[May 01, 2013] VONAGE HOLDINGS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations Tweet (Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion together with our consolidated financial statements and the related notes included elsewhere in this Form 10-Q and our audited financial statements included in our Annual Report on Form 10-K. This discussion contains forward-looking statements. These forward-looking statements are based on information available at the time the statements are made and/or management's belief as of that time with respect to future events and involve risks and uncertainties that could cause actual results and outcomes to be materially different. Important factors that could cause such differences include but are not limited to: the competition we face; our ability to adapt to rapid changes in the market for voice and messaging services; our ability to retain customers and attract new customers; our ability to establish and expand strategic alliances; governmental regulation and related actions and taxes in our international operations; increased market and competitive risks, including currency restrictions, in our international operations; risks related to the acquisition or integration of future businesses or joint ventures; our ability to obtain or maintain relevant intellectual property licenses; intellectual property and other litigation that have been and may be brought against us; failure to protect our trademarks and internally developed software; security breaches and other compromises of information security; our dependence on third party facilities, equipment, systems and services; system disruptions or flaws in our technology and systems; uncertainties relating to regulation of VoIP services; liability under anti-corruption laws; results of regulatory inquiries into our business practices; fraudulent use of our name or services; our ability to maintain data security; our dependence upon key personnel; our dependence on our customers' existing broadband connections; differences between our service and traditional phone services, including our 911 service; restrictions in our debt agreements that may limit our operating flexibility; our ability to obtain additional financing if required; any reinstatement of holdbacks by our vendors; our history of net losses and ability to achieve consistent profitability in the future; the Company's available capital resources and other financial and operational performance which may cause the Company not to make common stock repurchases as currently anticipated or to commence or suspend such repurchases from time to time without prior notice; and other factors that are set forth in the "Risk Factors" in our Annual Report on Form 10-K, in our Quarterly Reports on Form 10-Q and in our Current Reports on Form 8-K. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, and therefore, you should not rely on these forward-looking statements as representing our views as of any date subsequent to the date this Form 10-Q is filed with the Securities and Exchange Commission. Financial Information Presentation For the financial information discussed in this Quarterly Report on Form 10-Q, other than per share and per line amounts, dollar amounts are presented in thousands, except where noted. All trademarks are the property of their owners. Overview We are a leading provider of communications services connecting people through cloud-connected devices worldwide. We rely heavily on our network, which is a flexible, scalable Session Initiation Protocol (SIP) based Voice over Internet Protocol, or VoIP, network. This platform enables a user via a single "identity," either a number or user name, to access and utilize services and features regardless of how they are connected to the Internet, including over 3G, 4G, Cable, or DSL broadband networks. This technology enables us to offer our customers attractively priced voice and messaging services and other features around the world on a variety of devices. Over the past years, we have fundamentally transformed our company - strategically, operationally and financially. Strategically, we shifted our primary focus to serving rapidly growing but under-served ethnic segments in the United States with international calling needs. We improved our value proposition by being the first to deliver flat-rate, unlimited calling to over 60 countries with the launch of our Vonage World service, and we were the first to provide easy-to-use, enhanced features, like voice-to-text translation and mobile Extension services, at no extra cost. These strategic shifts have resulted in new customers with a higher average lifetime value and a better churn profile than those in the past. Our focus on operations during this period has resulted in a significantly improved cost structure. We have implemented operational efficiencies throughout our business and have reduced domestic and international termination costs per minute, and customer care costs. Importantly, we have enabled structural cost reductions while significantly improving network call quality and customer service performance. Improvements in the overall customer experience have contributed to lower churn, which was 2.5% at March 31, 2013. Through debt refinancings in December 2010, July 2011, and February 2013, we have fundamentally improved our balance sheet, reducing annual interest expense from $49 million in 2010 to $6 million in 2012 and reducing interest rates from as high as 20% in 2009 to less than 4% today. In part as a result of our operational and financial stability, on February 7, 2013, Vonage's Board of Directors discontinued the remainder of our existing $50,000 share repurchase program effective at the close of business on February 12, 2013 with 26 -------------------------------------------------------------------------------- Table of Contents $16,682 remaining, and authorized a new program to repurchase up to $100,000 of the Company's outstanding shares by December 31, 2014. We believe our repurchase program reflects our balanced approach to capital allocation as we invest for growth through our growth priorities and deliver value to shareholders without compromising our ongoing operational needs. We had approximately 2.3 million subscriber lines for broadband telephone replacement services as of March 31, 2013. We bill customers in the United States, Canada, and the United Kingdom. Customers in the United States represented 93% of our subscriber lines at March 31, 2013. Trends and Key Operating Data A number of trends have a significant effect on our results of operations and are important to an understanding of our financial statements. Competitive landscape. We face intense competition from traditional telephone companies, wireless companies, cable companies, and alternative communication providers. Most traditional wireline and wireless telephone service providers and cable companies are substantially larger and better capitalized than we are and have the advantage of a large existing customer base. In addition, because our competitors provide other services, they often choose to offer VoIP services or other voice services as part of a bundle that includes other products, such as video, high speed Internet access, and wireless telephone service, which we do not offer. In addition, such competitors may in the future require new customers or existing customers making changes to their service to purchase voice services when purchasing high speed Internet access. Further, as wireless providers offer more minutes at