Vonage Holdings Corp. (NYSE:VG) Q4 2011 Earnings Call February 15, 2012 10:00 AM ET
Leslie Arena – Vice President, Investor Relations
Marc Lefar – Chief Executive Officer
Barry Rowan – Chief Financial Officer
Michael Rollins – Citi
Mike Latimore – Northland Capital
Robert Routh – Phoenix Partners Group
Brian Hurray – Analyst
Good day, everyone. And welcome to the Vonage Holdings Corp. Fourth Quarter 2011 Earnings Conference Call. Just as a reminder, today’s call 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 Ms. Arena.
Thank you. Good morning. And welcome to our fourth quarter and full year 2011 earnings conference call. Speaking on our call this morning will be Marc Lefar, Chief Executive Officer; and Barry Rowan, CFO. Marc will discuss the company’s progress and strategy and Barry will review 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 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 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 slides and contained in our SEC filings. We caution listeners not to rely unduly on forward-looking statements and disclaim any intent or obligation to update them.
During this call, we will be referring to non-GAAP financial measures. A reconciliation to comparable GAAP measures is available on the IR website.
And now, I will turn the call over to Marc.
Thank you, Leslie. Before I review our results and provide our outlook for 2012. I’d like to provide an update on the response we’ve seen to our new Vonage Mobile app, which we launched last week.
Vonage Mobile, the most exciting product we’ve offered since the launch of our initial VoIP service and continues our heritage of offering innovative products to deliver great value and convenience to customers. If you have not yet downloaded the app or seen last week’s press release, let me take a moment to describe it for you.
Vonage Mobile is a free downloadable application for iPhone and Android that lets users make free high-definition calls and send free texts to all users of the app worldwide. It works over Wi-Fi, 3G and 4G wireless data networks. When calling people who don’t have the app, users get ultra low-cost calling worldwide with pay per-minute rates that are on average 70% less than major 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. Early interest has been extremely positive. There have already been over 500 stories published globally and we’ve substantially exceeded our pre-launch expectations of 100,000 downloads in the first week. Most user reviews have been very favorable. We plan to release improvements in new features every few weeks.
Vonage Mobile combines the best of free voice and messaging services with exceptional high-definition audio and incredible value for traditional international calling all while using the existing mobile number and address book. If you haven’t downloaded the app, I encourage you to do so and let us know what you think.
The successful development and launch of Vonage Mobile is an emblematic of the strategic and operational progress we’ve made transforming our company.
As we close out one year and begin the next. I would like to provide some context for where we are and how far we’ve come. Over the last three years we have completely transformed the operational, financial and strategic dimensions of our business.
Operationally, we’ve graded -- upgraded systems, streamline processes, improved the customer experience and stabilized our subscriber base. Through these efforts we’ve dramatically improved our operating and financial results, driving over $200 million in EBITDA improvement, while significantly improving customer satisfaction ratings.
A lowering churn from highs of nearly 3.5% will reduce customer losses from 155,000 in 2009 to 30,000 in each of the past two years and operational improvements have enabled us to lower our cost structure to its low level in six years.
Building on our sustained operational 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 cut our overall debt level by two-thirds saving $43 million in annual interest expense.
Not that long ago our business were unprofitable and burning significant amounts of cash. In 2011, our business generated nearly $100 million in net income and for the past two years it has generated more than $100 billion in free cash flow. And the decision to account for our $800 million in net operating losses as a deferred tax asset this quarter reflects our strong profitability and expectations for continuing future income. Many did not think these results were possible.
Perhaps more settled, but equally important shift has been on a strategic front. In 2009, we identified an opportunity to leverage our technology and position in the domestic home phone market to concentrate on international long distance callers, which led to the introduction of Vonage World.
This calling plan is grown into our flagship product representing more than 70% of new customer additions. Approximately half of our customers are now on the Vonage World plan and approximately 35% of our entire customer base are international long distance callers.
As our emphasis on international callers and sales of Vonage World increased, service ARPU grew, service ARPU has increased by 9% cumulatively over the three-year period. In parallel, we drove structural cost reduction throughout the company, enabling us to absorb the cost of our dramatic growth in international long distance minutes while maintaining direct margins at 68%.
Over the past three years, we have lowered international and domestic termination rates by more than 25%, reduced customer care costs per line by 29% and cut the cost of our devices by nearly a third. Together, these initiatives helped to improve EBITDA from a nearly $50 million loss in 2007 to a positive $168 million EBITDA during 2011.
While we largely offset general market trends in declining domestic phone service, meaningful revenue growth has not materialized as quickly as planned. For 2011, service revenue at $867 million was basically flat from 2010. We must do better.
Quality revenue growth is our top priority for 2012. Allow me to show our plans for executing on that priority. With the company now in a solid foundation operationally and financially, the time is right to accelerate our investment in our key strategic growth initiatives.
In 2012, we will invest in the following areas, the heart of our growth strategy. The first is international long distance. Where we will continue to penetrate ethnic calling segments and grow subscribers through our retail channels including event teams. The second, mobile services, which builds on the Vonage Mobile platform, and the third is international expansion, as we plan to enter new geographic markets outside North America and the U.K.
