Vonage Holdings Corp. (NYSE:VG) Q2 2010 Earnings Call August 4, 2010 10:00 AM ET
Leslie Arena - VP, IR
Marc Lefar - CEO
Barry Rowan - EVP, CFO & CAO
Kevin Toomey - Citi Investments
Mike Latimore - Northland Capital
Good day, everyone and welcome to the Vonage Holdings Corporation Second Quarter 2010 Earnings Conference Call. Just as a reminder, today's call is being recorded.
At this time, for opening remarks and introduction, I would like to turn the conference over to Ms. Leslie Arena, Vice President of Investor Relations. Please go ahead.
Thank you. Good morning and welcome to our second quarter 2010 conference call. Speaking on our call this morning will be Marc Lefar, Chief Executive Officer; and Barry Rowan, CFO and Chief Administrative Officer. Marc will discuss the company's progress in the quarter and our newly announced Vonage Mobile app for Facebook. Barry will discuss our financial results. Slides that accompany Barry's discussion are available on the Investor Relations website. At the conclusion of our prepared remarks, we will be happy to 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 depend on assumptions or data 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 highlighted on the second page of the slide and 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 these measures to comparable GAAP measures is available on the Investor Relations website.
And now, I will turn the call over to Marc.
Thank you Leslie and thank you all for joining our call today. It's our pleasure to update you on our continuing transformation progress and our operating results for the quarter.
We reported a very strong quarter on many fronts with record-high EBITDA and cash flow generated from operations and solid progress on our balance sheet. At the same time, we took concrete steps that laid the foundation for our future growth. We added key individuals to our executive team and Board of Directors, launched our exciting new Mobile application for Facebook users and continue to improve the customer experience, reducing churn to its lowest level in three and a half years.
We generated $41 million in EBITDA, a 30% increase in the prior year in our 11th consecutive quarter of increasing EBITDA and generated record-high free cash flow of $81 million during the quarter. We continue to improve the balance sheet as we retired $18 million of debt at par. This is in addition to the $23 million retired last quarter. Taken together, these actions reduced interest expense by $33 million over the life of the loans, this is significant progress.
Operationally, we reduce churns by 2.3% and stabilized our customer base with a modest loss of 5,000 net lines. And we continue to build our team with experienced technology leaders that will expand the capabilities of our network and deliver breakthrough services. In May, we announced the appointment of Amichay Oren, Head of Research and Development. Amichay previously held senior role at JAJAH and SAP following SAP's acquisition of Expression, a company that Mr. Oren co-founded.
And yesterday, we announced the addition of Dr. David Nagel to our Board of Directors. Dr. Nagel is widely know for his deep technical background and has helped senior leadership position in consumer technology companies including Apple, AT&T and Palm. He was most recently President and CEO of PalmSource and prior to that, he was Chief Technology Officer AT&T and President of AT&T Labs. We're very pleased to have him on our Board.
The decision by these talented individuals to join Vonage is a testament to the attractiveness of our strategy and our commitment to executing on it. Amichay and his team, along with many other Vonage employees are already contributing to the implementation of our vision, they were instrumental in enabling the launch of our new Mobile application for Facebook.
If you look and see the press release, early this morning, we announced an innovative service, allowing users with our application to make and receive free mobile calls between Facebook friends anywhere in the world, directly from their friends list with a single touch. It works on WiFi, 3G and 4G networks and is available for the iPhone, iPad -- iPod Touch and Android devices; an iPad app is coming soon.
This new service works for the user’s existing networking of Facebook friends, so there is no need to remember screen names, to input numbers or create a new user name and a new community. The user simply logs in with their Facebook credentials one time and their friends become their contact list for free calling.
In the past I've talked about how a single familiar identity, such as a user name or number, allows a person to initiate and receive calls and messages for their existing social network or contact list, while on any device. This application brings that concept to life and is a good example of our long term commitment, to deliver great value and a better communication experience.
