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Executives

Leslie Arena - Director, IR

Jeffrey Citron - Chairman

John Rego - CFO

Analysts

Clay Moran - Stanford Group

Chris Cook - Zazove

Vonage Holdings Corporation (VG) Q1 2008 Earnings Call May 8, 2008 10:00 AM ET

Operator

Good day and welcome to the Vonage Holdings Corporation First Quarter 2008 Earnings Call. Today's conference is being recorded.

At this time for opening remarks and introductions, I would like to turn the conference over to Ms. Leslie Arena, Vice President of Investor Relations. Please go ahead.

Leslie Arena

Thank you. Good morning and welcome to our first quarter 2008 conference call. Speaking on our call this morning will be Jeffrey Citron, Chairman, and John Rego, CFO. Jeffrey will begin by reviewing our accomplishments for the quarter, and John will review our financial results. The slides that accompany the discussion are available on the Investor Relations website. At the conclusion of our prepared remarks, Jeffrey and John will be happy take your questions.

As referenced on slide 2, I would like to remind everyone that statements made during this call that are not historical facts or information, may be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These and all forward-looking statements are based on management's current beliefs and expectations, and necessarily depend on assumptions, data, or message that maybe incorrect or imprecise.

Such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially. More information about those risks and uncertainties is contained in Vonage's SEC filings. We caution listeners not to rely unduly on forward-looking statements, and we disclaim any intent or obligation to update them. During this call, we will refer to non-GAAP financial measures. A reconciliation of the non-GAAP measures to most directly GAAP measures is available in our earnings release, which is posted on the site.

And now I will turn the call over to Jeffrey.

Jeffrey Citron

Thank you, Leslie. Good morning, everyone. Thank you for joining us on the call. Let me begin the call with a review of our progress this quarter and then follow-up with my thoughts, as we look forward to the remainder ever the year. As a management team, we are pleased with the financial results for the quarter. May I direct your attention to slide 3.

You will see the company's revenue increased to $225 million, up 15% year-over-year, as we focus on strengthening our relationship with our customers, and capturing new subscribers through targeted marketing. This marks our 21st consecutive quarter of double-digit year-over-year revenue growth. In addition, the company reported our second consecutive quarter of adjusted operating income. This number was $8 million in the first quarter, compared to a loss of $58 million in the year ago period, and versus a profit of $3 million in the prior period. The company's net loss for the quarter narrowed significantly to $9 million, or $0.06 per share, down from $72 million or $0.47 per share a year ago.

Now before I go into the details of the quarter, I would like to spend some time discussing announcement we made this morning with Covad. I am very excited that we have announced a strategic relationship with Covad to deliver Vonage broadband service. This service, which will be offered over Covad's DSL platform, is expected to be available to new and existing customers by the end of this year. Vonage Broadband will have a maximum download speed of 3 or 6 megabits per second, and will be available to both residential and small business customers. This offering will expand the company's competitive position in the marketplace, by integrating these services for customers, who prefer this option.

This enables us to respond to demand, the demand we hear from customers prefer the Vonage brand. In addition, it provides us with a competitive offering that continues to give customers the freedom of choice. Broadband fits perfectly into the MyVonage portfolio of products and services, such as Vonage Visual Voicemail, unlimited international long-distance calling, and V-Portal, which enables customers to control not only the way they communicate, but now the way they bundle. We are very excited about this offer.

Now moving on to the quarter, our results demonstrated that we are making consistent improvement in our financial position. We believe this is direct results of the progress that we have made against our strategy to 1) fix the fundamentals, 2) strengthen the core business, and 3) ultimate grow from the core. I have discussed our strategy in the past, but it is important to understand, why each stage of the strategy is so important and to assess the progress we have made thus far. The first stage, fixing the fundamentals has led us to revamp a number of our underlying processes, and alter the way we manage the business in three critical areas, marketing, cost management, and customer care.