These planned investments relate the groundwork for success in new markets as we increase our organizational capacity and launch new services. We will invest in areas such as product development resources, business development talent, network enhancements and marketing. We plan to invest in a range of $5 million to $10 million per quarter above 2011 levels. Of course, we will tightly manage this increased spending with the same financial discipline that’s driven our financial turn around.
A substantial portion of these investments will be success based allowing us to redirect or reduce investment levels if target results are not being achieved. Reflecting the additional investment and strategic growth initiatives, we expect to generate EBITDA of $30 million to $35 million per quarter during 2012 and $100 million to $140 million for the year.
With these initiatives in their early stage of execution, it’s too early to predict their level of success. However, we are targeting large markets with a robust technology platform and a well-recognized brand. We believe these growth initiatives have the potential to achieve over $100 million in annualized revenue within two to three years.
Let me now discuss each of the growth initiatives in little more detail. We continue to execute on our strategy to penetrate international calling segments and have substantially grown our base of international callers over the past three years.
The success reflects the prioritization of our marketing, sales and customer care teams to target and support International callers. In the past two years, we have increased our bilingual support by opening three new sales and service centers.
In 2011, we grew our Hispanic calling base by more than 50% through highly targeted marketing vehicles, more relevant messaging and enhanced products. We continue to have ample runway to grow our international base, 10% to 15% of all U. S. households are moderate to frequent international callers using a mix of both home and mobile phones.
The majority of these callers are paying three to four times the rate they could be getting from Vonage and the average Hispanic international callers spends $40 to $50 per month on international long distance service.
With Hispanic comprising 16% of the U. S. population, this large and rapidly growing segment continues to be an attractive opportunity for us. While the opportunity is significant, churn profiles for this segment are higher than other segments, partly due to socioeconomic factors. To help produce churn, we are evaluating a range of initiatives including alternate payment vehicle that would allow cash transaction.
In 2011, we significantly expanded our retail distribution through new retail partnerships with Best Buy, Kmart and Sears we doubled our store location to 6,000. We also now have nearly 60 event teams, up from six in January of 2011, operating in ethnic concentrated markets across 18 states including California, Texas, Florida and New York.
These performance base selling teams market and promote Vonage service a Hispanic and Asian-Indian events and community gathering places. In the fourth quarter, retail sales comprised 19% in gross line additions, more than double the 8% level of the first quarter.
During the fourth quarter, gains in this channel partially offset by softness in other channels, resulting in flat sequential growth line additions. However, for the full year growth line additions were up 5% over 2010. In 2012, we expected sales more expanded in direct channel will grow to more than 20% of gross line additions.
Our focus on mobile builds on our success targeting international long distance callers in the U. S. The power of this opportunity comes from leveraging our international long distance experience and termination rates, which are among the lowest in the world, along with fundamental market trends including increasing global access to broadband networks and Wi-Fi, accelerating smartphone penetration and consumer comfort with downloadable applications.
Our mission is to be a leading provider of low-cost communication services connecting people through broadband devices worldwide. To that end, last August we introduced a very successful extensions product, which enables Vonage VoIP subscribers to extend calling through mobile phones and now with Vonage Mobile, we build on all our previous apps to provide a compelling, all in one, on-net and off-net voice and messaging service.
With Vonage Extensions and Vonage Mobile, we are rapidly establishing the company as a leading provider of quality mobile voice and messaging services. We’re very pleased with the early success of these products. Vonage Extensions is clearly struck a chord with customers and now has nearly 500,000 users and Vonage Mobile is off to a great start.
Future releases will integrate MMS, a low-cost international roaming capability and/or extension service and we continue to evaluate the benefits and technical options for mobile video as well. Many other features and improvements are on the roadmap this year.
Our final growth initiative is geographic expansion. The global consumer communications market outside North America is more than $200 billion and it’s growing at nearly 7% per year. We plan to capitalize in these opportunities and expand our geographic footprint primarily through partnerships and we expect to announce our first partnership soon.
We plan to announce an international friends and family offer, whereby we exchange and terminate traffic with the foreign carrier jointly providing lower rate to consumers, while expanding our customer base and that of our partner.
Additionally, we are actively exploring the delivery of full VoIP communication services to be marketed and distributed as a compliment to an existing foreign provider’s product suite.
In 2011, we assessed the market landscape and put strategic plans in place to guide the execution of our growth initiatives. We built out our R&D capability in Israel, began to staff our international expansion team and accelerated the number of new products we are bringing to market.
Our core business has been stabilized and is generating significant cash flow. We’re now focused on the next phase of our transformation and we are pleased to be in a position to invest in opportunities in attractive new markets. We believe customer interest in Vonage Mobile is evident that we are making the right investment.
Before I pass the call to Barry, I’d like to thank our dedicated employees who enabled our transformation. They work tirelessly to enable us to reach this point and I look forward to announcing continued progress toward our key objectives through 2012.
And now, I’ll turn the call over to Barry who will review our financial performance in greater detail.
Thanks, Marc, and good morning, everyone. I’m pleased to review our financial and operating performance this year. In 2011, we delivered record high financial results and continue to build on the earnings and cash flow momentum established over the past several years.
For the fourth consecutive year, we generated positive and growing EBITDA, and for the third consecutive year, we reported a positive and increasing net income excluding adjustments, which more than doubled from 2010. We have improved our balance sheet dramatically through the two transformative refinancing we completed over the past 14 months.
