Description

Overview

In late 2014, Alan Masarek left his post as Google’s Head of Chrome and Apps to become the CEO of Vonage. In about a year, he has built a sizable Unified Communications as a Service (UCaaS) business targeting SMB and middle-market enterprises while simultaneously executing a turnaround of Vonage’s consumer business. This transformation has gone rather unnoticed by the investment community as the average investor reflexively dismisses it as a fading consumer VoIP business. Peeling back the layers however, reveals a valuable platform with superior brand awareness, structural cost advantages, strong cash flows, and a considerable new market opportunity.

Today, Vonage’s UCaaS offering (Vonage Business Solutions or VBS) is the second largest in the US and the fastest organic grower. In addition, its consumer business is throwing off $160m of EBITDA that is being redeployed to investment in VBS and share repurchases. We believe that VG is worth significantly more than its current enterprise value solely on the expected operating performance of the business in 2016. However, we also think this conventional near-term view undervalues the strategic asset that Masarek is building.

Alan is an entrepreneurial build/partner/sell CEO that sold his previous venture to Google. Vonage’s Google connection remains strong and its platform is increasingly interwoven into the Google ecosystem that Masarek formerly ran. Ultimately, we don’t believe that Masarek left his post at Google to add ~$1 per share to VG’s stock price. Rather, we think the formidable asset he’s building will have strategic value to a number of potential acquirers, including Google.

Unified Communications

The term Unified Communications is often abbreviated as UC or UCaaS (“as a service”) and denotes the integration of communications into other business processes. UC is typically comprised of a product set that provides a consistent interface and experience across multiple devices and media types. Elements of an integrated UC implementation can include real-time communication such as voice, instant messaging, presence, video, and mobile; non real-time communication such as voicemail, email, text, and fax; and business process software such as CRM, customer service, and practice management. Integration of these elements enhances organizational efficiency and reduces cost considerably relative to traditional enterprise communication systems.

UC offers low upfront capital cost, reduced maintenance and upgrade costs, and massive scalability. UCaaS takes it a step further by hosting the communication system in the cloud making it is as simple as plugging an IP phone into an Ethernet jack. In short, UCaaS is to communications what the cloud is to computing.

As aging PBX systems need replacement, Frost & Sullivan estimates that UCaaS spend will more than triple to $10b in the next five years representing a 27% CAGR. Due to the large size, low penetration (~15%), and attractive growth vector of the UCaaS market, leading participants command lofty valuations. Public pure play UCaaS providers trade for an average of 3.6x 2016 revenue.

Vonage Business Solutions (VBS)

New management has built a platform that provides Vonage with a distinctive competitive advantage in the UCaaS industry. Specifically, VBS is uniquely positioned to grow via acquisition in addition to rapid organic growth. Management has skillfully executed its acquisition strategy, building VBS into one of the largest UCaaS businesses in less than one year by assembling service providers operating on the Broadsoft (BSFT) platform.

Acquisitions

With more than 10m lines deployed, BSFT’s UCaaS platform is the de-facto standard in the industry. BSFT is carrier-agnostic and the largest ILECs including AT&T and Verizon deploy its platform to provide UC services to their own subscribers. Broadsoft handily outspends both RNG and EGHT on R&D, and has proven its reliability at scale; still a question mark for competing proprietary systems. Masarek orchestrated the integration of Broadsoft with Google Chrome and Apps while running that division and we’ve been told that he has a good working relationship with Broadsoft Chairman John “Jay” Markley having intersected with him at Harvard Business School.

Vonage faces limited competition for acquisitions as each set of potential acquirers has a disincentive to bid:

• Strategic Players have built proprietary competing platforms. It would be challenging and costly to support two platforms at scale while attempting to transition thousands of customers to the in-house platform potentially requiring new equipment and altered workflows. Moreover, even if strategics were inclined to bid, they’re operating on the edge of profitability and somewhat capital constrained. Meanwhile, VG’s investment grade rating provides easy access to credit markets and its consumer business throws off over $100m of FCF per annum.

• Financial Buyers also have a disincentive to bid. Smaller regional UC providers are subscale and lack meaningful cash flow deterring private equity. In addition, venture capital has slowed to a trickle as the investments made 8-10 years ago have left some tired swimmers.

As growth plateaus and capital becomes increasingly scarce, sellers have few exit alternatives and even Broadsoft is inclined to have a national service provider absorb smaller or subscale regional Broadsoft –enabled providers. As one of the few prospective buyers, Vonage has exceptional leverage in negotiations and acquisitions year-to-date have been valued at an average of 1.4x revenue vs. public comparables trading at 4.8x trailing sales.

Once an acquisition is made, Vonage’s harmonized platform allows for rapid operations integration and revenue growth ramp. Vonage has standardized its back office systems on Salesforce.com (sales pipeline), Logisense (billing), Oracle (accounting), and Zeus (internally developed provisioning and customer management tool). Management’s meticulous execution focus has resulted in passing on otherwise favorable acquisition candidates to avoid back office integration challenges. Anecdotally:

• Vonage acquired Vocalocity, took out 1000bps of cost, and offered its services into VG’s channel increasing lead generation 3x and its revenue growth rate by +40%.

• Vonage acquired iCore Networks and fully integrated it in less than ten weeks.

