Vonage’s Free Cash Flow Story

I have a tendency to go overboard when I’m writing up a new company.  There is so much to say.  The business, the growth opportunities, the competitors, the financials, the risk factors, it goes on.   I get half way through the write-up, look at the novel I’ve written and say, what am I doing here?

This is a blog.  Its meant to be bite sized quips.  Its intent is to share the investment ideas I have, discuss the reasons behind them and hopefully get feedback from others that help me distill the ideas down further and maybe get a few new ones as well.  I’m not getting anything for, nor do I think anyone is looking for, an exhaustive multi-page diatribe outlining every nuisance of the idea at hand.  If you are you should probably pay for it.

So after I’ve written a rambling soliloquy that no one is going to read, I take a step back and ask myself: what is the most important point here?  What’s the thing that makes this investment worthwhile?

That’s what I had to do in this post about Vonage.  I started off writing about everything.  And there is a lot in that everything.  Then I looked at what I had written and decided instead to take everything out but one idea.

With that in mind, here are all the things I’m not going to talk about.  I’m not going to talk about the organic growth opportunities; about BasicTalk, about Brazil, about mobile.  I’m going to try to not talk too much about the new acquisition of Vocalocity, the comparison of Vocalocity with the recent IPO of RingCentral and the small and medium sized business opportunity that Vonage has exposed itself to.  And I’m not going to mention the competition, not Ooma (which I’m actually thinking of trying out for myself) or Obihai or Skype or even MagicJack (full disclosure is that I have taken a smallish position in MagicJack), or discuss why I am still willing to make a bet on Vonage when these competitors are offering products that are, in some cases, significantly cheaper than what Vonage offers.

I’ll save all of that for other posts.

What I am going to talk about is one thing: free cash flow.

A Free Cash story

The first thing that drew me to Vonage was the free cash that comes from the core business of providing VoIP telephone service to retail customers.  There is a lot of potential in the company, and so you could spin the investment thesis a few different ways, but I think that underlying all of them is the simple fact that the company makes a lot of money on its existing business.  It also trades cheaply on current free cash flow metrics, cheap enough in fact that if you can have conviction that the existing business is sustainable at current levels then the stock is a buy on this alone.

I compiled the table below from 10-Q and 10-K data.  The operating expense number excludes one-time items and depreciation and they do not include anything from the Vocalocity purchase.  When I bought Vonage it was at $3, so its a bit less attractive by these numbers now, though with the acquisition of Vocalocity it is probably more attractive in terms of growth potential.

Where the cash comes from

Vonage  generates almost all its free cash from its products providing voice over IP home phone plans.  They offer a few options that are focused on North America calling but their more successful products focus on international long distance.

The company is much more competitive in the international calling market.  As you will see when I put together a post about Vonage’s competitors, for calls within North America, the competition is steep and Vonage is expensive compared to Ooma, Obihai, netTalk and Magicjack.

The primary international calling plan options are Vonage World and World Plus.  Both of these plans allow for essentially unlimited calls to landlines in 60 coountries and mobile devices in 10.  The cost of Vonage World is $27 (plus fees and taxes that make it around $33-$34) and for that you get unlimited calling for 60 countries.  Vonage World Plus is $3 more and you get additional calling to mobiles in 40 more countries.

The Vonage World plan is designed for people who are going to call out of the country on a regular basis.   Vonage is making a concerted effort to target the service to ethnic groups, who are more likely to friends and family out of the country that they want to keep in touch with. From the first quarter conference call:

Retail sales grew to 25% of gross line additions as we increased the number of stores with assisted selling to 525. We continue to expand this channel and are on plan to meet our 600 store target by June. In addition, we now have 375 sales agents and community teams, selling Vonage services directly to consumers in nearly every major ethnic market in the U.S. and in several Canadian markets. This is our 11^th consecutive quarter of gross line growth in these two channels.

Customer churn on the legacy business has always been high (typically greater than 2.5% of customers turn over each month) but this number has been coming down in recent quarters and actually dipped below 2.5% (to 2.4%) in the second quarter.  With churn decreasing, the company has been able to stem the declines of its subscriber base recently, showing a slight uptick in the second quarter.

I’m not sure that we should expect much growth from Vonage World in the upcoming quarters, but key metrics to watch will be the churn rate on existing customers and whether the overall customer count is stable.  If they are, then this is a stable business, producing significant free cash and acting as an excellent base from which other products can grow.

Marketing

While the company doesn’t provide the cheapest service out there, even for international calling (Ooma’s recently introduced unlimited International calling is cheaper) they are very good marketers of their product.   I think that they win a lot of customers on brand recognition, because they advertise intelligently and because they get their products into the right locations.  This Sumzero article, which was forwarded to me by an acquaintance of the blog that recommended Vonage in the first place (hat tip), makes a few good points about their marketing:

Consensus’ 2014E EBITDA $133mm overlooks how much Vonage has invested in its marketing and distribution channels, new selling approach of 375 part-time sales agents organized in community teams selling directly to ethnic groups; the increased number of stores with assisted selling to more than 300 in 2012, planned investments of $30 to $35mm in implementation of software solutions and purchase of network equipment to expand its network, along with strong pipeline of new products: Vonage World Plus, Extensions and Basic Talk brand launch nationwide through exclusive partnership with Wal-Mart.

Turning Cash into Growth

Cash generation is most useful when it can be used as capital to fund creative efforts in value creation by management.  I think you were starting to see this take place at Vonage with initiatives like BasicTalk, the expansion into Brazil and the mobile developments.

But perhaps the best example is what happened after I took a position in the stock, when Vonage bought Vocalocity.  It’s an impressive acquisition.  It was done at a decent price compared to the competition (if you listen to the conference call Vonage held to discuss the acquisition there were two separate analysts who basically questioned how Vonage could have gotten such a good deal) and it opens up a new area with strong growth potential.  Listening to the obstacles described by Vocalocity on the acquisition conference call, it sounds like merging with Vonage’s brand, leveraging their relationships, and utilizing the cash they have available to market their product is an excellent fit.

Conclusion

I’m reasonably excited about Vonage.  I am more excited than I was when I first bought the stock.  At that time I was uncertain about whether the existing consumer business would be able to stabilize,  I was concerned about the profitability of BasicTalk (there is a good discussion on the payback of BasicTalk during the Q&A of the Oppenheimer conference presentation in September), concerned about how they would monetize mobile and concerned about whether operating in Brazil would prove to be difficult. It was a free cash flow story but also a story with a few holes.

All of these worries are still there.  But the opportunity from the Vocalocity acquisition seems like a game-changer to me (I have added to my position since the news).  The fit seems ideal and Vonage has the cash to plough into the business and make it work.  It the typical watch and see type of story that I like to invest in – watch how things develop and if they progress in a positive direction add to the position.  I hope I will be adding significantly.