Our strong operating performance and lower interest expense combined to generate $108 million or $0.48 per share in free cash flow. This was our second year of positive free cash flow and each year generated over a $100 million.
With our core business now stabilized and highly profitable and with a fresh balance sheet, we are well-positioned to execute on the next phase of Vonage’s transformation through accelerating our investment and the strategic growth initiative Marc outlined.
Let me now move to review our financial performance in getting on slide three. Our results in fourth quarter were generally comparable to those reported in the third quarter of 2011. In the fourth quarter, we generated EBITDA of $40 million, our fifth consecutive quarter of EBITDA at or above $40 million.
For the full year, we grew EBITDA to a record high, a $168 million achieving our guidance of at least $165 million provided on our first quarter earnings call last year, which represents a 7% increase over the prior year as we delivered operational improvements across most segments of our business.
Through an aggressive focus on driving operating efficiency we reduced the unit cost of devices by approximately 10%, lower cost of telephony services by 3% and reduce customer care costs per line by 11%.
We generated these strong results even as we absorbed a $15 million increase in the cost of telephony services from our targeted international long distance users, who generated more than 20% higher minutes of use than during the prior year.
Moving to slide four, in the fourth quarter we reported net income of $25 million or $0.11 per share excluding adjustments, up from $15 million or $0.07 in the prior year’s quarter and an increase from $24 million or $0.11 sequentially.
Net income more than doubled for the first year growing to $96 million from $47 million in 2010 excluding adjustments. This is our third consecutive year of positive and growing net income, excluding adjustments reflecting a continue improvement in operations and sharply lower interest expense, which declined $31 million from 2010.
Let me take a moment to discuss the release of our net deferred tax asset valuation and the associated impact on our financial statement. Accounting rules require that we record a valuation allowance against our net deferred tax asset, if we determine that it is more likely than not, that we will use the net operating loss carry-forward prior to their expiration. Until the most recent quarter we have recorded a valuation allowance that reduced our net deferred tax asset to zero.
In the fourth quarter of 2011, we concluded that based on past profits as well as our expectation for future net income generation, it is more likely than not that we will use our NOL carry-forwards prior to their expiration.
Therefore, we released the related valuation allowance against our United States and Canada net deferred tax assets and now recognize the value of the NOL as an asset on our balance sheet. This resulted in a non-cash income tax benefit of $326 million and a corresponding net deferred tax asset of $326 million as of December 31, 2011.
Please note that while this accounting adjustment will lower net income in the future by the effective tax rate it will not effect the cash taxes paid by the company, which will continue to be offset by the approximately $800 million and net operating loss carry-forwards we had at the end of the year. The net result is that we expect to recognize income tax expense in 2012, but this will be a non-cash expense.
Reflecting this one-time gain of $326 million, GAAP net income for the quarter was $350 million or a $1.55 per share, which was up from a net loss of $42 million or $0.19 per share in the year ago quarter and up from net income of $60 million or $0.07 in the third quarter, both of which included charges related to refinancing our prior debts.
As you can see on slide five, total revenue for the quarter of $260 million was stable relative to both the sequential and the prior year’s quarters, declining less than 1% from each.
On an annual basis, total revenue declined to $870 million from $885 million in 2010 primarily as a result of a $12 million reduction in deferred revenue from legacy activation fees. These were largely paid out in mid 2009 to provide more straightforward pricing for our customers and this non-operating issue does not impact EBITDA. Equipment and shipping revenue declined $8 million as we no longer charge for customer equipment.
We continue to strengthen the quality of our customer base and revenue mix as we grow the number of customers on Vonage World, which now comprise approximately 50% of our base. 35% of our total customer base are now international long distance callers to make at least 20 minutes of ILD calls per month.
While the cost of telephony services for these customers is higher due to their long distance usage, they are attractive customers as they typically churn at lower rates than domestic callers.
Aided by the mix of Vonage World subscribers we have increased average revenue per user or ARPU in each of the past three years. For the fourth quarter telephony services’ ARPU was stable sequentially at $30.12.
On an annual basis, service ARPU increased to $30.22 and is up 9% since 2008. As we have attractive customers on higher rate plan and selectively increased prices as we enhance the value of our offering by adding features, such as unlimited calling on one call and Vonage digital voicemail.
Please turn to slide six. We added 169,000 gross lines in the fourth quarter on par with both the fourth quarter of last year and sequentially, while we’ve been pleased with the increase in sales to our retail channel, which was largely offset to declines in other channels, resulting in a minimal change to overall results in the fourth quarter.
Reflecting progress adding Vonage World customers and in line with our guidance for higher gross line additions per year, GLA improved by 5% to 672,000. We improved our marketing yield by 2% in 2011 from 2010 as subscriber line acquisition cost declined from $310 to $304 for the year. We required more customers to our lower cost retail channels.
Fourth quarter churn of 2.7% was flat compared to the third quarter. While we saw some benefit as planned from customers and their 13 to 15 months of no contract is gaining to offset by higher churn in some international calling segments.
But typically churns tends to be higher among our growing base of Hispanic subscribers relative to other international callers as Marc described, and we saw some increased competitive pressures in other ethnic segments.