Moving to slide 4, marketing continues to be a good news story for the company. Since Jamie Haenggi took over the lead as a Chief Marketing Officer in the second quarter of 2007, we have improved the effectiveness of our marketing spend. In the first quarter of 2008, the company continued to deliver a much improved subscriber line acquisition cost, or SLAC, which came in at $216. This is down from $273 a year ago and $223 in the fourth quarter. Consistent with seasonal trends that we have seen in prior years, we expect second quarter SLAC to be higher than the first quarter, while we continue to expect full year SLAC to form the previously established 225 to 250 range.

Now we have completed the first phase of fixing marketing, we will enter a new phase of improvements. As we assess the competitive landscape, we are confident we can continue to deliver compelling products through targeted offers to our customers. We will refine how we target and acquire customers, thus we will begin to shift our marketing strategy from delivering a product that people need, which can be perceived as low cost phone service, to a product people want.

Moving to slide 5, we recently launched MyVonage, our strategy to deliver innovative products and services, which enable customers to control the way they communicate. As part of this, we will soon launch VonagePro, a combined offer of Vonage Digital Voice, Vonage Digital Voicemail, integration with contact center, and an attached software client, called Companion, to deliver service and features that make customers lives easier. This strategy is already bringing benefit to the company through new products and offers, and feature enhancements.

The release of Vonage Digital Voicemail, our voicemail transcription service, and our unlimited international plans, were received favorably. We will continue to launch additional products and features this year, and we expect they will be accretive to both revenues and margins. The second part of our marketing strategy, is to improve the strength of the base by targeting our efforts to acquire customers with high lifetime value. These are highly profitable customers, with strong credit worthiness, and low cost of acquisition. How are we doing this? We continually review media and spend mix, and analyze churn and cost of acquisition, by media vehicle. We know that customer attributes can vary by existing channel.

For example, on average, customers that contact us online are more likely to have a broadband connection, than those required through a mass media channel, such as TV. Now with the introduction of Vonage Broadband, the company will be able to target customers on TV with a double play offer, while continuing to focus our voice product offer online, where customers are more likely to have a broadband connection. We are also optimizing our spending in all marketing channels, to target customers by segment around attributes that drive a higher lifetime value. While implementation of the strategy will have a short-term negative impact on gross additions it will benefit profitability in the long run.

We will continue to test different levels of spending, which will lead to slower growth in the second quarter, while the appropriate level of investment by channel is determined. The mix and marketing spend will change, we expect total marketing dollars to remain consistent with the first quarter. We expect to gradually increase our marketing spend in the second half of the year, as the company starts to accelerate our growth. Under Mike Sears' leadership, who joined us earlier this year, the company has reached a turning point in customer care.

We achieved Best-in-Class results for a number of metrics that are listed on slide 6, including average speed of answer, which declined to under 30 seconds, and call abandon rates, which fell to 3% in April. In addition, since December first call resolution increased 11% to 68%, and as a result customer satisfaction increased 10% to 82%.

While this is a step in the right direction, we still have a significant amount of work to do. There is ample opportunity to improve these results, to achieve our targeted satisfaction rate of 90%, and our first call resolution rate of 85%. The combination of low abandonment rates and improved FCR has also led to a 15% decrease in customer contacts per line, along with strong improvement in customer satisfaction.

Additionally, our net promoter score. The percent of customers, who actively promote Vonage, lets those who don't increase to 28% in April, up 10 full percentage points from the beginning of the year. The net promoter score is an important metric use to help assess the health of the customer base. Overall the higher the NPS, the healthier the base.

In recent months we have seen an increase in the percentage of promoters, and a decrease in the number of detractors. As this trend continues, we believe it will translate improvements in customer churn over time. Now since joining Vonage, Mike has focused on people, profits, and technology, to address customer care. He has built an organization to address key areas of care, including training, quality control, operations, and work force management, and through investments in CRM and call routing systems, we are making progress.

