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VONAGE HOLDINGS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(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; increased market and competitive risks, including currency restrictions; risks related to the acquisition or integration of businesses or joint ventures; the impact of fluctuations in economic conditions, particularly on our small and medium business customers; 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; 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. Since its inception, Vonage has used IP technology to disrupt large existing markets by offering high-value, low cost communications services. From its start-up roots, the Company has evolved into a leader in the VoIP services market, with 2.6 million customer lines serving residential and small and medium business customers. Customers using our core Vonage landline replacement service are located in the United States (94% of lines), Canada and the UK. Our mobile applications serve customers around the world. Key to the Company's evolution was our strategic, operational and financial transformation, which was largely completed in 2012. This transformation resulted in a dramatic swing to profitability enabled by significant cost reductions, a meaningful lowering of customer defections, and the successful restructuring our balance sheet. This transformation positioned the Company to pursue our current growth strategy. Strategically, we shifted our primary focus in our domestic markets to serving the rapidly growing but under-served ethnic segments in the United States with international calling needs. We improved the customer 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 differentiated our service by providing enhanced features, including our mobile Extensions service, 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 28-------------------------------------------------------------------------------- Table of Contents 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 has remained in the mid 2% range for six consecutive quarters. Through debt refinancings in December 2010, July 2011, and February 2013, we have fundamentally improved our balance sheet, reducing interest rates from as high as 20% in 2009 to less than 4%. In part as a result of our operational and financial stability, and our disciplined approach to cash management, we established our share repurchase program which was first instituted in August of 2012. The Company currently has a $100,000 repurchase authorization in place which expires on 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. Having achieved operational and financial stability, we are focused on driving revenue through three major growth priorities. The first of these is continued penetration of our core North American markets, where we will continue to provide value in international long distance and target under-served ethnic segments, where we have entered the low-end domestic market with our flanker brand, BasicTalk, a low-priced home phone service offering unlimited calling throughout the United States, and where we have expanded our offering to small and medium business (SMB) and small office, home office (SOHO) customers through the acquisition of Vocalocity, Inc. Our second growth priority is international expansion outside of North America through strategic partnerships. Finally, our third growth priority is mobile services, which we view as a strategic enabler of the Company's entire product offering. We had approximately 2.6 million subscriber lines for broadband telephone replacement services as of March 31, 2014. We bill customers in the United States, Canada, and the United Kingdom. Customers in the United States represented 94% of our subscriber lines at March 31, 2014. Trends and Key Operating Data A number of trends in our industry 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 in the United States, 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. A November 2010 order by the FCC that permits states to impose state universal service fund obligations on VoIP service, discussed in Note 10 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. 29-------------------------------------------------------------------------------- Table of Contents These rules made it more difficult for broadband Internet service providers to block or discriminate against Vonage service. On January 14, 2014, the D.C. Circuit Court of Appeals vacated the anti-blocking and the unreasonable discrimination provisions of the rules. The D.C. Circuit decision did not foreclose the FCC from adopting anti-blocking or non-discrimination rules. On February 19, 2014, FCC Chairman Tom Wheeler announced that the FCC would not appeal the D.C. Circuit decision, electing to pursue restoration of the vacated provisions using the authority that the FCC has over broadband services, as recognized by the D.C. Circuit. The FCC is scheduled to vote on a Notice of Proposed Rulemaking at its May 15, 2014. In addition, on February 9, 2011, the FCC released a Notice of Proposed Rulemaking on reforming universal service and the intercarrier compensation ("ICC") system that governs payments between telecommunications carriers primarily for terminating traffic. The FCC's adoption of an ICC proposal will impact Vonage's costs for telecommunications services. On October 27, 2011, the FCC adopted an order reforming universal service and ICC. 