As you may recall, we eliminated contracts in September of 2010, creating upward pressure on churn during the subsequent 12 months. In the first quarter, we have been providing customers a choice, offering those entering into a service agreement, a promotional discount in place at that time.
Increases in churn in the second half of the year led to full year churn of 2.6%, which matched the full year guidance we provided on the last earnings call. However, disappointed with the 20 basis points increase in churn from prior year, we believe reinstating contracts will help mitigate some pressure on churn during the later part of 2012.
The combination of slightly lower gross line additions on flat churn resulted in 14,000 net line losses in the fourth quarter, an increase of 5,000 lines loss compared to the third quarter of 2011. A 30,000 in net line losses for the year were stable with the level we experienced in 2010.
As we discussed, our strong EBITDA results for the year resulted from a combination of stable ARPU and an aggressive focus on operational improvements, which has substantially improved our cost structure.
Moving to slide seven, in the fourth quarter cost of telephony services or COTS of $59 million are flat sequentially and up $1 million from the same quarter a year ago as we increased the number of international long distance callers. On a per line basis cost of telephony services was $8.24 flat sequentially and up from $8.06 a year ago. We maintained direct margins of 68% both sequentially and compared to the prior year’s quarter.
For the full year of 2011, the total cost of telephony services was a very strong story beating our internal target. We reduced total cost to $236 million from $244 million in 2010, driven largely by a 38% decline in domestic termination cost, structural cost improvements, which helped to offset the rate of growth in cost for international callers and E911 vendor consolidation, let’s say, $4 million annually.
Going forward, we expect growth in cost from continued increases in international long distance calling due partially offset by the next-generation call routing and peering relationship we are implementing.
On slide eight, SG&A of $59 million in the fourth quarter was flat year-over-year and sequentially. On an annual basis, our focus on driving efficiencies throughout our operations resulted in further improvement in SG&A, but the SG&A declined 2% to $235 million during 2011.
In 2007, we’ve lowered SG&A by$87 million or 27% as we have made operational improvements in virtually every area of the business. The substantial portion of these savings has come through improvements in our customer care operations. We reduced care costs per line 11% in 2011, on top of the more than 20% reductions in each of the prior two years. These gains in 2011 came from improving first on tax resolution and our call handling efficiency.
We see further opportunities for gains including, for example, improving customer contacts to best-in-class level, additional reductions in customer handle time and through more customers accessing our online account management system, which we continue to enhance.
Moving to slide nine. While marketing expenses roughly flat sequentially, we continue to optimize the mix of media and channel expenditures to meet our marketing objective. For the year, marketing expense increased $6 million or 3% to $204 million, primarily related to the expansion of our retail channel. The increase in spending as I mentioned contributed to the 5% increase in GLA.
Now let’s move to a discussion of our CapEx, cash flow and balance sheet. For the second consecutive year, we generated significant cash flow through the combination of ongoing operational improvement and the benefit of our debt refinancing.
Looking at slide 10, CapEx for the year totaled $39 million in line with our guidance for CapEx not to exceed $40 million. During 2012, we expect capital expenditures including information technology infrastructure investments to remain at comparable levels in the $40 million to $45 million range.
We are pleased to report that we generated a $108 million in free cash flow for the year, meeting our guidance of at least $105 million. Free cash flow grew 27% from the prior year after eliminating the impact of a $59 million setting in working capital as 2010 benefited from prior year purchase discount. We reduced interest expense by 65% from 2010 to $70 million, which contributed meaningfully to the strong performance.
We exit 2011 with a pristine balance sheet characterized by low leverage and low interest rate. Total leverage is 0.5 times debt-to-EBITDA and allowing for the cash on the balance sheet, net debt was $30 million or 0.2 times. The interest rate on our term loan is at LIBOR plus 325 basis points based on our leverage ratios.
Now that we have stabilized our business, are generating meaningful cash flow and are operating with a completely fresh balance sheet, we are in a position to invest in the strategic growth initiatives Marc has described.
While most of the investments will be in the category of the SG&A, our efforts include a broad organizational realignment as we start to expand our product development capabilities, ensure that we have the requisite skills to market our product, enhance our network to accommodate worldwide mobile calling and add capacity to develop additional business partnership.
Again, we expect these increased investments to range from $5 million to $10 million per quarter versus 2011 levels. We will certainly manage this additional funding with the same discipline that has characterized the company’s financial turnaround over the past several years.
Reflecting these increased investments, we are targeting $30 million to $35 million in quarterly EBITDA throughout 2012. We have established this range of guidance to provide appropriate flexibility to manage the investment of our growth initiatives as they develop during this year of strategic transition.
We believe that redoubling our commitment to achieve quality, sustainable revenue growth through these initiatives represents a high priority use of a prudent portion of the strong cash flow we are now generating from our core business. Even with this increased level of investment, we expect to add cash to our balance sheet during 2012, while of course meeting our obligations under our current debt agreement.
Based on these plans, let me reiterate our guidance for 2012, EBITDA of $30 million to $35 million per quarter and $120 million to $140 million for the year, reflecting additional investment in strategic growth initiatives, capital expenditures in the range of $40 million to $45 million.
Thank you again for your interest in Vonage. And now, I’ll turn the call back over to Leslie to initiate the Q&A session.