This concept is not limited to a single community; this is just the starting point for a wide range of future capabilities that can change how people communicate. People don't have to be identified by a number any longer. Over time, dialing as we know it today can be virtually eliminated. Voice, messaging and video can all be initiated with a single touch, using communities to which consumers already belong and a single user will be able to use multiple devices seamlessly; PC and MAC integrations are in the works.
Our IP based communications platform enables cost-effective delivery of these services, allowing it to provide customers with more value than that exists today. For example, online and mobile chat services require customers to be online in order to receive messages. An SMS while providing customers with a real time messaging limits messages to a 160 characters.
Our approach does not require presence and can allow larger message lengths, with attached media such as pictures or video at a low cost to the consumer. This is just one example. Multiple communities, even families can be integrated into Vonage Mobile and we anticipate a full range of services, many of which may be monetized, including lower cost text messaging, premium services like readable voice mail and custom communities.
Of course, we'll also continue to provide the ability to complete calls off network. This will be especially valuable for international communications with countries and segments where smart phone penetration and broad band availability lag. We do believe that many of our next generations services will have global appeal and our new application will be available for download from the iTunes apps store in 87 countries and from the Android market in 48 countries within the next day or so. It is available in the U.S. and Canada now.
Based on this glimpse of the future, I think we'll share my excitement about the emerging opportunities for Vonage, as we've said previously we expect that these next generation products will begin to contribute measurably to revenue in 2011.
Let's now move to a review of our quarter’s results. I already highlighted our strong results and EBIDTA, free cash flow and the substantial progress we've made on our balance sheet. Barry will discuss these in greater detail. Our core business is strong and continues to generate significant cash flow. We again delivered strong improvements to our cost structure, through operating efficiency and cost management across the company.
We reduced SG&A by double digit percentages year-over-year, customer care cost per line were down more than 20%, driven by operational improvements and we improved customer satisfaction, leading to fewer customer contacts. We continued to aggressively negotiate rates with carrier partners to reduce international long distance cost per minute, which declined 7% sequentially.
Churn continues to be a strong story, declining to 2.3% this quarter, this represents a 90 basis points reduction from a year ago. These results continue to be driven by our customer mix, with international long distance caller churning at less than half the rates of domestic callers and the relentless focus on every element of the customer experience. The impact of this detailed operational focus can be seen in the 16% reduction in the number of calls in customer service. And then our post 30-day save rate or stick rate which increased 10 percentage points from the beginning of the year, highlighting the great work done by our retention teams.
We also continue to strengthen the quality and reliability of our network. The percent of impaired calls continues to trend down year-over-year. And we've reduced the frequency of call interference every quarter since the third quarter of last year, aided by call quality tools and metrics, which provide real-time information on network problems.
Importantly, we stabilized our customer base, reducing line losses as we indicated we would on last quarter's call. Net line loss was 5,000, a sequential improvement of 21,000. We increased gross line additions by 11,000 from the prior year on $3 million less than marketing spend. Gross line additions of 155,000 were flat sequentially.
We continue to test new products and rate plans that address the evolving needs of our customers. In June, we tested 9.99 offer targeted at low usage customers. While we saw some lift in customer additions and improved customer quality profiles during the month, it's too early to assess the full impact of the offer. Early results showed that high credit quality customers are attracted to this offer and the percentage of all Vonage customers signing up to our online channel has increased to nearly 60%. Both of these factors are historically correlated to lower churn. We will continue to assess the performance of these promotions and the cost benefit trade-offs.
We're also taking additional steps towards our strategic priorities of serving international long distance consumers. Our highly competitive Vonage World Product which bundles unlimited domestic calling with unlimited calling to 60 countries provides a compelling value proposition to customers and attractive economics to us.
And just as we launched our Spanish language website, this along with our Spanish language call center provides an end-to-end Spanish language experience that makes the Vonage World plan more accessible to Spanish speaking customers and offers a simple and affordable way to call friends and family back home.