lower prices, better coverage, and companion landline alternative services, their services have become more attractive to households as a replacement for wireline service. We also compete against alternative communication providers, such as magicJack, Skype, and Google Voice. Some of these service providers have chosen to sacrifice telephony revenue in order to gain market share and have offered their services at low prices or for free. As we continue to introduce applications that integrate different forms of voice and messaging services over multiple devices, we are facing competition from emerging competitors focused on similar integration, as well as from alternative voice communication providers. In addition, our competitors have partnered and may in the future partner with other competitors to offer products and services, leveraging their collective competitive positions. We also are subject to the risk of future disruptive technologies. In connection with our increasing emphasis on the international long distance market, we face competition from low-cost international calling cards and VoIP providers in addition to traditional telephone companies, cable companies, and wireless companies. Broadband adoption. The number of United States households with broadband Internet access has grown significantly. On March 16, 2010, the Federal Communications Commission ("FCC") released its National Broadband Plan, which seeks, through supporting broadband deployment and programs, to encourage broadband adoption for the approximately 100 million United States residents who do not have broadband at home. We expect the trend of greater broadband adoption to continue. We benefit from this trend because our service requires a broadband Internet connection and our potential addressable market increases as broadband adoption increases. Regulation. Our business has developed in a relatively lightly regulated environment. The United States and other countries, however, are examining how VoIP services should be regulated. The November 2010 order by the FCC in response to a request by Kansas and Nebraska that permits states to impose state universal service fund obligations on VoIP service, discussed in Note 6 to our financial statements, is an example of efforts by regulators to determine how VoIP service fits into the telecommunications regulatory landscape. In addition to regulatory matters that directly address VoIP, a number of other regulatory initiatives could impact our business. One such regulatory initiative is net neutrality. In December 2010, the FCC adopted a revised set of net neutrality rules for broadband Internet service providers. These rules make it more difficult for broadband Internet service providers to block or discriminate against Vonage service. Several broadband Internet service providers have filed appeals of the FCC's new rules at the D.C. Circuit Court of Appeals alleging that the FCC lacks authority to apply its rules to broadband Internet service providers. In addition, on October 27, 2011, the FCC adopted an order reforming universal service and intercarrier compensation. The FCC order provides that VoIP originated calls will be subject to interstate access charges for long distance calls and reciprocal compensation for local calls that terminate to the public switched telephone network ("PSTN"). The termination charges for all traffic, including VoIP originated traffic, will transition over several years to a bill and keep arrangement (i.e., no termination charges). We believe that the order will positively impact our costs over time. Numerous parties filed appeals of the FCC order that are pending. On April 18, 2013, the FCC issued a Notice of Proposed Rulemaking (NPRM) that proposes to modify FCC rules to allow VoIP providers to directly access telephone numbers. In addition, the FCC granted a waiver from its existing rules to allow Vonage to conduct a trial of direct access to telephone numbers. The trial will allow the FCC to obtain real-world data on direct access to telephone numbers by VoIP providers to inform consideration of the NPRM. Direct access to telephone numbers would facilitate IP to IP interconnection, which may allow VoIP providers to provide higher quality, lower cost services, promote the deployment of innovative new voice services, and experience reductions in the cost of telephony services. 27 -------------------------------------------------------------------------------- Table of Contents The table below includes key operating data that our management uses to measure the growth and operating performance of our business: Three Months Ended March 31, 2013 2012 Gross subscriber line additions 148,003 165,454 Change in net subscriber lines (12,400 ) (18,739 ) Subscriber lines (at period end) 2,347,416 2,356,148 Average monthly customer churn 2.5 % 2.8 % Average monthly operating revenues per line $ 29.61 $ 30.42 Average monthly direct cost of telephony services per line $ 7.82 $ 8.68 Marketing costs per gross subscriber line addition $ 349 $ 323 Employees (excluding temporary help) (at period end) 966 1,004 Gross subscriber line additions. Gross subscriber line additions for a particular period are calculated by taking the net subscriber line additions during that particular period and adding to that the number of subscriber lines that terminated during that period. This number does not include subscriber lines both added and terminated during the period, where termination occurred within the first 30 days after activation. The number does include, however, subscriber lines added during the period that are terminated within 30 days of activation but after the end of the period. Net subscriber line additions. Net subscriber line additions for a particular period reflect the number of subscriber lines at the end of the period, less the number of subscriber lines at the beginning of the period. Subscriber lines. Our subscriber lines include, as of a particular date, all paid subscriber lines from which a customer can make an outbound telephone call on that date. Our subscriber lines include fax lines including fax lines bundled with subscriber lines in our small office home office calling plans and soft phones but do not include our virtual phone numbers or toll free numbers, which only allow inbound telephone calls to customers. Subscriber lines decreased from 2,356,148 as of March 31, 2012 to 2,347,416 as of March 31, 2013. For the three months ended March 31, 2013, we added 148,003 subscriber lines. We believe that the decrease in our subscriber lines from the prior year was primarily due to increasing competition, particularly from cable companies and alternative voice communication providers. Average monthly customer churn. Average monthly customer churn for a particular period is calculated by dividing the number of customers that terminated during that period by the simple average number of customers during the period, and dividing the result by the number of months in the period. The simple average number of customers during the period is the number of customers on the first day of the period, plus the number of customers on the last day of the period, divided by two. Terminations, as used in the calculation of churn statistics, do not include customers terminated during the period if termination occurred within the first 30 days after activation. Our average monthly customer churn decreased from 2.8% for the three months ended March 31, 2012 to 2.5% for the three months ended March 31, 2013 and remained flat compared to the three