Thank you, Barry. Operator, please open the line for questions.
Thank you. (Operator Instructions) Our first question comes from Michael Rollins of Citi. Please go ahead with your question.
Michael Rollins – Citi
Hi. Good morning. Thanks for taking the questions. I think, three if I could please. The first one is, Marc you mentioned the success of the new application in terms of, I think you mentioned over 100,000 downloads in the first week. Can you share with us how that compares to the last couple of mobile product launches that you’ve done and how we should think about the way they should ramp?
The second question I had was you also described an expectation for incremental revenue, I think you said within the next few years of $100 million. Can you talk about what the margin potential for that is and how to think about the cash contribution from that type of revenue growth?
And then finally, if you could just talk about the churn and what’s keeping the churn elevated from where it was earlier in the year and yeah, maybe where initially you’re hoping to get that number down too? Thanks.
Sure, Mike. And thanks for the questions. Let me take them in order. On Vonage Mobile, just to clarify we had some in going expectations that we will be pleased if we were able to generate 100,000 downloads with basically virtually zero marketing spending in the first week.
We’re blown by that number by several fold and are pleased with the traction. It’s very difficult and something is only a week old to look at the viral nature and how it’s spreading. But the expectation for us at this point based upon how it compares to other application, in day five for example, we were seeing that, that acceleration was doubled what the kind of downloads were from day one.
That’s a very different dynamic than what we saw, which is more straight line, continuous motion from prior applications. That combined with increasing positive rating exposed in the Android market and in the iTunes store, as well we’re seeing in terms of number of invited friends that people now have, they can talk on net gives us some optimism that we think this could grow pretty quickly and it would not be unrealistic for us to hit ballpark of 1 million downloads by end of quarter, certainly at current courses speed.
Again, I want to warn folks that it’s only a weekend to it, very difficult to forecast a trend based on when we -- we are encouraged with the early signs and it’s growing much more quickly than our previous experience.
Let me hit the churn comment and I’m going to ask Barry to talk about the margin potential on the $100 million of new revenues. From a churn standpoint, as you know, one of the drivers that causes an uptick in churn over the past year was the elimination of contracts and service agreements.
We are putting that back in place this week and we expect that will start to give us some improvement in the back half of the year as a greater percentage of our customer bases on contracts. So, we have that and we can model that.
The other elements of the mix, the Hispanic customer base has a higher churn profile, frankly than we expected to be and obviously it’s grown much more quickly during the year.
Let me break down a couple of the areas for churn. Just for clarification, although there has been a mix in terms of where some of the churn rates have gone, our non-Hispanic domestic callers that churn rate has been dead flat for the last five quarters. So, there is virtually zero change in that portion of the customer base.
The largest single increase in churn has come from Hispanic customers break that into two pieces, domestic and international users. The domestic Hispanic customers are churning at extremely high rates. They’ve increased dramatically over the last few months and we see that as being a look at them after the fact as really socioeconomic issues.
It’s evidenced by having poor or unscoreable credit and as we talk to these customers, we understand it’s an issue of trying to manage their finances on debit cards and credit cards pretty much on monthly basis. So, automatic charges to those cards tend to be the kinds of things that cause them problems and throw them in to great status and suspend.
So we’re trying to work on different types of structures, the calling plans, as well as alternate payment vehicles that we think can help to improve that churn. There is definitely high level of satisfaction and desire for the product but this is getting to an ability to pay for that product that we need to try to manage.
In the international Hispanic segment, that is much, much lower churn rates, it parallels the international versus domestic differentials we’ve shared with you in the past. But it has also increased for some of the same reasons.
It’s still quite lower, quite a bit lower than our average, but because there is a large number of Hispanic international customer’s it’s increasing the average. Many of the same kinds of tactics that we’re pursuing in the domestic market, we think will help in the international area.
The final area that had an impact for us particularly in the fourth quarter and we’ve actually seen improvements here in the first month of the year as we’ve taken action, has been competitive smaller focused promotional offerings going after Asian-Indian customers. So, there are couple of small branded players using everything from prepaid to digital, virtual calling cards that have been aggressive in targeting our Asian-Indian base in the fourth quarter.
Candidly, we did not have particularly good retention offers for those customers. We now have the ability to real time re-rate or match and provide alternate rate plans when necessary to meet competitive offers, and we’ve seen that starting to improve our business in the fourth quarter.
In terms of guidance, there are a couple of things that cut both directions. So, the Asian-Indian churn levels we feel that we’ve got that in check. We feel like that’s moving in the right direction. We definitely expect to see benefit from the return to service agreements or contracts, and we believe that the movement in the domestic core business has been quite stable as has the non-Hispanic international group.
The wildcard is on Hispanic churn rates, can we -- the actions we put in place help us meaningfully and are there other wildcards that might come in the marketplace that could create some down -- some upside pressure to churn.
On the whole, we think that you should be thinking about roughly stable churn throughout the year with certainly improvements in the back half of the year relative to the front half. Sorry for the longwinded answer, but I’m sure that it’s on everybody’s minds, I wanted to give as much color as we could.
Michael Rollins – Citi
That’s very helpful. Thanks. And then on the margin potential for the $100 million?