Our goal is to continue to build the correct processes, which will result in improved metrics and customer satisfaction, which will ultimately reduce churn. The challenge facing us in care, while improving, continue to slow our growth. Churn increased to 3.3% in the first quarter, principally driven by an unusual spike in January to 3.6%. Resulting from a disruption associated with a change in outsourced vendor capabilities.

As a result, customers temporarily experienced a slower speed of answer, when contacting us and in turn had a poor user experience. The company responded to these vendor issues by shifting staff to other vendors, and bolstering onshore resources. This has led to improvements in the metrics, and a decline in churn to 3.2% in February, and 3.1% in March.

Despite the increase in the quarters churn number, we believe churn has peaked and expect churn to be lower in the second quarter, with continued improvements throughout the year. Over time we believe improvements in our care processes, will yield higher quality and a better user experience. Improving the quality of the customer base and fixing churn, will bring us to the end of Phase 1. As we move toward with our strategy, we were eager to continue through Phase 2 to strengthen the core, and then 3, ultimately grow from the core.

Note that while the company has pulled back on marketing spending, we have continued to invest in new products beyond Vonage Visual Voicemail, unlimited international calling plans, and V-Portal. Russ Dauer, who joined Vonage last quarter, brings extensive product development experience from Avaya, and he will be instrumental in leading this effort, to offer new differentiated products to our customers. We look forward to reviewing our product expansion project over the next several quarters.

Overall, I am pleased with our start to the New Year. We continue to make progress against our strategy to turn the business around. Our financial performance shows measurable improvement. Revenue is higher. Our expense structure is lower, and operating margins are expanding. As a business, we are stronger financially than we were a year ago.

As we move forward in 2008, we will maintain the same level of financial discipline that we have demonstrated over the past several quarters. This includes maintaining marketing spend until we see improvements in customer care. As care improves to sustainable levels, we expect to accelerate growth and marketing spend.

Now I will pass the call to John, to review the financial results for the quarter.

John Rego

Thank you, Jeffrey. Beginning with slide 7, on the top line, total revenue for the quarter grew to $225 million. That is a 15% year-over-year increase, and up 4% sequentially from $216 million. This growth was driven by subscriber line additions, as well as a benefit from the reduction in the period over which activation fees are amortized. Net loss for the first quarter 2008 narrowed to $9 million, or $0.06 per share, from a loss of $72 million, or $0.47 per share a year ago.

Breaking up the components of revenue on slide 8, you will see that telephony services revenue grew to $217 million, a 15% improvement from 1Q '07. Average revenue per user was $28.85, up from $28.31 in 1Q '07, and $28.19 sequentially. Average monthly telephony services revenue per line, which is the ongoing monthly revenue we collect from our customers was $27.87, up from $27.36 reported in the year ago quarter and $27.42 sequentially. Telephony services ARPU has remained strong. We expect it will remain steady, and ultimately increase as we launch new and differentiated services.

Now moving to slide 9, in the first quarter 2008, direct cost of telephony services was $56 million, flat with the year ago period, and up slightly from $54 million sequentially. Per line, this number was $7.26, down from $8.03 in the first quarter 2007, and up from $7.11 sequentially.

Cost of goods sold was up sequentially to $22 million from $17 million, driven by the utilization of most of our remaining inventory of higher cost CPE devices. This led to a higher CPE subsidy, which increased more than $10 sequentially, to $51.31. Direct margins remain steady year-over-year at 65%, and fell sequentially from 67% due to the higher CPE subsidy. We expect the subsidy to decline next quarter.

Moving to slide 10, SG&A as percentage of revenue continues to fall, dropping to a record low 35%, from 46% a year ago, and down 1% sequentially. SG&A of $79 million was flat sequentially, and down $12 million from $91 million in 1Q '07. The $12 million year-over-year decline is a direct result of the cost cutting initiatives announced last year. Included in the $79 million is $2 million in non-cash stock compensation expense.