We continue to extend the reach of Vonage World across ethnic segments and internationally by leveraging Vonage World success in the Asian Indian community. And we've planned to launch Vonage World for Canada in the coming months. Additionally, we're evaluating new ideas beyond traditional advertising, including trade organization partnerships and sponsorships to accelerate sales into our targeted ethnic communities.
Our search is currently underway for Chief Marketing Officer to replace our former CMO, who left the company at the end of the second quarter. I would remain personally engaged to the marketing role until that position is filled.
In summary, it was a very strong financial quarter. We delivered record level EBITDA and cash flow and paid down a meaningful amount of our debt. We launched our Vonage mobile application for Facebook users, taking a major step towards enabling communication across those communities.
And we continue to make progress, improving the value generated from our core business. We're enthusiastic about our future as we look forward to delivering compelling and innovative products to meet the emerging communications needs of our customers.
And now, I would turn the call over to Barry.
Thank you Marc. I am very pleased to review our financial and operating results for the quarter in more detail with you. As Marc highlighted, it was a very strong financial quarter as we generated record high EBITDA, record high cash flow, lowest churn in three and half years and we continue to improve our balance sheet. In the past four months alone, we have reduced our term debt obligations by $41 million, resulting in interest expense savings of at least $33 million over the life of the loan. These reductions in principals, supported by strong free cash flow have enabled us to reduce our net debt balance from $197 million a year ago to $72 million, yielding a net debt leverage ratio of 0.5 times. Let's walk through the details of our results beginning on slide 3.
Our attractive business model with high service margins and increasingly satisfied customer base is delivering on its financial promise as we generated EBITDA of $41 million on $225 million of revenue. That's a 30% increase in EBITDA from a year ago and a respectable 18% margin. These gains have been driven by a higher ARPU and cost management in operating efficiencies, primarily in customer care, legal facilities and payment processing.
You will note on slide 4 that we generated $12 million of net income excluding non-cash charges, up significantly from the $1 million level a year ago and on par with the $12 million generated last quarter.
GAAP net income was a negative $600,000 rounding to $0.00 per share in Q2 and the 15 million reduction net income from last quarter is predominantly due to non-cash charges related to two positive circumstances. First, net income for the second quarter includes the $4 million charge relating to the $23 million in debt, we prepaid at par this quarter. Secondly, it includes an $8 million non-cash expense related to unconverted third-lien notes, reflecting the $0.95 increase in our stock price in the second quarter.
Turning to slide 5, total revenue for the quarter increased to $225 million from $220 million in the second quarter of 2009.
Telephony services revenue was $222 million, up 3% year-over-year and down 1% sequentially. The year-over-year improvement was driven by higher average service revenue per user, which increased 9% or $2.53 from the second quarter of 2009, reflecting an increase in the number of customer signing out for higher price rate plans, higher fees and improved customer quality which lower bad debt cost.
We indicated on last quarter's call though we expected ARPU to decline slightly sequentially which it did as service ARPU fell $0.19 or less than 1% from the first quarter. This was a result of promotions which were partially offset by other rate favorability including the fee increase for Unlimited 411 Directory Assistance introduced in the second quarter. As we look to the third quarter, we do expect ARPU to decline modestly as a result of pressure from promotions.
Moving to slide 6, our direct cost of telephony services or COTS was $63 million, roughly flat sequentially and up from $51 million in the prior year as anticipated due to international long distance usage by Vonage World customers.
We continue to focus on driving down termination rates both internationally and domestically and that reduced our overall ILD cost per minute by more than 50% since the second quarter of last year and 7% sequentially. This represents approximately $20 million in cost savings on second quarter COTS had rates stayed at year ago levels.