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). Numerous parties filed appeals of the FCC's ICC order. We believe that the order, if effected, will positively impact our costs over time. 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, 2014 2013 Gross subscriber line additions 191,413 148,003 Change in net subscriber lines 12,503 (12,400 ) Subscriber lines (at period end) 2,555,429 2,347,416 Average monthly customer churn 2.6 % 2.5 % Average monthly operating revenues per line $ 28.86 $ 29.61 Average monthly direct cost of telephony services per line $ 6.88 $ 7.82 Marketing costs per gross subscriber line addition $ 299 $ 349 Employees (excluding temporary help) (at period end) 1,287 966 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 increased from 2,347,416 as of March 31, 2013 to 2,555,429 as of March 31, 2014, which includes lines at acquisition from Vocalocity. For the three months ended March 31, 2014, we added 12,503 subscriber lines. 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 was 2.6% for the three months ended March 31, 2014 compared to 2.5% for the three months ended March 31, 2013 and from 2.5% for the three months ended December 31 2013. The increase was due primarily to the higher early life churn rate of customers acquired through retail channels without a minimum service requirement, including assisted selling and community sales channels, which have increased as a percentage of our total customer base. 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 30-------------------------------------------------------------------------------- Table of Contents 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 slightly to $28.86 for the three months ended March 31, 2014 compared to $29.61 for the three months ended March 31, 2013 due primarily to rate plan mix. The continued expansion of lower priced plan offerings including BasicTalk to meet customer needs may cause downward pressure on average monthly revenues per line, offset by any selected pricing actions. 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 $6.88 for the three months ended March 31, 2014 compared to $7.82 for the three months ended March 31, 2013, due primarily to the decrease in termination costs driven by more favorable rates negotiated with our service providers and the decrease in our network costs and in our E-911 costs. 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 lower at $299 for the three months ended March 31, 2014 compared to $349 for the three months ended March 31, 2013 as a result of higher gross subscriber line additions driven by BasicTalk and Vonage Business Solutions. Employees. Employees represent the number of personnel that are on our payroll and exclude temporary or outsourced labor. Revenues Revenues consist 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 and mobile plans. The "Vonage World" plan, 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 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. 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. Through our recent acquisition of Vocalocity, we offer SMB and SOHO customers several service plans with different pricing structures under the Vonage Business Solutions brand. The service plans include an array of basic and enhanced features applicable to the needs of SMB and SOHO customers. Customers also have the opportunity to purchase premium features for additional fees. We are integrating the combined operations of Vocalocity, now under the Vonage Business Solutions brand, with Vonage, eliminating overlapping processes and integrating products and sales efforts. We are also optimizing lead flow generated by the Vonage brand, directing prospective business customers from Vonage inbound telemarketing or websites to the Vonage Business Solutions website and inbound telesales channels. We expect these efforts to shift certain core gross subscriber line additions and revenue from the Vonage consumer business to Vonage Business Solutions, leading to subscriber additions with higher total lines and average monthly revenue per line. 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 provides free 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. 31-------------------------------------------------------------------------------- Table of Contents We derive most of our telephony services revenue from monthly subscription fees that we charge our customers under our service plans. We also offer fax service, virtual phone numbers, toll free numbers and other services, and charge an additional monthly fee for each service. 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. 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 revenues include revenues from the sale of VoIP telephones in order to access our small and medium business services on a net basis rather than a gross basis as we act as an agent, rather than a principal. Customer equipment and shipping revenue also 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 49% and 51% of our total direct cost of telephony services for the three months ended March 31, 2014 and 2013, 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. 