Yeah. Let me speak to that, Mike. So let me start with, I mean, the revenues, we do see as having that kind of potential through a combination of the strategic growth initiatives between both the mobile services business, as well as expansion outside of the U. S. So since we’ve just introduced Vonage Mobile products, let me talk about that margin potential and how we think about it.
And first is, we have very low termination rates as you know, which enabled us to be able to price at the kind of levels that we described and we have priced this for penetration. The real objective here is to build a community, because that’s really when you get the revenue potential to start to grow once you get that community build, people start making those off-net calls, which is the primary source of revenue in the early stages.
So with our low cost and termination, we have been able to price this in a way that gives a good incremental contribution margins in the range of our current core business. So and overtime, what we’ll have to monitor is how the market evolves.
So, as I mentioned, it’s priced to be able to drive downloads. We will continue to evolve the business model over time as we look, for example, at various alternatives or payments and the like. So, but the strategy is to be able to price it now, to drive penetration to make acceptable and attractive contribution margins and then, we will evolve that over time as we see the overall user base grow.
Michael Rollins – Citi
Great. Thanks, just a follow-up for one more moment, I apologize for asking so many questions. But just in terms of, you guys obviously get a lot of valuation of the incremental investment relative to the incremental returns. And it seems like the story for Vonage over the last couple of years has been about looking to develop this optionality that you have to move into new markets, while harvesting the cash out of the home replacement business, if I have that right?
And it seems like now you are willing to take some of that home replacement cash and really get more aggressive for these new sources of growth. So, as we’re trying to evaluate returns for that, I mean is there a way to think about maybe the rate of return you should get that over a five-year period or just the ability to generate long-term margins where you are today or better. Any further thoughts on that will be just incredibly helpful? Thanks.
So, Mike, let me take the front end of that in terms of the framing, I had to think about what we’ve been doing, where we’re going. You’re largely correct in stating that we have over the last couple of years had to get to a point where we had the stable -- the stability and the cash flow that gave us this optionality to begin to invest and we saw, well, the time is right, we had the organizational capacity, the product and understood the markets.
It was not long ago when we didn’t have even the flexibility of indebt covenants to be able to ride very far away from a very specific set of financial metrics that had very high pain thresholds, if we were to miss any kind of numbers. We’ve now been able to generate tremendous cash. We’ve been able to stabilize the business. Mike, Barry, talked about the pristine balance sheet.
And now we’ve also, while doing that we’ve been able to understand better these markets, build some of the products and services as you see in Vonage Mobile which from that capabilities we had 18 months ago.
And now that we are much closer to the ability to start really selling and marketing these and managing with the interfaces for partners, whether it be distribution partners or it be partnerships internationally, or whether it be to accelerate the speed with which we actually bring new products and services in mobile to market, we now have the ability to invest as prudently to drive these revenues.
In terms of overall return, I’ll let Barry comment in terms of our internal targets kind of over a five-year, what kind of IRR we are targeting, but that’s exactly the way we’re thinking about the business, which get it to this point, generate the cash, know that we can continue to generate cash and be able to afford investment in those things that we think have strong returns and leverage our technology and organizational skills.
Yeah. Let me just drill on that a minute, Mike. You used the word harvesting, I’m not sure, I would not use that word, I think when we have got the core business to the point where it’s driving stable cash flows, we view this as an appropriate use of a portion of that cash to really drive the growth. And now as Marc described, we developed with the conviction and the plans around these growth initiatives.
So, as you know this is not a change in direction at all that was really a continuation of the direction, but a deepening and an increase of -- deepening of the conviction and an increase of the investment, now that we have that conviction.
So, as we have laid plans during the course of this year and now we’ve put the business models in place, we certainly are going to bring a prudent, measured financially disciplined approach to the way we evaluate these opportunities.
So, we would look, for example at around 20% kind of in our threshold to both projects. That’s been the case as we look at these opportunities. We talked a lot about mobile and we also say that on the international expansion alternative, that is going to be done as we’ve described on a more case-by-case, partner-by-partner type basis. So we will look at each of those projects and opportunities as we develop a very detailed cash flow model and take projection around that, that are designed to meet those internal thresholds.
Michael Rollins – Citi
That’s very helpful. Thank you.
Let me add one more point on the guidance. Again, we are pretty straight shooters and try to give the transparency that we can and also where you don’t have it, we won’t. I think on the guidance, we wanted to communicate to folks at the start of this year that we believe the time for investment and accelerating that investment really is now.
We have enough visibility to products and servicing and opportunities that we don’t want to surprise somebody later in the year. It’s not a guarantee that it will be five or 10 or that it is consistent through the quarters during the course of the year.
We are providing a range of estimates because we need the flexibility, we think about our total marketing spend and total size of our business, $5 million to $10 million a quarter is not a lot, when you think about starting businesses of this magnitude. So we want to share with you the range, lay them on the table and trust that we are going to execute each one of those projects and each one of those investments and evaluate them individually.
It’s not a right of communication that the money will be spent. It’s -- us trying to share with you the range of investments that we think will be required and we are going to do that very opportunistically and if something catches fire, we are going to cede it and if something isn’t working particularly well, we’re going to cut it back. That’s the way we’ve operated for the last three years, but now we are going to do that with a broader range against driving revenues.
Michael Rollins – Citi
That’s very helpful. Thank you guys very much.
