and we are making investments of course in that as I described. We think that is a prudent use of the cash, but during 2012 that is the priority to use a portion of the cash for those investments to really drive growth.

On a go-forward basis, overtime we certainly think that it’s something that we look at during stock buyback for example we have looked at that with our board. We think that given where we are now being relatively new to this position, investing in the growth initiatives that we talked about is what make sense for now, but certainly it’s not an either or proposition. I think with the kinds of investments that we are making and the continued growth and EBITDA and cash on the balance sheet during 2012, I think it’s not inappropriate to think of a balanced approach where we could both invest in organic growth, leave money available as appropriate for inorganic growth if that seems the right thing to do and prospectively return cash to shareholders. So, it’s something that we actively look at and we will continue to do.

Leslie Arena

Perfect, perfect. Before I go on I wanted to check with the audience if there are any questions out there. Thanks. I’ll keep on going then.

Barry Rowan

I will just add one last point to the question on the potential buyback as I would just say that we are I think relatively conservative in our approach to capital structure and we think that for a company that is in the market (inaudible) it isn’t a bad idea to have some cash on the balance sheet also. So, I think just as a framework and as a philosophical foundation, I would love people to understand that as well.

Unidentified Analyst

Can you talk a little about how your slack charges have changed over time, especially as you’ve now focused on some of the ethnic markets and can you talk about it historically as well as kind of where it is today because we think that would be very interesting as we talk those involved with the turnaround stories.

Barry Rowan

Yeah, the slack of the subscriber line acquisition cost, for those of you who are less familiar with the story is clearly an important part of the subscriber economics and we have been able to modestly reduce the subscriber line acquisition cost. They were down 2% last year for example. They are in the $300 range plus the cost of the device that we generally give away, but subscriber acquisition costs have been stable but underneath that stability we have been very aggressively managing the overall marketing spend and the channels of distribution.

So it’s both a shift in the mix of marketing and the channels through which we sell the product. So for example in 2011 we really emphasize the retail channel and for us retail includes big box retailers, we’ve doubled the number of channels from 3,000 stores to 6,000 stores by adding Best Buy, Sears, and Kmart last year. It also in the retail channel includes what you call event teams. So this is kind of guerilla marketing where we’ll have people set up a table, not unlike this and set it up with a street fair on a weekend and sell at a Hispanic fair for example. And we have similar success in the retail channel. That has grown from 8% of gross line additions in the first quarter of last year to 19% in the most recent quarter. We expect it to be over 20% this year.

So there has been a shift to retail and that channel costs less than the traditional general market advertising channel and we also have made an important strategic emphasis on the Hispanic market and over the course of last year or so put in a full end-to-end Spanish language experience. Currently the Hispanic population is largely fastest growing segment, ethnic segment in the U.S so we added outbound telemarketing capability in Costa Rica, we added call centers in Chile and Mexico, we introduced a Spanish language IVR and then started advertising in Spanish and so now we are focusing more and more on that targeted Spanish market and we're doing that through a shift in the media advertising. We advertised on Indian TV channels, on Hispanic TV channels.

In addition there are some segments that do better with direct mail, the Hispanic market being one of those. So we have increased the direct mail spending to go after that targeted market as well. So within a relatively flat marketing spend and modestly improving subscriber line acquisition cost there have been substantial changes in the overall mix and the channel structure.

Unidentified Analyst

Can you talk a little bit also about your ARPU and that’s something that obviously, it's hard to increase over time given all the pricing and competitiveness in the marketplace. So if you could talk about that and also maybe about the competitive environment and how you are positioned to keep the ARPU stable?

Barry Rowan

So let me give you a little bit of data on the ARPU and the then the philosophy behind our average revenue per user and how we approach that. So we’ve increased the average revenue per user 9% over the last three years. It increased about 1% in the last year or so. So it did not increase it much but it’s been a combination of two things.

One is our focus on higher priced plan and that was really a big part of philosophy behind the introduction of Vonage World in 2009, that’s our highest price plan. So as we now have half of our customer base on Vonage World, that is clearly a way that we can enhance ARPU and has been a major contributor to that.

Our second philosophy with regard to ARPU is that we believe in trying to increase the value to the customer. So we have increased price over the last couple of years on several occasions and by doing that we have done that in conjunction with adding values.

So we added unlimited directory assistance calling for example, in conjunction with the $2 charge across the board. So we gave people better value for their money but we’re also able to improve the economics of the customers as well.

So the nature of the competitive environment and what does this mean going forward, ARPU we have been pleased with the results we have achieved. I think we look to relatively stable ARPU at this point.