32-------------------------------------------------------------------------------- Table of Contents • 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 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. • License fees for use of third party intellectual property. 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: • 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. • Acquisition related transaction and integration costs. • 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 (developed technology, customer relationships, non-compete agreements, patents, trademarks and trade names). • Loss on disposal or impairment of property and equipment. Other Income (Expense) Other Income (Expense) includes: • Interest income on cash and cash equivalents. 33-------------------------------------------------------------------------------- Table of Contents • 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. 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, 2014 2013 Revenues 100 % 100 % Operating Expenses: Direct cost of telephony services (excluding depreciation and amortization) 24 26 Direct cost of goods sold 4 4 Selling, general and administrative 35 30 Marketing 26 25 Depreciation and amortization 6 4 95 89 Income from operations 5 11 Other Income (Expense): Interest income - - Interest expense (1 ) (1 ) Other income (expense), net - - (1 ) (1 ) Income before income tax expense 4 10 Income tax expense (2 ) (4 ) Net income 2 % 6 % Plus: Net loss attributable to noncontrolling interest - % - % Net income attributable to Vonage 2 % 6 % 34-------------------------------------------------------------------------------- Table of Contents Summary of Results for the Three Months Ended March 31, 2014 and March 31, 2013 Revenues, Direct Cost of Telephony Services and Direct Cost of Good Sold (in thousands, except percentages) Three Months Ended March 31, Dollar Percent 2014 2013 Change Change Revenues $ 220,733 $ 209,087 $ 11,646 6 % Direct cost of telephony services(1) 52,617 55,181 (2,564 ) (5 )% Direct cost of goods sold 9,739 8,878 861 10 % 158,377 145,028 13,349 9 % (1) Excludes depreciation and amortization of $5,154 and $3,452, respectively. Three Months Ended March 31, 2014 compared to three months ended March 31, 2013 Revenues. The increase in revenues of $11,646, or 6%, was driven by an increase of $12,316 in monthly subscription fees primarily due to revenue of $16,339 from Vonage Business Solutions, partially offset by rate plan mix and lower customer acquisitions on premium plans of $4,023. There was an increase in our regulatory fee revenue of $275, which includes an increase of $531 in USF fees offset by a decrease in regulatory recovery fees and E-911 fees of $256. There was also a decrease in credits issued to subscribers of $432, an increase in equipment and shipping revenue of $255, and an increase in overage in plan minutes of $764. These increases were offset by a decrease in international minutes of use revenue of $1,050 and an increase in bad debt of $641. There was also a decrease in additional features revenue of $226 and a decrease in fees that we charged for disconnecting our service of $468. Direct cost of telephony services. The decrease in direct cost of telephony services of $2,564, or 5%, was primarily driven by a decrease in international usage of $2,621, a decrease in our network costs of $724, 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. These decreases were offset by an an increase in domestic termination costs of $140, which are costs that we pay other phone companies for terminating phone calls and an increase of USF and related fees imposed by government agencies of $590. Direct cost of goods sold. The increase in direct cost of goods sold of $861, or 10%, was primarily due to an increase in customer equipment costs of $2,258 from additional customers from our retail expansion, which was offset by a decrease in waived activation fees for new customers of $1,228 and a decrease in shipping costs of $104. Selling, General and Administrative (in thousands, except percentages) Three Months Ended March 31, Dollar Percent 2014 2013 Change ChangeSelling, general and administrative $ 78,453 $ 62,910 $ 15,543 25 % Three Months Ended March 31, 2014 compared to three months ended March 31, 2013 Selling, general and administrative. Selling expense increased by $3,637 including $572 due to the expansion of the number of community sales teams, $2,597 due to an increase in the number of retail stores with assisted selling, and commissions paid to retailers of $594. General and administrative expense increased by $11,906 due mainly to higher share based cost of $2,312 and an increase in compensation and employee related expense of $5,657, mainly from inclusion of Vonage Business Solutions. There was also an increase in acquisition related costs of $115 in connection with the acquisition of Vocalocity, primarily related to professional fees, an increase in customer care costs of $1,320, an increase in facility expense of $661, and an increase in state and municipal taxes of $1,353. 