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Vonage Holdings Corp. (NYSE:VG)

Q2 2008 Earnings Call

August 7, 2008 10:00 am ET

Executives

Leslie Arena – Vice President, Investor Relations

Jeffrey Citron - Chairman

Marc Lefar - Chief Executive Officer

Jerry Maloney - Senior Vice President of Finance

Analysts

Michael Rollins – Citi Investment Research

Chris Cook – Zazove Associates

Operator

Welcome to the Vonage Holdings Corporation's second quarter 2008 earnings conference call. (Operator Instructions) At this time for opening remarks and introductions I would like to turn the conference over to Leslie Arena, Vice President of Investor Relations.

Leslie Arena

Speaking on our call this morning will be Jeffrey Citron, Chairman, Marc Lefar, Chief Executive Officer, and Jerry Maloney, Senior Vice President of Finance. Our CFO, John Rego is unable to be here today due to personal reasons.

Jeffrey will provide opening remarks, Marc will overview the company's accomplishments for the quarter and Jerry will review our financial results. The slides that accompany this discussion are available on the investor relations website. At the conclusion of our prepared remarks, we'll be happy to take your questions.

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

Such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially. More information about those risks and uncertainties is contained in Vonage's SEC filings. We caution listeners not to rely unduly on forward-looking statements and we disclaim any intent or obligation to update them. During this call we will be referring to non-GAAP financial measures. A reconciliation of the non-GAAP measures to most directly comparable 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 for joining us on our second quarter earnings call. Let me begin by saying I'm very pleased that Marc is on the call with us today. Just last week, we announced that Marc joined Vonage as Chief Executive Officer, stepping into a role that I had been serving on an interim basis since April 2007. At that time more than a year ago, the company was in the midst of a crisis. The company's prior CEO had stepped down. We lost a major litigation with Verizon and were partially enjoined. The business had become less efficient and we were burning cash at a high rate.

Since that time, we have settled all of our material IP litigation including cases with Verison, AT&T, Sprint and Nortell. We reduced our cost structure bringing SG&A as a percentage of revenue down from 46% in Q1, '07 to 34% today, and we've built what I believe to be a stronger, more effective team to operate the business. The financial performance of the company's operations have improved and we're now generating positive adjusted operating income and cash from operations.

So now, with the announcement of signing a commitment letter to refinance the convertible debt, the timing is right to bring in a permanent CEO to take the business to the next level of growth and performance. I believe there is no better person than Marc to step into the business and lead Vonage at this time. He possesses a wealth of experience in the telecom industry and a track record of delivering results.

Marc has held senior positions at Cingular Wireless, Cable Wireless, Verizon Wireless and Proctor and Gamble. During his tenure at Cingular, the company's customer base more than tripled and subscriber turn declined by nearly 50%. I feel confident that his industry expertise coupled with deep level of marketing experience and executive management skills will help the company realize future growth and profitability. He has my full support along with that of the Board of Directors and the team here at Vonage.

I have assumed the role of non-Executive Chairman and will serve in a consultative role to Vonage to assist Marc in defining the company's long term vision strategy. I'm very confident that Marc's focus is Chief Executive Officer and my increased attention on my role as Chairman will best serve our customers and shareholders.

Now I'd like to pass the call to Marc.

Marc Lefar

I'm thrilled to be joining at such a time of such exciting change and tremendous opportunity for the company and the industry. Since the company's inception, the Vonage team has changed the way people think about communication. This is a company of energetic, hard working men and women. They have welcomed me warmly. I'm looking forward to helping this talented team realize the full potential of our business.

Although it's just been over one week since I joined Vonage, the senior team is already helping me to see opportunities to improve the competitiveness and performance of the business. In the past several days, I've been meeting with front line employees, listening to customer calls and engaging in a series of deep dive discussions on the key drivers of our business. These sessions are part of a comprehensive effort to assess our business plans, core operations and customer health.

I will report back to you on the next quarterly call my perspective on the company's existing plans and strategies. I expect that this will include improvements in the clarity of our message, the yield of our marketing investment and satisfaction with the end to end Vonage experience.

Before I go into a discussion on the quarter, I'd like to thank Jeffrey and the team for what they've done during Jeffrey's tenure as interim CEO. Clearly the last year and a half has been challenging for the company. As a result of Jeffrey's leadership, the business core operations are stronger. I'm looking forward to working with the team to further our progress.

Now, let's move to the results of the quarter. Beginning on slide three, the quarter was one of both progress and challenge. We saw meaningful progress in the financial performance of our core operations. The company reported solid performance in a number of key financial metrics. We delivered double digit year over year top line growth and generated positive adjusted operating profits of $12 million. Pre-marketing operating income in the quarter reached a record high of $87 million.