months ended December 31, 2012. The decline from March 31, 2012 is the result of improvements in overall customer satisfaction, as well as changes in retention processes and the impact of service agreements, which were put in place in February of 2012. We monitor churn on a daily basis and use it as an indicator of the level of customer satisfaction. Other companies may calculate churn differently, and their churn data may not be directly comparable to ours. Customers who have been with us for a year or more tend to have a lower churn rate than customers who have not. In addition, our customers who are international callers generally churn at a lower rate than customers who are domestic callers. Our churn will fluctuate over time due to economic conditions, competitive pressures, marketplace perception of our services, and our ability to provide high quality customer care and network quality and add future innovative products and services. Average monthly revenues per line. Average monthly revenues per line for a particular period is calculated by dividing our revenues for that period by the simple average number of subscriber lines for the period, and dividing the result by the number of months in the period. The simple average number of subscriber lines for the period is the number of subscriber lines on the first day of the period, plus the number of subscriber lines on the last day of the period, divided by two. Our average monthly revenues per line decreased to $29.61 for the three months ended March 31, 2013 compared to $30.42 for the three months ended March 31, 2012 due primarily to the expansion of lower priced plan offerings to meet customer segment needs, lower activation fee revenue, and lower USF fees, offset by selected pricing actions and higher priced rate plans. The continued expansion of lower priced plan offerings to meet customer segment needs may cause downward pressure on average monthly revenues per line. 28 -------------------------------------------------------------------------------- Table of Contents Average monthly direct cost of telephony services per line. Average monthly direct cost of telephony services per line for a particular period is calculated by dividing our direct cost of telephony services for that period by the simple average number of subscriber lines for the period, and dividing the result by the number of months in the period. We use the average monthly direct cost of telephony services per line to evaluate how effective we are at managing our costs of providing service. Our average monthly direct cost of telephony services per line decreased to $7.82 for the three months ended March 31, 2013 compared to $8.68 for the three months ended March 31, 2012, due primarily to the decrease in domestic and international termination costs due to a lower customer base and more favorable rates negotiated with our service providers, the decrease in our network costs and in our E-911 costs, and the decrease in regulatory fees. Direct cost of telephony services both overall and on a per line basis is expected to experience upward pressure from increased international calling by our base of Vonage World customers offset by intelligent call routing, peering relationships we are implementing, and improved pricing from various carriers. Marketing cost per gross subscriber line addition. Marketing cost per gross subscriber line addition is calculated by dividing our marketing expense for a particular period by the number of gross subscriber line additions during the period. Marketing expense does not include the cost of certain customer acquisition activities, such as rebates and promotions, which are accounted for as an offset to revenues, or customer equipment subsidies, which are accounted for as direct cost of goods sold. As a result, it does not represent the full cost to us of obtaining a new customer. Our marketing cost per gross subscriber line addition was higher at $349 for the three months ended March 31, 2013 compared to $323 for the three months ended March 31, 2012. Employees. Employees represent the number of personnel that are on our payroll and exclude temporary or outsourced labor. Revenues Revenues consists of telephony services revenue and customer equipment and shipping revenue. Substantially all of our revenues are telephony services revenue. In the United States, we offer domestic and international rate plans to meet the needs of our customers, including a variety of residential plans, mobile plans, and small office and home office calling plans. The "Vonage World" plan, now available in the United States and Canada, offers unlimited calling across the United States and Puerto Rico, unlimited international calling to over 60 countries including India, Mexico, and China, subject to certain restrictions, and free voicemail to text messages with Vonage Visual Voicemail. Each of our unlimited plans other than Vonage World offers unlimited domestic calling as well as unlimited calling to Puerto Rico, Canada, and selected European countries, subject to certain restrictions. Each of our basic plans offers a limited number of domestic calling minutes per month. We offer similar plans in Canada and the United Kingdom. Under our basic plans, we charge on a per minute basis when the number of domestic calling minutes included in the plan is exceeded for a particular month. International calls (except for calls to Puerto Rico, Canada and certain European countries under our unlimited plans and a variety of countries under international calling plans and Vonage World) are charged on a per minute basis. These per minute fees are not included in our monthly subscription fees. In addition to our landline telephony business, we are leveraging our technology to offer services and applications for mobile and other connected devices to address large existing markets. We introduced our first mobile offering in late 2009 and in early 2012 we introduced Vonage Mobile, our all-in-one mobile application that now provides free voice and video calling and messaging between users who have the application, as well as traditional paid international calling to any other phone. This mobile application works over WiFi, 3G and 4G and in more than 90 countries worldwide. The application consolidates the best features of our prior applications, while adding important functionality, value and ease of use including direct payment through iTunes. We derive most of our telephony services revenue from monthly subscription fees that we charge our customers under our service plans. We also offer residential fax service, virtual phone numbers, toll free numbers and other services, and charge an additional monthly fee for each service. One business fax line is included with each of our two small office and home office plans, but we charge monthly fees for additional business fax lines. We automatically charge these fees to our customers' credit cards, debit cards, or electronic check payments ("ECP"), monthly in advance. We also automatically charge the per minute fees not included in our monthly subscription fees to our customers' credit cards, debit cards or ECP monthly in arrears unless they exceed a certain dollar threshold, in which case they are charged immediately. By collecting monthly subscription fees in advance and certain other charges immediately after they are incurred, we are able to reduce the amount of accounts receivable that we have outstanding, thus allowing us to have lower working capital requirements. Collecting in this manner also helps us mitigate bad debt losses, which are recorded as a reduction to revenue. If a customer's credit card, debit card or ECP is declined, we generally suspend international calling capabilities as well as the customer's ability to incur domestic usage charges in excess of their plan minutes. Historically, in most cases, we are able to correct the problem with the customer within the current monthly billing cycle. If the customer's credit card, debit card or ECP could not be successfully processed during three billing cycles (i.e., the current and two subsequent monthly billing cycles), we terminate the account. 