Okay. Next question, Operator.
Our next question comes from Mike Latimore with Northland Capital. Please go ahead with your question.
Mike Latimore – Northland Capital
Great. Thanks a lot. In terms of the $100 million kind of view, how would you divide that among the three kind of growth initiatives that you have here. Would you say that kind of get $33 million from roughly each of those three growth areas or is one going to be the predominant key for that $100 million? And then which of the three kind of growth areas you think will be most impactful this year?
Mike, I think it’s too early to divide those. We wanted to give a sense of guidance for what we thought the overall opportunity could result in. The way I -- we would describe them I think are generally in order of priority and sequencing as we laid out. So it’s really the mobile services opportunity, as you know, a very large market.
We have a product that is out of the gate now and I’m very pleased with those initial results. So clearly that has a platform and extensions of that platform are going -- is going to be a very important for us as where we go and are probably certainly the highest priority at this point in terms of time.
The second priority is, on the international geographic expansion, we’re active in discussions about that. As we’ve talked about, that will depend on the nature of the relationships that we develop because we do see that it’s primarily coming through business partnerships, so but those markets are very large and some of those potential opportunities are large.
So, I think that is going to be -- characteristics of that growth are going to be different, because they are going to be based more on a project-by-project kind of a basis versus the mobile opportunity that is really driven by the overall market opportunity and the position we’re in to be able to compress the pricing in the industry historically and with our -- leveraging our technologies platform.
And the third area is continuing to drive the penetration into ILD callers in the U. S. So we do see that as an opportunity, that’s a more mature market and we continue to tune up that marketing spend to drive that, that’s the order of priority and I think we put them in internally as they unfold.
Mike Latimore – Northland Capital
Great. On the mobile -- the new mobile apps, sounds like downloads are going well. Do you have a sense or a goal as to what percent of the download will be paying users versus free users?
We didn’t -- we have a robust model on that and we’ve looked at what are general industry norms along these lines. So you have downloads obviously that translates into number of active users and in our case that then translates into the number of people that are actually monetizing it based on off-net calling.
So, as typical in the industry, well, it’s a relatively small percentage of it ultimately go all the way from download to monetize calls. But the early results are positive actually. The active users are ahead of expectations. It’s too early to see how the monetization results are going to unfold. But we’re very pleased with how that is unfolding at this point relative with the model we have in mind.
Yeah. I mean over the next few months, Mike, the goal in this kind of model is you’ve got to build large community. You’ve got to get folks who are active users, using the free services that are then pulling through those additional revenue streams.
And by the way, there is additional revenue streams, we talked about them as the international calling and texting, but there is also opportunities if you get the right kind of size of base particularly they’re heavily using chat and SMS to use develop advertising models, as well as there is wealth of information created based upon a large-scale community that can be monetized potentially as well.
So, I think the key metrics we’re focused on right now, our downloads and folks who are actually engaging with the product and inviting others to join and having those contacts, that is where we got to go first and foremost. If you do that well then the revenues will follow.
Mike Latimore – Northland Capital
Okay. And then on the reintroduction of annual contracts, is there going to be some sort of ARPU trade out there? How should we think about ARPU versus move back to annual?
No. There won’t be an ARPU trade-off with return to service agreements. The way we’re structuring this is, previously everybody got our promotion [dossier] and now the way we’re going to structure this is, much like the wireless industry in terms of device subsidies. If you want to get the promotional pricing, you get -- it will take us a 12 month service agreement and if you simply want to pay the full both $26 per month, then you don’t have to take that contract.
Net-net, with holding any other potential ARPU compressors or competitive stuff, that will technically give you something more of an ARPU increase because you wouldn’t spend more that promotion, we are not forecasting that, but mathematically that’s what you conclude.
It’s just a function of taking existing promotions and those who would require service agreement, it really returns to what we were before, but looking at people choice, so that, those who simply don’t want to be locked into a contract do have an alternative with us.
Mike Latimore – Northland Capital
Okay. Thank you.
Okay. NEXT question, Operator.
(Operator Instructions) Our next question comes from Robert Routh with Phoenix Partners Group. Please go ahead with your question.
Robert Routh – Phoenix Partners Group
Hi. Good morning, guys. Thanks for taking my questions. Just two quick ones. First, I noticed, I mean, clearly, you guys reverse the NOL, which you didn’t think you’d ever be able to use and that tells me that you obviously see sustained profitability from a pre-tax point of view for GAAP in the foreseeable future. I’m just wondering if I’m reading into that right and if you can tell us kind of, obviously, how much clarity priority did you have in order to take the step of reversing that NOL and then actually putting it back on the books and being able to utilize it?
And then second question is, obviously you spoke about your return on capital, you look for 20% IRR and looking to your stock down today 15% and giving your balancing sheet with solid as a rock, the free cash flow expectations, the growth and even though you had de minimis loss of subscribers for the year given your sub-base, we would see the best use of your cash now would clearly be on stock because your cost of equity has got to be over 50%.
And yet, with your debts so low for the company that could be leveraged two times at almost a zero interest rate environment. I’m just wondering whether management would consider at some point instituting some kind of a share buyback because it would see as though in additions rather initiatives that would be a really good use of your cash, as well as the good signal to your major shareholders that you believe your -- stock is cheaper at current levels.