The company continued to effectively manage its expenses with SG&A declining in absolute dollars and as a percentage of revenue. These declines are on both a sequential and year over year basis. Net loss for the quarter narrowed significantly, $7 million or $0.04 per share down from a loss of $23 million or $0.15 per share a year ago. Solid progress.

Moving to slide four, Churn, a top priority for the company declined sequentially to 3% in the second quarter from 3.3% in the first quarter, and while our actions have led to improvements, we realize there is still a great deal more to be done. Some of the initiatives implemented in customer care over the past several quarters have contributed to the recent Churn improvements and I'd like to highlight some of these specific programs.

The recent implementation of a new customer relationship management system has already led to higher customer satisfaction and improvements in first call resolution or FCR. Customer satisfaction increased to 84% in the second quarter, up from 79% in the first quarter, and FCR which is the percentage of customer issues resolved on the first contact, is nearly 72%, up from 64% sequentially. In addition, we implemented new call routing software that allowed us to optimize staffing levels in our call centers. As a result, average speed of answer is now less than 30 seconds.

Beyond these initiatives, we're investing more heavily in the training of agents and supervisors. On average, during the past 90 days, our front line representatives received an extra 2 1/2 hours per week in training. The training focused on the new desk top technology aimed at improving call handling time as well as extra coaching time for our representatives. Beyond this we improved our hiring criteria so new representatives can be more effective, faster.

I'm encouraged by the directional improvement in Churn during the second quarter. The leading indicators show promise, but we must remain laser focused on further improvements. We'll continue investing resources to drive these reductions. There is much to be done.

The growth in pre-marketing income and operating cash flow as well as the improvements in Churn project solid progress. There are however, areas of the business where we have not performed as well. Despite improvements in Churn, customer net additions were below our expectations coming in just about flat for the quarter.

Moving to slide five, let me talk a bit about the gross line additions. As the company discussed on the last quarters call, we are focused on improving the quality of the customer base. Specifically, this means adding customers with higher average revenue and a lower propensity to churn. In an effort to accomplish this goal, the company made changes in the level of marketing spend and the mix of media across vehicles.

While those efforts have resulted in sequential improvements of 30% in early life churn, and more than 10% improvement in return rates, we underestimated the overall impact on gross line additions. We did expect some softening but the impact was larger than anticipated. The team quickly identified the impact and made additional adjustments mid quarter, and although gross line additions did bounce back, it was not enough to offset the early softness.

As a result, in the seasonally slower second quarter, gross line ads indexed at only 98% percent versus the prior year, and sequentially our acquisition cost per subscriber line rose significantly. We simply must improve the yield on our marketing investments in order to maintain our competitiveness.

Updating projections that we'd given last quarter, we expect to invest approximately 28% to 30% of revenues on marketing in the third quarter. I will personally be working closely with the marketing organization and our agencies in the coming weeks and months with the goal of further enhancing our messaging and driving efficiency.

So to sum up the quarter on slide six, our financial results were solid. We continue to grow cash from operations, delivered record pre-marketing income and continue to show declining SG&A as a percent of revenue. Additionally, we made progress on improving the customer experience and reducing churn. We have a great opportunity to generate a higher return for every marketing dollar we spend and of course, churn reduction will remain the company's primary focus.

Before I hand it over to Jerry to go through the detailed numbers, I'd like to take a moment to mention last weeks' launch of Vonage Pro. Vonage Pro is a unique digital voice offering which includes the soft phone which allows users to use their home number from any desk top or laptop PC. Additionally, it includes unlimited residential voice, visual voice mail and a wide array of features. Over time the company expects to continue to bring innovative products and features to the market in order to further our competitive differentiation and address the need of key segments.

Let me also make a brief comment about our refinancing efforts. Jerry will talk about the transaction in more detail. As everyone is aware, the difficulties in the credit markets have made it extremely challenging for companies to gain access to capital. Vonage however, thanks to the tremendous efforts of John Rego and his team, have taken a major step toward completing the debt refinancing two weeks ago, with the announcement that we signed a commitment letter with Silverpoint, establishing the terms for up to $215 million in private debt financing. We believe the first close will take place shortly after the special meeting of stockholders in the third quarter.

In closing, let me say we do have our share of challenges, but I am truly excited and optimistic about the opportunities for a bright future. I'm looking forward to providing you with updates as we progress throughout the year. And now, I'll pass it to Jerry to review the financial results for the quarter.

Jerry Maloney

Beginning with slide seven, on the top line, total revenues for the quarter grew to $228 million, an 11% year over year increase and a 1% sequential increase from $225 million. Year over year growth was driven by subscriber line additions.