29 -------------------------------------------------------------------------------- Table of Contents In the United States, we charge regulatory, compliance, E-911, and intellectual property-related recovery fees on a monthly basis to defray costs, and to cover taxes that we are charged by the suppliers of telecommunications services. In addition, we recognize revenue on a gross basis for contributions to the Federal Universal Service Fund ("USF") and related fees. All other taxes are recorded on a net basis. In addition, historically, we charged a disconnect fee for customers who terminated their service plan within the first twelve months of service. Disconnect fees are recorded as revenue and are recognized at the time the customer terminates service. Beginning in September 2010, we eliminated the disconnect fee for new customers. In February of 2012 we re-introduced service agreements as an option for new customers. Telephony services revenue is offset by the cost of certain customer acquisition activities, such as rebates and promotions. Customer equipment and shipping revenue consists of revenue from sales of customer equipment to our wholesalers or directly to customers and retailers. In addition, customer equipment and shipping revenue includes the fees, when collected, that we charge our customers for shipping any equipment to them. Operating Expenses Operating expenses consist of direct cost of telephony services, direct cost of goods sold, selling, general and administrative expense, marketing expense, and depreciation and amortization. Direct cost of telephony services. Direct cost of telephony services primarily consists of fees that we pay to third parties on an ongoing basis in order to provide our services. These fees include: • Access charges that we pay to other telephone companies to terminate domestic and international calls on the public switched telephone network. These costs represented approximately 51% and 48% of our total direct cost of telephony services for the three months ended March 31, 2013 and 2012, respectively, with a portion of these payments ultimately being made to incumbent telephone companies. When a Vonage subscriber calls another Vonage subscriber, we do not pay an access charge. • The cost of leasing Internet transit services from multiple Internet service providers. This Internet connectivity is used to carry VoIP session initiation signaling and packetized audio media between our subscribers and our regional data centers. • The cost of leasing from other telephone companies the telephone numbers that we provide to our customers. We lease these telephone numbers on a monthly basis. • The cost of co-locating our regional data connection point equipment in third-party facilities owned by other telephone companies, Internet service providers or collocation facility providers. • The cost of providing local number portability, which allows customers to move their existing telephone numbers from another provider to our service. Only regulated telecommunications providers have access to the centralized number databases that facilitate this process. Because we are not a regulated telecommunications provider, we must pay other telecommunications providers to process our local number portability requests. • The cost of complying with FCC regulations regarding VoIP emergency services, which require us to provide enhanced emergency dialing capabilities to transmit 911 calls for all of our customers. • Taxes that we pay on our purchase of telecommunications services from our suppliers or imposed by government agencies such as Federal USF and related fees. Direct cost of goods sold. Direct cost of goods sold primarily consists of costs that we incur when a customer first subscribes to our service. These costs include: • The cost of the equipment that we provide to customers who subscribe to our service through our direct sales channel in excess of activation fees when an activation fee is collected. The remaining cost of customer equipment is deferred up to the activation fee collected and amortized over the estimated average customer life. • The cost of the equipment that we sell directly to retailers. • The cost of shipping and handling for customer equipment, together with the installation manual, that we ship to customers. • The cost of certain products or services that we give customers as promotions. Selling, general and administrative expense. Selling, general and administrative expense includes: 30 -------------------------------------------------------------------------------- Table of Contents • Compensation and benefit costs for all employees, which is the largest component of selling, general and administrative expense and includes customer care, research and development, network engineering and operations, sales and marketing, executive, legal, finance, and human resources personnel. • Share-based expense related to share-based awards to employees, directors, and consultants. • Outsourced labor related to customer care, kiosk and events sales teams, and retail support activities. • Product awareness advertising. • Transaction fees paid to credit card, debit card, and ECP companies and other third party billers such as iTunes, which may include a per transaction charge in addition to a percent of billings charge. • Rent and related expenses. • Professional fees for legal, accounting, tax, public relations, lobbying, and development activities. • Litigation settlements. Marketing expense. Marketing expense includes: • Advertising costs, which comprise a majority of our marketing expense and include online, television, direct mail, alternative media, promotions, sponsorships, and inbound and outbound telemarketing. • Creative and production costs. • The costs to serve and track our online advertising. • Certain amounts we pay to retailers for activation commissions. • The cost associated with our customer referral program. Depreciation and amortization expenses. Depreciation and amortization expenses include: • Depreciation of our network equipment, furniture and fixtures, and employee computer equipment. • Amortization of leasehold improvements and purchased and developed software. • Amortization of intangible assets (patents and trademarks). • Loss on disposal or impairment of property and equipment. Loss from abandonment of software assets. Loss from abandonment of software assets include: • Impairment of investment in software assets. Other Income (Expense) Other Income (Expense) includes: • Interest income on cash and cash equivalents. • Interest expense on notes payable, patent litigation judgments and settlements and capital leases. • Amortization of debt related costs. • Realized and unrealized gains (losses) on foreign currency. 