Slide 11 highlights our pre-marketing operating income, which reflects cash thrown off from our existing customer base. PMOI increased to a record-high $83 million or $10.66 per line in the first quarter. That is up from $39 million, or $5.68 in the year ago quarter. Incremental PMOI was $16.23 in the first quarter 2008, up from $13.49 the prior year.

On slide 12, marketing expense for the first quarter was $61 million, down significantly from $91 million in Q1 '07, and down from $63 million sequentially. Marketing expense as a percentage of revenue, hit a record low 27% in the first quarter, down from 46% a year ago. This is the third consecutive quarter of sub-30% of revenue levels for marketing.

The company expects second quarter marketing spend to be in-line with the first quarter. As the company starts to accelerate growth, we will increase marketing spending to approximately 30% to 32% of revenue in the second half of this year. Marketing cost per gross subscriber line addition or SLAC came in at $216, down 21% from $273 in the first quarter 2007.

Consistent with seasonal trends in prior years we expect 2Q SLAC to be higher than the first quarter, but we anticipate full year SLAC will follow the previously established range of $225 to $250. It makes sound financial sense to push forward with our growth spending, as customer care continues to improve. On an incremental basis, we know that each line throws off $16.23 in cash per month. Based on this quarter's SLAC of $216, the company would pay back acquisition costs in less than 14 months.

On slide 13, for the second quarter in a row, we generated adjusted operating profit. Adjusted operating income was $8 million, versus a loss of $58 million in the year ago quarter. The company added 30,000 net subscribers, and ended the quarter with 2.6 million lines in service.

I briefly wanted to comment on the broader economy. Although concerns exist about the impacts of rising fuel costs, and the challenging housing market, these concerns have not had a material impact on the company's operations, or on our ability to add subscribers. Nor have they led to a significant change in the amount of non-paid churn.

Turning to the balance sheet on slide 14, cash and marketable securities and restricted cash at quarter end was $190 million, which includes $42 million in restricted cash used for routine business operations. The change in cash from the prior quarter was driven by cash provided from operations of $11 million, CapEx of $10 million, and a $2 million increase in restricted cash. This is the third consecutive quarter the company has generated positive cash from operations.

Moving to slide 15, I would like to spend some time discussing the letter of intent the company signed, related to refinancing the convertible debt. On April 25th, we announced that we had signed a non-binding letter of intent with a third party financing source, to provide $215 million in a private debt financing. The company expects that approximately two-thirds of the financing will be provided through a senior secured credit facility, and approximately one-third will be provided through the issuance of convertible secured notes. The letter of intent is a proposal that will be used as a basis for financing, and does not constitute a commitment. We will provide additional details on the financing, once the commitment letter is signed.

The company intends to use the net proceeds from this financing, plus cash on hand, to repay, tender for, or redeem its existing convertible notes, which can be put to the company on December 16, 2008, and have a principle amount due of approximately $253 million. We are pleased to reach this stage in refinancing our convertible debt. Completing this effort will not only lessen the uncertainty associated with the company's liquidity, but it will clear a path for us to invest and grow our business.

And now, Operator, let's open up the line for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And our first question will come from Clay Moran with Stanford Group. Go ahead, sir.

Clay Moran - Stanford Group

Good morning. It is Clay Moran. Couple of quick questions. On the Covad relationship, is there any margin in that for you, or is that simply a pass-through that you are doing to improve your competitive positioning?

Jeffrey Citron

Sure Clay. This is Jeffrey here. First of all, thank you for joining us. Yes, there is absolutely ample margin in the business model that we set up with Covad. And while we haven't established pricing, we expect margins to be comparable to our current product offering. This could be a very big positive, in terms of improving the lifetime value, and net present value of existing customers that take the double play.

