Who hasn't heard of Vonage (NYSE:VG)? One of the pioneers of the voice-over-IP (VoIP) telephony business, the company came to prominence with aggressive marketing and rapid revenue growth in the middle of the last decade. It also earned infamy in the investment community, badly botching its 2006 IPO by soliciting its customer base to participate, fighting off patent infringement lawsuits from several wireless carriers, delivering massive net losses, and also working up an ugly balance sheet with crippling debt terms and dilutive stock warrants.
So you can imagine my surprise when the stock showed up recently in the Magic Formula Investing lists. Like most, my impression of Vonage was formed from the highly negative coverage of the stock several years ago. But after some research, I believe the firm no longer deserves such a bad rap. Let's take a look.
For those who don't know, VoIP is a service that allows you to make phone calls over an Internet connection instead of a wireless voice network or traditional landlines. VoIP calls can be made over any Internet connection, be it cable modem, DSL, or 3G/4G wireless data networks, using an array of devices including telephones (with an adapter), cell phones, PCs, and so forth. VoIP services such as Vonage's generally include wireless-like features such as caller ID, call waiting, visual voicemail, etc. Vonage has about 2.5 million subscriber lines, about 95% of which are in the U.S.
The main allure of VoIP is the lack of long distance charges. VoIP-to-VoIP connections are usually unlimited for a single price, while VoIP-to-landline or wireless calls may involve an extra fee as it requires 3rd party carriers to connect them.
Given this fact, Vonage changed its marketing strategy in 2009. Previously focused on broad national marketing, the company introduced the Vonage World plan, with unlimited calling domestically and to over 60 countries including India, Mexico, and China. This makes the service quite attractive for recent immigrants or students with friends and family overseas. By focusing its marketing on these groups, Vonage has gotten a lot more bang for its marketing buck. From its introduction in the 3rd quarter of 2009, Vonage World now accounts for about 43% of all subscriber lines. New services such as Extensions and Time to Call are aimed squarely at the international calling customer. At the same time, marketing spend is down 29% from 2007 while revenues have held steady.
Operational improvements have been another part of the story. From 2007, gross margin has improved to 67.5% from 62.8%, and SG&A costs are down over 20%, in addition to the marketing rationalization. As a result, Vonage has gone from sizable operating losses to a current operating profit margin of 10.7%. This trend is still going. In the past two quarters, continuing cost improvements have delivered operating margins of 13.6% in Q1 and 14.3% in Q2 this year. This is no longer a money losing outfit - the company is firmly profitable.
The third major change here is in financial strength. A quick look at the balance sheet might raise concern - total debt is $126 million vs. $63 million in cash, and interest charges are covered only 2.7 times by cash flow (I like to see at least 5 times). However, the company is now generating close to $100 million in free cash flow annually - plenty to cover or even pay down the debt. In fact, $50 million has already been repaid early this year. A second refinancing in August cut the interest rate on their debt from 8% over LIBOR to just 3.5% over - a massive improvement that management believes will save the company $43 million in interest expense over 2010. As a result, coverage ratio should improve to over 15 times, in plenty safe territory. This also directly influences the earnings per share number the company will report going forward.
Now, with all that said, I still don't find Vonage to be an extremely attractive stock at current prices near $3. Despite all of the operational improvements here, growth is going to be a challenge. Vonage has lost a net 8,000 subscriber lines so far this year. The competition is brutal - cable companies are bundling VoIP with broadband and TV, and several free VoIP services (such as Skype and Google Voice) challenge the company's pricing.
Finally, Vonage has a history of being highly dilutive with stock options and warrants. Share count is up an alarming 57% since the IPO. While this will surely moderate, until we start seeing share buybacks it is a concern.
Given the fact that recent profit growth is not based on revenue growth (which is falling about 1-2% annually), I can't see Vonage being worth much more than $3 over the long term. This makes the firm just about fairly valued at current. It doesn't make the cut as a Top Buy candidate.