Net loss for the second quarter of 2008 narrowed significantly to $7 million or $0.04 per share down from $23 million or $0.15 per share a year ago. Breaking out the components of revenue on slide eight, you'll see that Telephony services revenue grew to $219 million, a 9% improvement from Q2, '07. Average revenue per line was $29.04, up from $28.38 in Q2, '07 and $28.85 sequentially.

Average monthly Telephony services per line which is the ongoing monthly revenue we collect from our customers, was $27.92, up from $27.63 reported in the year ago quarter, reflecting a benefit from the reduction in the period over which activation fees are amortized. On a sequential basis, average monthly service revenue per line rose $0.05 from $27.87. We continue to expect ARPU trends to remain steady. Over time, as we launch new and enhanced services such as Vonage Pro, we anticipate ARPU will increase.

Moving to slide nine,in the second quarter of 2008, direct costs of collecting services was $57 million, up from $52 million a year ago. The Q2 number was abnormally low due to a USF tax refund. Sequentially, direct costs of Telephony services was flat. On a per line basis, direct cost of Telephony services was $7.22, up $0.01 from $7.21 in the second quarter of 2007 and down from $7.26 sequentially.

Cost of goods sold dropped to $19 million from $22 million in the prior quarter as a result of lower gross line addition. Direct margins were 67% in the second quarter, up from 65% sequentially.

Moving to slide ten, SG&A percent of revenue continues to fall, dropping to a record low of 34% from 38% a year ago and 35% last quarter. SG&A of $78 million, or $1 million sequentially and was flat year over year.

Slide 11 highlights our pre-marketing income which reflects cash generated from our existing customer base. PMOI increased to a record high $87 million or $11.15 per line the second quarter, up from $56 million or $7.69 in the year ago quarter. Incremental PMOI per line was $16.43 in the second quarter of 2008, up 9% from $15.08 the prior quarter.

On slide 12, marketing expense in the second quarter came in slightly higher than forecast at $65 million. This was down from $68 million in Q2, '07 and up from $61 million sequentially. Marketing expenses percentage of revenue fell to 29% in the second quarter from 32% a year ago and up from 27% in the first quarter of 2008.

Cost of adjusted income increased to $283.00 up from $216.00 in the first quarter of 2008. As we discussed last quarter, we anticipate an increase in second quarter cost of acquisition due in part to seasonality. In addition, the timing and mix of these investments further drove up acquisition costs. First line additions for the quarter were $230,000 down from $237,000 year over year. Net line additions were $2,000. The company ended the quarter with more than 2.6 million lines in service.

On slide 13, for the third quarter in a row, we generated an adjusted operating profit. Adjusted operating income was $12 million versus a loss of $18 million in the year ago quarter.

Turning to the balance sheet on slide 14, cash marketable securities and restricted cash at quarter end was $192 million which includes $42 million in restricted cash used for routine business operations. The increase of $2 million cash in the prior quarter was driven by provided by operations of $14 million, partially offset by capital expenditures of $12 million.

Moving to slide 15, I'd like to spend some time discussing the commitment letter that the company signed with Silverpoint related to the refinancing of our convertible debt. This is a significant step along with way to complete the refinancing and we are pleased with our progress, particularly in this difficult credit environment.

[inaudible] is the net proceeds on the financing plus cash on hand to repurchase our existing convertible notes which can be put to us on December 16, 2008 out of a principal amount outstanding of approximately [inaudible].

Let me walk through the details of the deal. The commitment letter starts with the terms and conditions for an initial $185 million private debt financing. Silverpoint allocated $125 million of this amount as an initiative to closing of the private debt financing as we identify other lenders that will commit to provide up to $60 million.

Silverpoint has also agreed, subject to certain conditions to use commercially reasonable efforts to assemble a syndicate of lenders to provide up to $30 million of incremental private debt financing. The company and Silverpoint are currently negotiating definitive documentation for the financing while we are concurrently working diligently towards satisfying all the expected closing conditions.

In addition to obtaining commitments from lenders for $60 million of the private debt financing, those conditions include holding a stockholders meeting to obtain stockholder approval of all matters relating to the financing in accordance with New York Stock Exchange rules. The stockholder meeting is scheduled for August 20, 2008.

As required by the financing documentation, on July 30, 2008 we had a tender of offer of the company's standing convertible notes which included payment of the interest which amounts to $257 million in the aggregate, assuming tentative offer from variable notes. As the closing conditions for the financing are met, the proceeds of $185 million under the initial private debt financing, as expenses related to the financing of $21 to $24 million, approximately $3 million of which was paid prior to June 30, 2008. It will be used to repurchase convertible notes.