35-------------------------------------------------------------------------------- Table of Contents Marketing (in thousands, except percentages) Three Months Ended March 31, Dollar Percent 2014 2013 Change Change Marketing $ 57,264 $ 51,669 $ 5,595 11 % Three Months Ended March 31, 2014 compared to three months ended March 31, 2013 Marketing. The increase in marketing expense of $5,595, or 11%, primarily resulted from the additional marketing investment generated by our investment in Vonage Business Solutions. Depreciation and Amortization (in thousands, except percentages) Three Months Ended March 31, Dollar Percent 2014 2013 Change Change Depreciation and amortization $ 12,338 $ 7,975 $ 4,363 55 % Three Months Ended March 31, 2014 compared to three months ended March 31, 2013 Depreciation and amortization. The increase in depreciation and amortization of $4,363, or 55%, was primarily due to the amortization of acquisition-related intangibles of $3,762, an increase in software amortization of $225, and an increase in depreciation of network equipment, computer hardware, and furniture of $373. Other Income (Expense) (in thousands, except percentages) Three Months Ended March 31, Dollar Percent 2014 2013 Change Change Interest income $ 91 $ 37 $ 54 146 % Interest expense (2,077 ) (1,457 ) (620 ) (43 )% Other income (expense), net (13 ) (39 ) 26 67 % $ (1,999 ) $ (1,459 ) $ (540 ) Three Months Ended March 31, 2014 compared to three months ended March 31, 2013 Interest expense. The increase in interest expense of $620, or 43%, was due mainly to the funds we borrowed from the 2013 Revolving Credit Facility in November 2013 in connection with the acquisition of Vocalocity. Provision for Income Taxes (in thousands, except percentages) Three Months Ended March 31, Dollar Percent 2014 2013 Change Change Income tax expense $ (4,118 ) $ (7,968 ) $ 3,850 48 % Effective tax rate 49.5 % 37.9 % We recognize income tax expense equal to 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. 36-------------------------------------------------------------------------------- Table of Contents The effective tax rate is calculated by dividing income tax expense by income before income tax expense. The 2014 estimated annual effective tax rate is expected to approximate 47%, but may fluctuate each quarter due to our foreign operations and certain discrete period transactions. In 2014, our effective tax rate will be impacted by the effect of losses incurred in certain foreign jurisdictions for which we may not realize a tax benefit. The losses reduce our pre-tax income without a corresponding reduction in our tax expense, and therefore increase our effective tax rate. Net Income (in thousands, except percentages) Three Months Ended March 31, Dollar Percent 2014 2013 Change Change Net income $ 4,205 $ 13,047 $ (8,842 ) (68 )% Three Months Ended March 31, 2014 compared to three months ended March 31, 2013 Net income. Based on the explanations described above, net income decreased by $8,842, or 68%. Net Loss Attributable to Noncontrolling Interest (in thousands, except percentages) Three Months Ended March 31, Dollar Percent 2014 2013 Change Change Net loss attributable to noncontrolling interest $ 383 $ - $ 383 - % Three Months Ended March 31, 2014 compared to three months ended March 31, 2013 Net loss attributable to noncontrolling interest. The net loss attributable to noncontrolling interest of $383 for the three months ended March 31, 2014, represented 30% of the net loss of a consolidated subsidiary in Brazil. Net Income Attributable to Vonage (in thousands, except percentages) Three Months Ended March 31, Dollar Percent 2014 2013 Change ChangeNet income attributable to Vonage $ 4,588 $ 13,047 $ (8,459 ) (65 )% Three Months Ended March 31, 2014 compared to three months ended March 31, 2013 Net income attributable to Vonage. Based on the explanations described above, net income attributable to Vonage decreased by $8,459, or 65%. 37-------------------------------------------------------------------------------- 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, 2014 2013 (in thousands) Net cash provided by operating activities $ 9,387 $ 9,752 Net cash used in investing activities (3,729 ) (3,087 ) Net cash (used in) provided by financing activities (34,690 ) 2,646 Operating Activities Cash provided by operating activities decreased slightly to $9,387 for the three months ended March 31, 2014 compared to $9,752 for the three months ended March 31, 2013, primarily due to planned investments in our growth initiatives, offset by 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 decreased by $6,195 during the three months ended March 31, 2014 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, 2014 of $3,729 was attributable to capital expenditures of $942 and development of software assets of $2,786. 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. Financing Activities Cash used in financing activities for the three months ended March 31, 2014 of $34,690 was primarily attributable to $25,833 in 2013 Credit Facility and 2013 Revolving Credit Facility principal payments, $682 in capital lease payments, $10,011 in common stock repurchases, offset by $1,836 in proceeds received from the exercise of stock options. 