We pointed out last quarter that ILD users of Vonage World carry a higher net present value than domestic only callers as the higher COTS is more than offset by the benefit of customers churning at less than half the rate of their domestic counterparts. As we continue to reduce our cost of delivering calls for these higher usage customers, they become even more valuable to us throughout their customer level.
Looking ahead, we are planning for an increase in total costs during the second half of 2010, as the usage from our growing base of Vonage World customers is expected to more than offset the savings on termination rates.
Direct margins of 66% were down from 69% in the second quarter of last year, reflecting the higher costs associated with the growth in these high-value international calling customers. On a sequential basis, direct margin increased by 1%.
Moving to slide 7, our continued focus on driving operating efficiencies and productivity improvements drove SG&A reductions of 15% to $61 million from $71 million in the year quarter, resulting in SG&A as a percentage of revenue of 27% down from 32% a year ago. Excluding one time severance and litigation cost incurred last year, SG&A was $5 million lower than a year ago.
We have lowered per line customer care cost by 21% during the past four quarters through our relentless focus on the operational elements of well executed customer care. Improving agent staffing levels, reducing the number of customer contacts through improved customer facing processes, as we transfer 29% fewer calls versus the prior year and we increased online self-service.
We will continue to pursue structural cost saving opportunities through our tactical initiatives process, which includes, for example a focus on increasing the percentage of our sales and support functions performed online.
You can see from slide eight that we generated $100 million or $13.89 per line in pre marketing operating income. We believe this metric particularly highlights the cash generation capability of our core business model. Turning to slide nine, we held marketing expenses flat with Q1 at $49 million for the quarter, adding 11,000 more gross lines than a year ago on 5% less marketing spend, resulting in 12% lower slack.
Sequentially we achieved the same 155,000 in GLA's on the same marketing spend resulting in identical slack of $318. While these GLA levels are lower than we hoped for coming into the year, we are pleased with the progress in stabilizing our customer base. As we look to the third quarter, we expect marketing spend to be roughly flat sequentially.
Slide ten depicts a substantial progress in churn which Mark highlighted. The 2.3% churn result this quarter were the best since the fourth quarter of 2006, and as Mark mentioned the lowest level in three and a half years and reflects improvement every quarter since Q3 of last year.
As we stated, these substantial improvements in churn are driven by two factors, a growing mix of ILD callers, churning at substantially lower rates and continuing progress in enhancing the end-to-end customer experience.
The strong churn results lead to a narrowing of net line losses from 26,000 last quarter to 5,000 in Q2, meeting the expectations for an improvement in net ads from Q1 to Q2 we'd set on the last earnings call. We are pleased with the positive results in stabilizing our customer base, as a relatively modest 5,000 line decline in this quarter, compares to more than 40,000 lines lost on average per quarter for the last year. We believe this progress in solidifying our base of both customers and cash flow provides a solid foundation in which we can build a compelling long-term vision for Vonage that Marc described.
Now let's move to discussion of our balance sheet and cash flow results, headlined by strong cash flow, continuing progress and paying down debt at par, a substantially improving net debt position and freeing up cash previously held by vendors. These results are summarized on slide 11.
Our operational results were indeed strong. We generated $93 million in cash from operations and increased total cash to $179 million at quarter end, which includes $54 million in restricted cash.
Capital expenditures were $12 million in the quarter and totaled $16 million year-to-date. We're still expecting full year capital expenditures to be in the mid-$40 million range. Free cash flow was $81 million for the quarter, although we would point out that this includes a substantial increase in cash due to changes in working capital which we would not expect to incur on an ongoing basis.
We're again pleased to report that we used the strong cash flow from this quarter to reduce our debt balance. As a reminder, the debt agreements provide that once our unrestricted cash balances exceed $75 million, which occurred during the first quarter, half of the calculated "excess cash flow amount" is offered to debt holders to retire the debt at par.
That process continues each quarter thereafter, with 50% of ECF offer to pay down first lien holders at par, and the remaining funds are then offered to second lien holders through a similar process.