Clay Moran - Stanford Group

Okay and then two other questions. One just on the G&A line item, you noted that the cutbacks. Are those cutbacks now fully reflected, so that the $79 million is the run rate going forward?

John Rego

Yes, Clay John Rego here. Yes, they are. Remember, we announced that on April 12th of '07, so we did the reduction in force, and we had some other cuts that totaled up to $30 million. So yes, it is.

Clay Moran - Stanford Group

And then lastly, the cable companies have been reporting some pretty strong numbers, in terms of VoIP subs. Clearly your growth has slowed significantly there. Can you just talk about how you see your competitive positioning there, and how you think possibly you can pull some share, or what you are going do to reverse that trend? Thanks.

Jeffrey Citron

Clay, it’s a good question. As you know, Vonage made a conscious choice to grow much slower, while resolving internal issues at the company. If you take a look at the company's competitive position in the marketplace, there are a couple of key measurements, you can use to see how well we were competing against cable operators, and really acquiring customers from the underlying phone companies. And the subscriber line acquisition cost is a really good metric for that.

As you noted about a year ago, when I stepped back into my role, that number had gone up from the low 200s, to over $300, before I stepped back into my role. And of course, we have done a great job with Jamie's help, in bringing the number back down. So, we know that for certain segments in the marketplace, the company has a very good competitive offering, that is attracting customers, and all we need to do now is, start marketing to the customers to bring them in the door, and that’s why in the second half of the year, we will accelerate our marketing. We just want to use the rest of the second quarter to continue to make some more improvements in customer care.

On the competitive front against other segments, we also know that there is a whole range of customers that are contacting us that they don't have broadband. And they are looking to Vonage for a broadband solution, along with the voice service. So, by being able to offer that to a new segment of customers, a segment that we currently don't market to, we should be able to make further enhancements in our ability to acquire subs, and to grow share of our base.

Now by growing share on the revenue side in the digital voice product space, that is important, and that is going to generate obviously the main amount of growth, but at the same time, adding the incremental revenue from the Vonage Broadband offering, also furthers to strengthen our position in the markets, and strengthen our relationship with our customers, and provide obviously, a greater amount of not just revenue but EBITDA, or [OBITDA] down to the bottom line from that relationship, as referenced by your first question. So, those two together coupled with the increase in marketing, should allow the company to start accelerating growth and take share.

Clay Moran - Stanford Group

Okay. Thank you.

Operator

(Operator Instructions). Now moving to Chris Cook with Zazove.

Chris Cook - Zazove

Hi, quick question on the refinancing. You indicated in an 8-K that you gave exclusivity to the party until June 13th, I think. And then it also says if you do not complete the financing prior to November 13th, you have to pay them $6.5 million. If they don't come up with a financing package by June 13th, I assume that exclusivity goes away?

John Rego

This is John Rego. That is correct.

Chris Cook - Zazove

And so you would be able to pursue other financings at that point and if you did another financing before November 13th, you would not have to pay them $6.5 million. Correct?

John Rego

Yes, correct.

Chris Cook - Zazove

Okay. Thanks.

Operator

(Operator Instructions) And with no additional questions, I will turn the call back over to Mr. Citron for closing remarks.

Jeffrey Citron

Thank you very much, operator. As we look ahead, we are excited about 2008. We have made a significant step toward refinancing convertible debt, and financially our business fundamentals are solid and improving. We are executing against our strategy. We are making progress on reducing churn, and we will look to grow the business as churn improves.

The new products and services that are in the pipeline will enable us to strengthen our relationships with existing customers, and differentiate ourselves from our competitors. We have made a great deal of progress and are positioning ourselves for the future. I look forward to providing you with an update, as we progress throughout the year. And thank you very much for joining us today on our call.

Operator

Once again, that will conclude today's conference. Thank you for your participation. Everyone have a wonderful day.

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Source: Vonage Holdings Corporation. Q1 2008 Earnings Call Transcript
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