31-------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth, as a percentage of consolidated operating revenues, our consolidated statement of operations for the periods indicated: Three Months Ended March 31, 2013 2012 Revenues 100 % 100 % Operating Expenses: Direct cost of telephony services (excluding depreciation and amortization) 26 28 Direct cost of goods sold 4 4 Selling, general and administrative 30 29 Marketing 25 25 Depreciation and amortization 4 4 89 90 Income from operations 11 10 Other Income (Expense): Interest income - - Interest expense (1 ) (1 ) Other income (expense), net - - (1 ) (1 ) Income before income tax expense 10 9 Income tax expense (4 ) (2 ) Net income 6 % 7 % Summary of Results for the Three Months Ended March 31, 2013 and March 31, 2012 Revenues, Direct Cost of Telephony Services and Direct Cost of Good Sold (in thousands, except percentages) Three Months Ended March 31, Dollar Percent 2013 2012 Change Change Revenues $ 209,087 $ 215,903 $ (6,816 ) (3 )% Direct cost of telephony services(1) 55,181 61,623 (6,442 ) (10 )% Direct cost of goods sold 8,878 9,846 (968 ) (10 )% 145,028 144,434 594 - % (1) Excludes depreciation and amortization of $3,452 and $3,930, respectively. Revenues. For the three months ended March 31, 2013, revenues decreased by $6,816, or 3%, compared to the three months ended March 31, 2012. This was primarily driven by a decrease of $7,353 in monthly subscription fees resulting from a decreased number of subscription lines, which reduced from 2,356,148 at March 31, 2012 to 2,347,416 at March 31, 2013, and the expansion of lower priced plan offerings. There was also a decrease in activation fees of $454 and a decrease in other revenue of $794 due to lower rates from our revenue sharing partners. In addition, there was an increase in credits issued to subscribers of $748. These decreases were offset by an increase in fees that we charged for disconnecting our service of $1,132 due to reinstatement of contracts for new customers beginning in February 2012, and an increase in our regulatory fee revenue of $1,751, which includes a decrease of $2,519 in USF fees offset by an increase in regulatory recovery fees and E-911 fees of $4,270. 32 -------------------------------------------------------------------------------- Table of Contents Direct cost of telephony services. For the three months ended March 31, 2013 compared to the three months ended March 31, 2012, the decrease in direct cost of telephony services of $6,442, or 10%, was primarily driven by a decrease in domestic termination costs of $328 due to improved termination rates, which are costs that we pay other phone companies for terminating phone calls, and fewer minutes of use and a decrease in our network costs of $1,916, which includes costs for co-locating in other carriers' facilities, leasing phone numbers, routing calls on the Internet, E-911 costs, and transferring calls to and from the Internet to the public switched telephone network. There was also a decrease in other costs of $433, a decrease in international usage of $1,263 driven by improved termination rates, and a decrease of USF and related fees imposed by government agencies of $2,519. Direct cost of goods sold. For the three months ended March 31, 2013 compared to the three months ended March 31, 2012, the decrease in direct cost of goods sold of $968, or 10%, was primarily due to a decrease in amortization costs on deferred customer equipment of $305, a decrease in waived activation fees for new customers of $1,501 due to lower direct customer adds, and a decrease in shipping costs of $385. These decreases were offset by an increase in customer equipment costs of $1,226 from additional customers from our retail expansion. Selling, General and Administrative (in thousands, except percentages) Three Months Ended March 31, Dollar Percent 2013 2012 Change Change Selling, general and administrative $ 62,910 $ 61,835 $ 1,075 2 % Selling, general and administrative. For the three months ended March 31, 2013 compared to the three months ended March 31, 2012, selling expense increased by $286 including $1,539 due to the expansion of the number of community sales teams and $442 due to an increase in the number of retail outlets with assisted selling, offset by a decrease of $1,696 related to product awareness advertising of our mobile offering launched in February 2012. For the three months ended March 31, 2013 compared to the three months ended March 31, 2012, general and administrative expense increased by $790 due to an increase in professional fees of $1,485 and higher share based cost of $1,358, offset by a decrease in compensation and employee related expense of $1,078 including a further reduction in customer care costs, a decrease in telecommunications expenses of $549, and a decrease in facility expense of $241. Marketing (in thousands, except percentages) Three Months Ended March 31, Dollar Percent 2013 2012 Change Change Marketing $ 51,669 $ 53,422 $ (1,753 ) (3 )% Marketing. For the three months ended March 31, 2013 compared to the three months ended March 31, 2012, marketing expense decreased slightly by $1,753, or 3%, mainly due to the decrease in investment in television, offset by the increase in retail to reach targeted ethnic segments and incremental media expenses associated with the market test of our low-priced domestic offer. Depreciation and Amortization (in thousands, except percentages) Three Months Ended March 31, Dollar Percent 2013 2012 Change Change Depreciation and amortization $ 7,975 $ 8,644 $ (669 ) (8 )% Depreciation and amortization. The decrease in depreciation and amortization of $669, or 8%, for the three months ended March 31, 2013 compared to the three months ended March 31, 2012, was primarily due to lower depreciation of network equipment, computer hardware, and furniture of $617. 33 -------------------------------------------------------------------------------- Table of Contents Other Income (Expense) (in thousands, except percentages) Three Months Ended March 31, Dollar Percent 2013 2012 Change Change Interest income $ 37 $ 20 $ 17 85 % Interest expense (1,457 ) (1,751 ) 294 17 % Other income (expense), net (39 ) 42 (81 ) (193 )% $ (1,459 ) $ (1,689 ) $ 230 Interest expense. For the three months ended March 31, 2013 compared to the three months ended March 31, 2012, the decrease in interest expense was due to to our credit facility entered into in connection with our refinancing in February 2013 and the payoff of a settlement agreement in August 2012. Provision for Income Taxes (in thousands, except percentages) Three Months Ended March 31, Dollar Percent 2013 2012 Change Change Income tax expense $ (7,968 ) $ (4,923 ) $ (3,045 ) (62 )% Effective tax rate 37.9 % 26.1 % We recognize income tax expense equal to our pre-tax income multiplied by our effective income tax rate, an expense that had not been recognized prior to the reduction of the valuation allowance in the fourth quarter of 2011. In addition, adjustments are recorded for discrete period items related to stock compensation and changes to our state effective tax rate. The provision also includes the federal alternative minimum tax and state and local income taxes. The effective tax rate is calculated by dividing the income tax expense by income before income tax expense. The effective rate for the three months ended March 31, 2012 was less than the federal statutory rate due, in part, to our Canadian operations and certain discrete period items, which primarily consisted of adjustments related to stock compensation, including a non-cash deferred tax adjustment totaling $4,077 for certain stock compensation previously considered nondeductible under Section 162(m) of the Internal Revenue Code. The 2013 estimated annual effective tax rate is expected to approximate 41%, but may fluctuate each quarter due to the timing of other discrete period transactions. Net Income (in thousands, except percentages) Three Months Ended March 31, Dollar Percent 2013 2012 Change Change Net income $ 13,047 $ 13,921 $ (874 ) (6 )% Net income. Based on the explanations described above, our net income of $13,047 for the three months ended March 31, 2013 decreased by $874, or 6%, from net income of $13,921 for the three months ended March 31, 2012. 