Through this excess cash flow sweep mechanism, we made an offer to our debt holders to redeem $41 million of debt at par. While certain holders waived their right to receive their prepayment, others accepted the offer, reducing our principal balance by $18 million, $5 million and $13 million respectively for the first and second liens.
While the full amount of the offer was not taken, we're pleased to have redeemed this additional debt at par through the ECF mechanism. And we believe that the holder's interest in maintaining their position is an indication of their confidence in the company's performance. After giving effect to the net debt pay down, the principal balance remaining on the first lien is $99 million and the second lien is $87 million. The combination of this debt pay down over the last two quarters and our strong cash generation has resulted in a substantial reduction in net debt in recent quarters.
Slide 12 reflects that our net debt defined as gross debt less unrestricted cash and the $30 million concentration account, sat at $197 million a year ago. And it's been reduced to $72 million as of the end of this quarter, yielding a 0.5 times net debt leverage ratio, calculated as net debt divided by trailing four quarter EBITDA.
Combined with actions taken in Q1, we have reduced our debt by $41 million, resulting in interest expense savings of $4 million in 2010 and $33 million over the life of the loan.
We do not anticipate generating the same level of excess cash flow again next quarter, primarily due to the contribution from working capital changes this quarter but we do remain focused on continuing to improve our capital structure.
As we said in the past, we are comfortable that we can continue to satisfy our debt obligations. That said, this early debt retirement is great news and is part of our continuing focus on opportunities to reduce our debt. We continually assess our capital structure and from time to time discuss with lenders the opportunities to repay, refinance or revise the terms of our credit agreements but of course, there can be no assurance that such efforts will be successful on terms acceptable to us or them.
One final note on the balance sheet is the progress we made in freeing up restricted cash during the quarter. We highlighted on the last earnings call what we believe to be an opportunity to reduce the non-debt portion of restricted cash and successfully released $29 million in deposits during the quarter. Through discussions with our vendors and as a result of the improvement in our credit quality, $17 million in previously restricted cash was released in the second quarter and $3 million released just after the end of the quarter.
In addition, our device manufacturers returned $9 million that was classified in other long-term assets which also contributed to the excess cash flow generated during the quarter. We are very pleased to have been able to release this cash as a result of our sustained positive financial performance.
In summary, it was a very strong financial quarter operationally, and for the second consecutive quarter, we made substantial progress on the balance sheet leading to significant interest expense savings. With the stabilization of our customer base, we expect third quarter revenue to be roughly flat year-over-year and down slightly sequentially, largely due to the impact on ARPU from promotions as we described.
Our expectations for third quarter EBITDA are for a year-over-year growth but it was modest decline sequentially due to growth from the base of Vonage World subscribers, the continuing impact of promotions and increased investment in new products. We continue to expect next generation Vonage services to meaningfully impact revenue beginning in 2011.
And now I'd like to turn the call back over to Leslie and we'll be happy to address your questions.
Thank you Barry. And now operator, please open the line for questions.
Thank you. (Operators Instruction). Our first question is from Michael Rollins of Citi Investment. Your line is open sir.
Kevin Toomey - Citi Investments
Hi good morning, this is Kevin Toomey calling from Mike Rollins. Just one question, how long can we expect CFFO to stay above OIBDA less interest expense, is there a reversal coming and what should we expect for the second half of the year? Thanks.
Kevin, can you please repeat the question?
Kevin Toomey - Citi Investments
How long can we expect CFFO to stay above OIBDA less interest expense? And is there a reversal coming and what should we expect for the second half of the year?
Kevin, we expect continuing solid EBITDA performance, we expect as we continued to reduce half of the interest expense service obligations that we will continue to be able to be in very good shape there on the interest expense. So as we look forward, we would expect the solid financial performance from OIBDA, continuing progress on interest expense. And as we discussed, we will continue to look at opportunities to recapitalize the balance sheet to the extent that they are available to us.