Well, let me take your first question first, relative to the NOL’s, you’ve got that exactly right, it does -- it requires a very significant analysis both by management, the Board, internal audit, sorry, external auditing firm, as well as other experts to determine what is the probability that you’ll be able to use those before expiration and the measure is degree of confident that you in fact do that so it does reflect as you rightly pointed out confidence to sustain profitability. So, that is a very bullish action to take that and put that as a differed tax asset on the balance sheet. Barry, do you want to take that?
Yeah. And so that is absolutely the case and can’t do that and make that’s kind of adjustment that is in accounting and prove without taking of course a very careful look at that that is along with scrutiny. So, we really did that and it is certainly an indication of our confidence there.
With regarding the use of the cash and would we considered about buyback and the answer is yeah. As we think about per use of cash and we talk about this in the past and clearly, as we build even with the investments that we are planning and making to drive growth. We do plan to continue to build cash during the course of 2012 albeit more modestly then if we had not been making these kind of investments.
So paying -- we’re paying for growth out of the operating earnings of the company. We will also continue to evaluate opportunities for inorganic growth that would make sense. But at the right time we would also consider returning capital to shareholders at an appropriate time in the future.
So, as we talked about in the past, being in this position of having reasonably sizable cash positions of $59 million at the end of the this quarter, for example, it’s new to Vonage but as things unfold that is certainly something that we will and we actively discuss with our Board and in something that we would considered doing at the right time.
Robert Routh – Phoenix Partners Group
Great. And just a follow-up to the first answer, is there any, if you are as on our side of fence, are you looking at the company. How would you quantify the cash value of taking those NOLs and now you have the benefit of them as you wouldn’t before. What do you think is our fare kind of tax rate to apply to that number to get to the incremental equity value you’ve created by being able to do that?
Well, I think the best way to look at that is that, you look at the entry that was put on the balance sheets for the deferred tax assets are in $326 million. So, that is in fact the NOL that we have in place, that we believe are more likely than which is the pick of the tax to be used before they expire you take those NOLs and apply the effective tax rate.
So that is the expected cash savings from those NOLs at prevailing tax rate at $326 million. And then you to get a present value of that, you’d have to discount it back obviously based on the expected usage over time.
Robert Routh – Phoenix Partners Group
Sure. Great. Thank you very much.
Okay. Operator, we have time for one more question please.
Our final question comes from [Brian Hurray] with (inaudible) and Management. Please go ahead with your question.
Brian Hurray – Analyst
Hi. Thanks for taking my question. I actually have three. Just to follow-up on the last question. Do you have a target leverage ratio in mind for the business because it looks likes you’ll be either completely debt free or in a net cash position before the end of the year? Do you have any thoughts about philosophically what the right level of leverage is?
Our strategy on that Brian is to pay down the debt according to the current schedule, as you know historically, we had prepaid debt when we had interest rates up in the 9%, 10% range. At these current interest levels, it does not make sense in our view to prepay that.
So the plan would be to pay debt down according to schedule and that debt gets paid off in the middle of 2014. And the strategy there is to be able to maintain debt capacity. It’s not using it for things that would make sense in the future. So the strategy is to maintain that level of debt for the foreseeable future but have that capacity available as appropriate for future uses.
Brian Hurray – Analyst
Okay. And then on the Mobile app that has just been introduced, do you have a kind of a range of ARPU number there that you think is realistic to achieve once you get the community built?
Yeah. We do have expectation for that, I mean, when you look at where the market is, I mean it’s in the kind of sub $10 range, but that’s what you see is typical, for example, not to give you when you go to the Skype, that’s one for example, you see that, but what we look at is, is something in that kind of a zipcode.
Brian Hurray – Analyst
Okay. That’s fair.
... high single-digit.
Brian Hurray – Analyst
Okay. And then lastly with the three growth initiatives that you’ve discussed during the call, can you give us any sense as to what kind of transparency or visibility you are going to offer on the -- be it the growth or profitability or both of those, those three efforts over the course of the year?
We recognize the need for visibility into that. So we will describe those in ways that make sense as they unfold, for example, numbers of download that Marc described for the Mobile app is the best early indication of how that’s taking fold -- taking hold.
In terms of profitability and we’ll have to just let this unfold, it’s obviously, it’s going to take some time for this to be material, we’ve described the in response to the previous question. Our approach to that which is to make sure that the -- make sure that the businesses indicate that mobile and the new specific opportunity achieved a targeted internal threshold, so as -- that certainly what we are achieving and we will give additional information on those revenues as they materialize over time, but it will take time.
Let me just to clarify, so we will provide tactical indicators of progress, but we do not plan to do segments specific reporting until it becomes material to the business. You should not expect that in the next couple of quarters.
So we will keep you posted on progress. So you can assess how we are performing, but the level of detail as individual line item metrics and segment traditional reporting that you might expect and something that was 30% or 40% of our business. We don’t foresee that in the next couple of quarters and now we want to set certain expectation that you will see that.
Brian Hurray – Analyst
Okay. Understand. Thank you.
With that, we’ll conclude the call. Thank you for joining us today.
Thank you. Ladies and gentleman, thank you for your participation in today’s conference. This thus concludes the conference. You may now disconnect. Good day.
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