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. For the three months ended March 31, 2014, we generated income from operations. We expect to continue to balance efforts to grow our revenue while consistently achieving operating profitability. To grow our revenue, we continue to make investments in growth initiatives, marketing, application development, 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. Acquisition of Vocalocity Vocalocity was acquired for $130,000 adjusted for $2,869 of excess cash as of the closing date and the increase in value of the 7,983 shares of Vonage common stock from the signing date to the closing date of $1,298, resulting in a total acquisition cost of $134,167. We financed the transaction through $32,981 of cash and $75,000 from our credit facility. The acquisition of Vocalocity immediately positioned Vonage as a leader in the SMB hosted VoIP market. SMB and SOHO services are offered under the Vonage Business Solutions brand. 38-------------------------------------------------------------------------------- Table of Contents 2013 Financing On February 11, 2013 we entered into Amendment No. 1 to our July 2011 Credit Agreement (as further amended by Amendment No. 2 to our 2011 Credit Facility, 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 our wholly owned subsidiary, Vonage America Inc., and us. 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. On July 26, 2013 we entered into Amendment No. 2 to our 2011 Credit Agreement, which amends our financial covenant related to our consolidated fixed charge coverage ratio by increasing the amount of restricted payments excluded from such calculation from $50,000 to $80,000. Use of Proceeds We used $42,500 of the net available proceeds of the 2013 Credit Facility to retire all of the debt under our 2011 Credit Facility. Remaining net proceeds 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 used $75,000 from the 2013 revolving credit facility in connection with the acquisition of Vocalocity on November 15, 2013. 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. 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; 39-------------------------------------------------------------------------------- Table of Contents • a consolidated fixed coverage charge ratio of no less than 1.75 to 1.00 subject to adjustment to exclude up to $80,000 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, 2014, 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, 2014, we had a reserve of $6,308. 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, 2014, 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, 2014 were $3,728, of which $2,786 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 2014, we believe our capital and software expenditures will be no greater than $30,000. 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 period from January 1, 2013 to February 12, 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 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, 2014, we repurchased $10,043, or 2,447 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. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements. Item 3. Quantitative and Qualitative Disclosures about Market Risk We are exposed to financial market risks, including changes in currency exchange rates and interest rates. Foreign Exchange Risk We sell our products and services in the United States, Canada, and the United Kingdom. Changes in currency exchange rates affect the valuation in our financial statements of the assets and liabilities of these operations. We also have a portion of our sales denominated in Euros, the Canadian dollar, and the British Pound, which are also affected by changes in currency exchange 40-------------------------------------------------------------------------------- Table of Contents rates. Our financial results could be affected by changes in foreign currency exchange rates, although foreign exchange risks have not been material to our financial position or results of operations to date. Interest Rate and Debt Risk Our exposure to market risk for changes in interest rates primarily relates to our long-term debt. On February 11, 2013, we entered into Amendment No. 1 to the 2011 Credit Agreement. We are exposed to interest rate risk since amounts payable under the 2013 Credit Facility, at our option, 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. If the interest rate on our variable rate debt changed by 1%, our annual debt service payment would change by approximately $960. Item 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures. Based on the evaluation of our disclosure controls and procedures (as defined in Securities Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e)) required by Securities Exchange Act Rules 13a-15(b) or 15d-15(b), our Chief Executive Officer and our Chief Financial Officer have concluded that as of the end of the period covered by this report, our disclosure controls and procedures were effective. Changes in Internal Controls. There were no changes in our internal control over financial reporting that occurred during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 41-------------------------------------------------------------------------------- Table of Contents |