Make no mistake; this is a highly competitive market, but it has been for a long time. We compete with the triple-play providers and the telcos and the cable cos for example and many of them presented at your conference and they are aggressive on price but we can hold our own there particularly when customers come off of the bundle or come off of the promotion rather and that was also a big part of our strategy and focusing on international long distance. That is an area that is less competitive, so we can cut a slot between the triple-play providers on the on the hand who were less focused on long distance and secondly the calling card companies on the other hand, who offer inexpensive rates but often the quality is not as good and they certainly don’t offer it. We have our own bundle and that is unlimited calling domestically as well as internationally with Vonage World plan. So it’s a competitive market that’s really been the way we approached it.

Unidentified Analyst

Just one kind of follow-up question. We see you in your mobile apps, outside of Skype is there anyone else doing what you are doing with the mobile apps and if so how but it seems to me that you have something very unique here?

Barry Rowan

There is really not anybody else doing this at this level of integration and with the on-net and off-net calling and the significance of this is that we have unlimited calling and texting if you are on-net and by on-net it really means that you are calling somebody who has also downloaded the app or Vonage customer at their home phone.

And we have integrated calling and texting with the on-net and off-net capability and the advantage of that is that people can use the Vonage app as a primary calling device. So, it works in 3G and on Wi-Fi and the quality is great. So there are people who do pieces of it, so there are small startup companies like a Tango does video, WhatsApp does free on net messaging, Viber does free calling but frankly doing things for free on-net is not that challenging, I mean there are many-many startups for example that are doing free on net calling.

The real challenge and I think the real hallmark of Vonage’s technical platform is the interoperability between the internet and the public switch telephone network. So, the many-many carrier relationships we have around the world enable us to offer these calls at very-very low prices while we still make money.

So, the way we think about it is that the communications business is really shifting from a regional business that starts even by country and Skype is the first company to really do this. So they turn it from their vertical, regionally oriented business to a more horizontal global business and where geography does not provide barriers. So the Vonage Mobile app for example, we fully expect that will be downloaded equally, frequently outside the U.S. as it within the U.S. and those calls will be initiated from outside the U.S. and will not just be U.S. based international calling.

So it opens up a very large market for us. As you can see from the slide, it’s an over $200 billion market, a combination of roaming, international long distance calling and text messaging. Now, those markets are clearly going to compress over time with applications like ours but that still represents a very sizeable opportunity for a company like that. Sorry about that, my Vonage Mobile out, going out. So that’s where we see the opportunity is, going after this very large existing revenue streams that are susceptible to our technology and offering very disruptive prices through it.

Unidentified Analyst

The penetration you gave comparing your app to Skype was quite illuminating and it obviously shows yours as being much easier to use relatively. How do you think you’ve managed to stop your start up forms to Skype given that they are probably much more well-known and have deeper pockets than you?

Barry Rowan

Yeah please. We view Skype as a very valid (ph) competitor. They’ve done a fabulous job at what they’ve done. We have approached the same new market from different starting points. So Skype of course started with PC-based calling, on-net calling and off-net calling. By the way if you look at theirs, one about 85% of their revenues are from Skype apps. So it’s exactly what we are talking about here is terminating to the public switch telephone network.

So they started from peer-to-peer technology model that was based on PC calling. We came at it from the other side, which is from the home phone market. So, we understood the phone market and both of us now are focusing on the mobile opportunity, on smartphones with downloadable apps. So, they have a set of challenges to go from a peer-to-peer PC-based model, we have a set of challenges to go from a traditional home phone market that is more Telco-oriented.

So I think what we’ve been able to do is to lever the technology capability we have and put it into the mobile platform and is it easy to use, no, it’s not easy but we have a lot of bright engineers as well have substantially increased our development capability. And the thing about Vonage and I’ve been with Vonage now for two years, and came out of Nextel Partners most recently; I’ve been in the communications technology business now for 30 years in various operating and financial capacities and I think one of the things that was really attractive about Vonage that was not well understood, particularly when it was covered up underneath the very negative financial performance was that this technology was very leverageable and the kinds of opportunities that were available to Vonage are available today weren’t available three years ago and it’s due to some external factors and internal factors.

So externally increased broadband penetration, increased ubiquitous smartphone, downloadable apps, people calling through social networking, all of those factors are fundamental trends that have really provided a rising tide that has enabled us to go after these markets.

So that’s on the external end market side. Then internally we’ve been able to take what has been a somewhat Telco-oriented company that's really a software-oriented company and significantly enhanced that software capability and that’s what's enabled us then to put this on the mobile platform and we really view this mobile app not just as an app but as a platform.

So we plan to be able to introduce significant enhanced calling capabilities like roaming for example, which is a very large business and very expensive when you got off the airport, any international airport in the world and there is no reason for it to be expensive as it is currently. So we see this as a platform that we can continue to leverage.

Unidentified Analyst

Great. Barry, thank you very much. Thank you for coming to the conference too.

Barry Rowan

Thank you.

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