34 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Overview The following table sets forth a summary of our cash flows for the periods indicated: Three Months Ended March 31, 2013 2012 (in thousands) Net cash provided by operating activities $ 9,752 $ 11,119 Net cash used in investing activities (3,087 ) (8,034 ) Net cash provided by (used in) financing activities 2,646 (7,084 ) For the three months ended March 31, 2013, we generated income from operations. We expect to continue to balance efforts to grow our customer base while consistently achieving operating profitability. To grow our customer base, we continue to make investments in marketing, application development as we seek to launch new services, network quality and expansion, and customer care. Although we believe we will achieve consistent profitability in the future, we ultimately may not be successful and we may not achieve consistent profitability. We believe that cash flow from operations and cash on hand will fund our operations for at least the next twelve months. February 2013 Financing On February 11, 2013 we entered into Amendment No. 1 to our July 2011 credit agreement (the "2013 Credit Facility"). The 2013 Credit Facility consists of a $70,000 senior secured term loan and a $75,000 revolving credit facility. The co-borrowers under the 2013 Credit Facility are us and Vonage America Inc., our wholly owned subsidiary. Obligations under the 2013 Credit Facility are guaranteed, fully and unconditionally, by our other United States subsidiaries and are secured by substantially all of the assets of each borrower and each of the guarantors. Use of Proceeds The net proceeds received of $27,500 from the senior secured term loan and the undrawn revolving credit facility under the 2013 Credit Facility will be used for general corporate purposes. We also incurred $2,009 of fees in connection with the 2013 Credit Facility, which is amortized, along with the unamortized fees of $670 in connection with the 2011 Credit Facility, to interest expense over the life of the debt using the effective interest method. 2013 Credit Facility Terms The following description summarizes the material terms of the 2013 Credit Facility: The loans under the 2013 Credit Facility mature in February 2016. Principal amounts under the 2013 Credit Facility are repayable in quarterly installments of $5,833 per quarter for the senior secured term loan. The unused portion of our revolving credit facility incurs a 0.45% commitment fee. Outstanding amounts under the 2013 Credit Facility, at our option, will bear interest at: • LIBOR (applicable to one-, two-, three- or six-month periods) plus an applicable margin equal to 3.125% if our consolidated leverage ratio is less than 0.75 to 1.00, 3.375% if our consolidated leverage ratio is greater than or equal to 0.75 to 1.00 and less than 1.50 to 1.00, and 3.625% if our consolidated leverage ratio is greater than or equal to 1.50 to 1.00, payable on the last day of each relevant interest period or, if the interest period is longer than three months, each day that is three months after the first day of the interest period, or • the base rate determined by reference to the highest of (a) the federal funds effective rate from time to time plus 0.50%, (b) the prime rate of JPMorgan Chase Bank, N.A., and (c) the LIBOR rate applicable to one month interest periods plus 1.00%, plus an applicable margin equal to 2.125% if our consolidated leverage ratio is less than 0.75 to 1.00, 2.275% if our consolidated leverage ratio is greater than or equal to 0.75 to 1.00 and less than 1.50 to 1.00, and 2.625% if our consolidated leverage ratio is greater than or equal to 1.50 to 1.00, payable on the last business day of each March, June, September, and December and the maturity date of the 2013 Credit Facility. The 2013 Credit Facility provides greater flexibility to us in funding acquisitions and restricted payments, such as stock buybacks, than the 2011 Credit Facility. 35 -------------------------------------------------------------------------------- Table of Contents We may prepay the 2013 Credit Facility at our option at any time without premium or penalty. The 2013 Credit Facility is subject to mandatory prepayments in amounts equal to: • 100% of the net cash proceeds from any non-ordinary course sale or other disposition of our property and assets for consideration in excess of a certain amount subject to customary reinvestment provisions and certain other exceptions and • 100% of the net cash proceeds received in connection with other non-ordinary course transactions, including insurance proceeds not otherwise applied to the relevant insurance loss. Subject to certain restrictions and exceptions, the 2013 Credit Facility permits us to obtain one or more incremental term loans and/or revolving credit facilities in an aggregate principal amount of up to $60,000 plus an amount equal to repayments of the senior secured term loan upon providing documentation reasonably satisfactory to the administrative agent, without the consent of the existing lenders under the 2013 Credit Facility. The 2013 Credit Facility includes customary representations and warranties and affirmative covenants of the borrowers. In addition, the 2013 Credit Facility contains customary negative covenants, including, among other things, restrictions on the ability of us and our subsidiaries to consolidate or merge, create liens, incur additional indebtedness, dispose of assets, consummate acquisitions, make investments, and pay dividends and other distributions. We must also comply with the following financial covenants: • a consolidated leverage ratio of no greater than 2.00 to 1.00; • a consolidated fixed coverage charge ratio of no less than 1.75 to 1.00 subject to adjustment to exclude up to $50,000 in specified restricted payments; • minimum cash of $25,000 including the unused portion of the revolving credit facility or $35,000 in the event of certain specified corporate actions; and • maximum capital expenditures not to exceed $55,000 during any fiscal year, provided that the unused amount of any permitted capital expenditures in any fiscal year may be carried forward to the next following fiscal year; in addition, annual excess cash flow up to $8,000 increases permitted capital expenditures. As of March 31, 2013, we were in compliance with all covenants, including financial covenants, for the 2013 Credit Facility. The 2013 Credit Facility contains customary events of default that may permit acceleration of the debt. During the continuance of a payment default, interest will accrue at a default interest rate of 2% above the interest rate which would otherwise be applicable, in the case of loans, and at a rate equal to the rate applicable to base rate loans plus 2%, in the case of all other amounts. State and Local Sales Taxes We also have contingent liabilities for state and local sales taxes. As of March 31, 2013, we had a reserve of $1,541. If our ultimate liability exceeds this amount, it could affect our liquidity