I think the progress the company has made financially enables us to refinance the debt at certainly lower interest rates today than we are currently paying based on very different capital market situation, now versus 2008 and also the continuing strength of the company's financial performance.
Kevin Toomey - Citi Investments
Okay, thank you.
Next question operator.
Thank you. Our next question is from Mike Latimore of Northland Capital. Your line is open, sir.
Mike Latimore - Northland Capital
Okay thanks, pitching on the churn improvement again, is the current churn level sustainable or is there more potential improvement there?
Hey Mike, it's Marc. As we look at the changing mix of our customer base and the increasing penetration on the World product which churns at lower levels, we do think there is some opportunity over the long pre-term to get some additional improvement. You never know what can happen as long as customer service quality and network quality remain improving to constant, we think we are in pretty good shape.
We don't see any real bubbles on the horizon that give us any significant cause for concern, but I don't think that you’re going to see the kind of year-over-year improvement that we've seen this past year, but we're optimistic that we can get the number lower as we go into 2011. I would caution you though that there is a little bit of seasonality in the quarter versus the second quarter with relocations of people, so you think about that as a long term trend.
We expect from that year-over-year comparison to be exceptionally favorable.
Mike Latimore - Northland Capital
I get it, how about the -- for Vonage World offering, what percent of the gross subscribers that you're seeing are coming in on Vonage World and what percent of the base is on Vonage World now?
In total it's roughly around 80% that are coming in on Vonage World. We have now roughly a third of our customer base on the Vonage World plan.
Mike Latimore - Northland Capital
In terms of just the gross subscribers adds in the quarter, were they as you were expecting in terms of your internal plan?
It was close; we actually were uncertain what we'd expect to see in the four week time of the low end rate plan. We'd not been at that price plan before with a capped number of minutes and we got a lot of learning and experience there. The quality of customers coming in was much higher. Folks have a huge willingness to actually shop online, which is really encouraging for us as we think about out distribution strategy going forward.
We need to see what their acceptance is, what the usage levels are over the next few months and what their long term churn profiles are, but we’re not far off of what our expectations were. We had said last quarter we'd expected to improve our net and we did, year-over-year was significantly better, but as always until we are well into the black, we are not satisfied with the progress.
Mike Latimore - Northland Capital
Okay, and then on your mobile app for Facebook announced today, can you talk just a little bit, give more clarity around how you will monetize that? Because it's obviously a free app right now.
Sure. So as I said before this is just a start. You know our philosophy is different than many other player in our space, we view the world as one, where you don't need numbers, any user identity that connects to any digital community should be able to be exposed and to deliver any communications feature, not just voice.
As we've talked in the past we think there is significant opportunity in the messaging business, where the mobile model is largely one of charging for SMS and then again for data traffic as separate packages. We think that the ability to unleash multiple communities over time as well as being able to create ad hoc communities and bring in or get a contact book as well, gives us an opportunity to provide a much lower cost service with greater feature functionality and value, including message link, attachments, that don't have limitations of instant messaging that requires presence.
So, we think the large SMS marketplace globally is a place where there is opportunity for significant revenues. To other places, we think that there is a lot of opportunity in premium services. Once you start to create communities and services that gives everything from visual voice mail to other enhanced services on customization and personalization, help people connect with one another, we can create some unusual models as people start to try to entertain and engage their friends as they are making phone calls or other contacts.
And lastly, while people no longer need to have phone numbers, we certainly expect that off-net calling to mobile termination numbers and the PSTNs is going to happen at the global level for an extended period of time. There is a long tail there. And certainly for international, we expect significant revenue opportunities to do off-net calling. So, that's a few of them and we also expect that the communities expand and not everything would be free service.
Mike Latimore - Northland Capital
Okay. Thanks a lot.
Thank you. (Operator Instructions)
If there are no further questions, operator. We would conclude the call. Thank you for joining us today.
Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Have a wonderful day.
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