Accordingly, we will need to set aside $93 million from cash on hand to satisfy our obligation to repurchase existing convertible notes that may be tendered. At June 30, 2008 we had approximately $130 million of unrestricted cash.

For the full quarter after the closing of the process of financing assuming no increase in the interest environment we expect that our close [inaudible] will be slightly higher than the second quarter of 2008, and our total interest expense will more than double.

At present, we expect that all closing conditions in closing our private debt financing in the third quarter of 2008, with the approach of successfully completing this funding.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Michael Rollings – Citi Investment Research

Michael Rollins – Citi Investment Research

In terms of the marketing strategy, as you look at your competition, cable and even the incumbent to some extent, one of the advantages they have is that they send people out to install your telephone service for the customer. Can you talk about how that's impacting the competitive environment for you and how you're going to structure the product to continue to make it easier for the customers to install, or alternatively, would you reconsider getting more aggressive with the professional installation option?

Marc Lefar

Let me talk about competition more broadly first off, and talk more specifically about the opportunity for professional install. As I've talked in calls last week with a number of you, it is an extremely attractive overall for multiple competitors to grow in the market as of today, with roughly 60 million broadband users, only 25% of the using digital voice. There is an incredible upside market potential and which we expect three or more competitors to be able to grow very profitably over time.

You're certainly going to have the cable folks, you'll have the telecodes, and we believe that Vonage will be a strong third. Customers want choice. They want flexibility and we provide feature sets as well as choice that the bigger guys simply don't provide.

Relative to professional installation, it is something that we have done and continue to evaluate in order to optimize, and we are evaluating partnerships to consider whether it's something that we can expand and should expand. Of course, we have to balance that against the cost of doing that, and the customers' willingness to pay. More specifically though, I think the solution lies in improving overall end to end customer experience and delivering products that are much more intuitive and seamless in terms of their ability to purchase and then install in an individual's home on their own. So we're pursuing both paths.

What I'll also tell you is, we do not believe that this is something that has been an impediment to growth in any significant way although it's only one week that I've been in the job, I've spent a tremendous time on the phones with our call center representative and the front line employees, and while competition is certainly nothing to be underestimated, what I hear more frequently is that we have opportunities to improve our overall experience and when we lost people to competition, it is generally a function of having disappointed them some other way in terms of our ease of going business with them.

And again, we've made improvements in the recent quarter and I continue to believe that we can invest driving churn lower.

Michael Rollins – Citi Investment Research

What do you think, as you do the call to action in the promotions, I'm sure you've seen a lot of what Vonage has done over the last few years. In your mind, what is the biggest barrier to the customer picking up the phone or going onto the internet and ordering the product? Is it education? Is it some facet of the product that they don't understand? Where do you think the biggest hurdle is in terms of why more customers don't pick up the phone to activate the service?

Marc Lefar

Over the next 60 days, I'll be spending a bit more time to make sure I've got facts and data to support what might be my initial belief. My initial belief and hypothesis speaks to an awful lot of people I don't think really understand what the product delivers and what those benefits happen to be and how they can use it. I don't think they understand the flexibility of having a number that can work anyplace across multiple different vehicles, from you PC to your phone.

And we need to be able to deliver that story in a context of competiveness so people understand both the feature sets we provide that don't exist when you buy it from an NSO, and also the true value proposition that exists. I think people are confused about the true value that's provided in our stand alone offers versus what is perceived as benefit in some of the bundles, which is frankly many hidden fees and costs and promotions that when all things are considered on an apples to apples basis, really provide a premium priced product without significant value.

So I think we're going to have to attack all of those in our messaging. When I report back next quarter, I'll give you much more specificity in terms of those things that I've got facts to back up and what I think we're going to do about it.

Operator

Your next question comes from Chris Cook – Zazove Associates

Chris Cook – Zazove Associates

What is the cost of this financing? I think you said $24 million?

Marc Lefar

Yes. That includes the fees paid to Silverpoint for arranging the deal as well as all the legal, professional and other fees that will be incurred to complete the closing.

Chris Cook – Zazove Associates

So none of that's non-cash. It's all cash.

Marc Lefar

Yes.

Operator

There are no further questions.

Marc Lefar

To wrap up, I'd really like to express my enthusiasm for the opportunity at hand. We do have tremendous, tremendous growth potential. I want to thank Jeffrey for the significant contributions he's made during his time as interim CEO. I look forward to his insight and council going forward and I'll report back to you next quarter after I've had a chance to complete my evaluation of the business, our priorities and strategies going forward. Thank you and have a great day.

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Source: Vonage Holdings Corp. Q2 2008 Earnings Call Transcript
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