unfavorably. However, we do not believe it will significantly impair our liquidity. Capital Expenditures For the three months ended March 31, 2013, capital expenditures were primarily for the implementation of software solutions and purchase of network equipment as we continue to expand our network. Our capital expenditures for the three months ended March 31, 2013 were $4,344, of which $2,313 was for software acquisition and development. The majority of these expenditures are comprised of investments in information technology and systems infrastructure, including an electronic data warehouse, online customer service, and customer management platforms. For 2013, we believe our capital and software expenditures will be between $30,000 and $35,000. Common Stock Repurchases On July 25, 2012, our board of directors approved a plan to buy back up to $50,000 of Vonage common stock through December 31, 2013. The specific timing and amount of repurchases would vary based on available capital resources and other financial and operational performance, market conditions, securities law limitations, and other factors. The repurchases would be made using our cash resources. The repurchase program was subject to suspension or discontinuation at any time without prior notice. For the three months ended March 31, 2013, we repurchased $5,374, or 2,189 shares of Vonage common stock under the $50,000 repurchase program. On February 7, 2013, Vonage's Board of Directors discontinued the remainder of our existing $50,000 repurchase program effective at the close of business on February 12, 2013 with $16,682 remaining, and authorized a new program to repurchase up to $100,000 of the Company's outstanding shares by December 31, 2014. The specific timing and amount of repurchases would vary based on available capital resources and other financial and operational performance, market conditions, securities law 36 -------------------------------------------------------------------------------- Table of Contents limitations, and other factors. The repurchases will be made using our cash resources. The repurchase program may be suspended or discontinued at any time without prior notice. For the three months ended March 31, 2013, we repurchased $11,007, or 4,039 shares of Vonage common stock under the $100,000 repurchase program. In any period under either repurchase program, cash used in financing activities related to common stock repurchases may differ from the comparable change in stockholders' equity, reflecting timing differences between the recognition of share repurchase transactions and their settlement for cash. Stock Option Cancellation As part of our strategy to build shareholder value and to facilitate our goal of reducing the number of shares of common stock outstanding, on February 19, 2013, we entered into an agreement with our Chief Executive Officer to cancel a total of 4,500 of his vested stock options for $5,463. The payment reflects a discount, in favor of the Company, from the closing price of the common stock on the New York Stock Exchange on February 19, 2013. Operating Activities Cash provided by operating activities decreased to $9,752 for the three months ended March 31, 2013 compared to $11,119 for the three months ended March 31, 2012, primarily due to planned investments in our growth priorities, lower revenues and changes in working capital. Changes in working capital requirements include changes in accounts receivable, inventory, prepaid and other assets, accounts payable, accrued and other liabilities, and deferred revenue and costs. Cash used for working capital requirements increased by $5,087 during the three months ended March 31, 2013 compared to the prior year period primarily due to timing of payments. Investing Activities Cash used in investing activities for the three months ended March 31, 2013 of $3,087 was attributable to capital expenditures of $2,031 and development of software assets of $2,313, offset by a decrease in restricted cash of $1,257 due primarily to the return of part of the security deposit of $1,000 on our leased office property in Holmdel, New Jersey and the release of our letter of credit from our energy purchase plan of $257. Cash used in investing activities for the three months ended March 31, 2012 of $8,034 was attributable to capital expenditures of $2,033 and development of software assets of $7,000, offset by a decrease in restricted cash of $999 due primarily to the return of partial security deposit on our leased office property in Holmdel, New Jersey. Financing Activities Cash provided by financing activities for the three months ended March 31, 2013 of $2,646 was primarily attributable to $27,500 in net proceeds received from our 2013 Credit Facility and $5,746 in proceeds received from the exercise of stock options, offset by $5,463 in proceeds paid in connection with the stock option cancellation, $5,834 in 2013 Credit Facility principal payments, $582 in capital lease payments, $16,712 in common stock repurchases, and $2,009 in 2013 Credit Facility debt related costs. Cash used in financing activities for the three months ended March 31, 2012 of $7,084 was primarily attributable to $7,083 in 2011 Credit Facility principal payments and $495 in capital lease payments, offset by $494 in proceeds received from the exercise of stock options. Summary of Critical Accounting Policies and Estimates Our significant accounting policies are summarized in Note 1 to our consolidated financial statements. The following describes our critical accounting policies and estimates: Use of Estimates Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States, which require management to make estimates and assumptions that affect the amounts reported and disclosed in the consolidated financial statements and the accompanying notes. Actual results could differ materially from these estimates. On an ongoing basis, we evaluate our estimates, including the following: • the useful lives of property and equipment, software costs, and intangible assets; • assumptions used for the purpose of determining share-based compensation using the Black-Scholes option pricing model ("Model"), and various other assumptions that we believed to be reasonable. The key inputs for this Model 37-------------------------------------------------------------------------------- Table of Contents are our stock price at valuation date, exercise price, the dividend yield, risk-free interest rate, life in years, and historical volatility of our common stock; and • assumptions used in determining the need for, and amount of, a valuation allowance on net deferred tax assets. We base our estimates on historical experience, available market information, appropriate valuation methodologies, and on various other assumptions that we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Revenue Recognition The point in time at which revenues are recognized is determined in accordance with Staff Accounting Bulletin No. 104, Revenue Recognition, and Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 605, Revenue Recognition. At the time a customer signs up for our telephony services, there are the following deliverables: • Providing equipment, if any, to the customer that enables our telephony services and • Providing telephony services. The equipment is provided free of charge to our customers and in most instances there are no fees collected at sign-up. We record the fees collected for shipping the equipment to the customer, if any, as shipping and handling revenue at the time of shipment. A further description of our revenues is as follows: Substantially all of our operating revenues are telephony services revenues, which are derived primarily from monthly subscription fees that customers are charged under our service plans. We also derive telephony services revenues from per minute fees for international calls if not covered under a plan, including applications for mobile devices and other stand-alone products, and for any calling minutes in excess of a customer's monthly plan limits. Monthly subscription fees are automatically charged to customers' credit cards, debit cards or electronic check payments, or ECP, in advance and are recognized over the following month when services are provided. Revenues generated from international calls and from customers exceeding allocated call minutes under limited minute plans are recognized as services are provided, that is, as minutes are used, and are billed to a customer's credit cards, debit cards or ECP in arrears. As a result of our multiple billing cycles each month, we estimate the amount of revenues earned from international calls and from customers exceeding allocated call minutes under limited minute plans but not billed from the end of each billing cycle to the end of each reporting period and record these amounts as accounts receivable. These estimates are based primarily upon historical minutes and have been consistent with our actual results. We also provide rebates to customers who purchase their customer equipment from retailers and satisfy minimum service period requirements. These rebates in excess of activation fees are recorded as a reduction of revenues over the service period based upon the estimated number of customers that will ultimately earn and claim the rebates. Customer equipment and shipping revenues include sales to our retailers, who subsequently resell this customer equipment to customers. Revenues were reduced for payments to retailers and rebates to customers, who purchased their customer equipment through these retailers, to the extent of customer equipment and shipping revenues. Inventory Inventory consists of the cost of customer equipment and is stated at the lower of cost or market, with cost determined using the average cost method. We provide an inventory allowance for customer equipment that has been returned by customers but may not be able to be reissued to new customers or returned to the manufacturer for credit. Income Taxes We recognize deferred tax assets and liabilities at enacted income tax rates for the temporary differences between the financial reporting bases and the tax bases of our assets and liabilities. Any effects of changes in income tax rates or tax laws are included in the provision for income taxes in the period of enactment. Our net deferred tax assets primarily consist of net operating loss carry forwards ("NOLs"). We are required to record a valuation allowance against our net deferred tax assets if we conclude that it is more likely than not that taxable income generated in the future will be insufficient to utilize the future income tax benefit from our net deferred tax assets (namely, the NOLs) prior to expiration. We periodically review this conclusion, which requires significant management judgment. If we are able to conclude in a future period that a future income tax benefit from our net deferred tax assets has a greater than 50 percent likelihood of being realized, we are required in that period to reduce the related 38 -------------------------------------------------------------------------------- Table of Contents valuation allowance with a corresponding decrease in income tax expense. This will result in a non-cash benefit to our net income in the period of the determination. In the future, if available evidence changes our conclusion that it is more likely than not that we will utilize our net deferred tax assets prior to their expiration, we will make an adjustment to the related valuation allowance and income tax expense at that time. In the fourth quarter of 2011, we released $325,601 of valuation allowance. In subsequent periods, we would expect to recognize income tax expense equal to our pre-tax income multiplied by our effective income tax rate, an expense that was not recognized prior to the reduction of the valuation allowance. Net Operating Loss Carry Forwards As of December 31, 2012, we had NOLs for United States federal and state tax purposes of $744,139 and $290,196, respectively, expiring at various times from years ending 2013 through 2030. In addition, we had NOLs for Canadian tax purposes of $25,476 expiring through 2028. We also had NOLs for United Kingdom tax purposes of $37,765 with no expiration date. Under Section 382 of the Internal Revenue Code, if we undergo an "ownership change" (generally defined as a greater than 50% change (by value) in our equity ownership over a three-year period), our ability to use our pre-change of control NOLs and other pre-change tax attributes against our post-change income may be limited. The Section 382 limitation is applied annually so as to limit the use of our pre-change NOLs to an amount that generally equals the value of our stock immediately before the ownership change multiplied by a designated federal long-term tax-exempt rate. At December 31, 2012, there were no limitations on the use of our NOLs. Net Operating Loss Rights Agreement On June 7, 2012, we entered into a Tax Benefits Preservation Plan ("Preservation Plan") designed to preserve stockholder value and tax assets. In connection with the adoption of the Preservation Plan, our board of directors declared a dividend of one preferred share purchase right for each outstanding share of the Company's common stock. The preferred share purchase rights were distributed to stockholders of record as of June 18, 2012, as well as to holders of the Company's common stock issued after that date, but will only be activated if certain triggering events under the Preservation Plan occur. Under the Preservation Plan, preferred share purchase rights will work to impose significant dilution upon any person or group which acquires beneficial ownership of 4.9% or more of the outstanding common stock, without the approval of our board of directors, from and after June 7, 2012. Stockholders that own 4.9% or more of the outstanding common stock as of the opening of business on June 7, 2012 will not trigger the preferred share purchase rights so long as they do not (i) acquire additional shares of common stock or (ii) fall under 4.9% ownership of common stock and then re-acquire shares that in the aggregate equal 4.9% or more of the common stock. The Preservation Plan expires no later than the close of business June 7, 2013, unless extended by our board of directors. On April 4, 2013, after consultation with our advisors, our board of directors determined to extend the Preservation Plan through June 7, 2015, subject to ratification of the extension by stockholders at our 2013 annual meeting of stockholders. Share-Based Compensation We account for share-based compensation in accordance with FASB ASC 718, "Compensation-Stock Compensation". Under the fair value recognition provisions of this pronouncement, share-based compensation cost is measured at the grant date based on the fair value of the award, reduced as appropriate based on estimated forfeitures, and is recognized as expense over the applicable vesting period of the stock award using the accelerated method. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements. [ Back To TMCnet.com's Homepage ]