Organic Growth

Vonage Business Solutions is the fastest growing UCaaS service provider due to its highly recognizable brand, growing direct sales force, and mature indirect channels. Moreover, VBS can grow where others face difficulties, specifically small businesses that want unified communications but have been left to languish by Tier 1 telcos. Vonage has spent $2b building its brand over the last fifteen years. As a result, it has significant brand recognition relative to UCaaS peers.

Vonage is able to leverage its brand awareness to generate leads thereby reducing customer acquisition cost and opening up the penetration opportunity of even the smallest of organizations. Moreover, VG has tripled the size of its channel sales team with recent hires in addition to incorporating the channel teams from acquisitions. VBS is a preferred provider for many of the largest master agents in the country which in turn leverage more than 20k sub-agents that sell the full range of VBS offerings. Meanwhile, UCaaS competitors have publicly announced their movement away from SMB and toward larger enterprise given the difficult economics underlying smaller customers.

We were pleasantly surprised to find that competitors generally had positive commentary with regard to VG’s competitive position and strategy during our interviews. Vonage’s brand recognition, ability to deliver solutions across the full spectrum of customer size and complexity, and its broad reach have resulted in superior organic growth relative to peers.

VBS Today

VBS is on an estimated revenue and EBITDA run rate of $280m and -$15m, respectively. VBS has two offerings based on customer size:

• Essentials: this offering focuses on Small office / Home office (SoHo) with 20 users or less. It is primarily the result of VG’s acquisition of Vocalocity and is sold through telesales and online. The Essentials service is highly reliable, running on Vonage’s proprietary platform that terminates billions of domestic and international minutes per year. It is a low-cost offering with enhanced features and dependable customer care.

• Premier: Premier focuses on small and medium sized businesses (SMB) with 20-1000+ users. It is an enterprise-grade solution based on the Broadsoft platform that includes the use of edge routers or dedicated MPLS circuits. Premiere is sold with long-term contracts primarily through Value Added Resellers.

Assuming no further acquisitions, we model $330m of VBS revenue for 2016 and EBITDA breakeven. VBS’ expected 2016 revenue is less than 10% shy of RingCentral estimates, implying that Masarek has built the second largest UCaaS provider in about a year.

Based on interviews with management and other specialists in the UCaaS space, we expect VBS to fold in more small/regional UCaaS acquisitions in the near-term. Vonage has reportedly been evaluating UCaaS acquisition candidates representing aggregate revenue of $700m. VG’s existing credit facility could facilitate another $120m dollar value of acquisitions before using existing balance sheet cash or free cash flow generated over the next few quarters. At the average 2015 multiple of 1.4x, this would equate to $86m of incremental revenue in 2016 making VBS the leading UCaaS provider by a healthy margin.

VBS Valuation

Pure-Play Multiples

Based on the current public pure-play UCaaS revenue multiples, the standalone value of VBS is in the range of $4.78 to $7.29 per share, 95-144% of VG’s consolidated enterprise value. At the high end, one would be getting paid to own the highly cash generative Consumer segment. At the low end, an investor today would be buying the Consumer business for 27¢/share, or $60m representing roughly 0.5x Consumer FCF. To put this in perspective, VG was a primarily Consumer business throughout 2014, a period during which it had an average enterprise value of more than $800m. As we’ll outline below, we think the Consumer business is worth more than it was last year, not 93% less.

Future Profitability

As value investors, we like to contemplate valuations relative to future profitability and cash flows. This is a difficult exercise in VBS’ case given that it is being managed to a modest loss as it invests in growth. Further, the only pure play UCaaS multiples currently available are revenue based given that RNG is unprofitable and EGHT is straddling breakeven. VG management commentary is that at maturity (i.e. operations at scale, moderating S&M spend) VBS is expected to generate 25-30% EBITDA margins. This margin profile is in the middle of the range represented by more capital intensive telco and wireless carrier EBITDA. Moreover, VG’s consolidated year-to-date EBITDA margins are already in the high-teens even with VBS - 1/3 of revenue - being managed to a loss. Thus, we think that management’s long-term margin targets are reasonable.

The UCaaS industry is expected to grow at a 27% CAGR through 2020. Using the first scenario from the chart above (no future acquisitions) as a baseline and growing VBS at market rates through 2020 results in $855m of revenue. A 27.5% midpoint margin on this revenue would represent $235m of EBITDA which could adequately justify our present value target (8x * $235m / 1.12^4 / 225m = $5.31 per share for VBS). Given management’s acquisition strategy and VBS’ above market growth, it’s not inconceivable that VBS could be a $1b+ revenue UCaaS provider over the next couple of years which would justifiably command a >$2b valuation.

Relative Size

Finally, VBS is roughly the same size as RingCentral from a revenue standpoint, is growing faster on an organic basis, has a proven acquisition strategy, sits atop a profitable supportive legacy business, owns a recognizable brand name that cost $2b to build, and burns less EBITDA. Yet, RingCentral currently has a $1.44b enterprise value vs. VG’s overall $1.3b, which includes VG’s cash generative legacy business. Net/net, we think an investor today is getting paid to own the consumer business, and then some.

Vonage Consumer

Vonage's consumer business provides attractively priced VoIP and messaging services around the world on a variety of devices regardless of connection (3G, LTE, Cable, DSL). The company is also working to adapt certain UCaaS features for consumer in the near term. The Consumer segment is what investors are most familiar with, and why we believe the Vonage investment opportunity exists.

Although the Consumer segment is in slow decline, it generates significant cash flow to reinvest in VBS and repurchase shares under VG’s $100m authorization. Moreover, Alan Masarek has completed a successful restructuring and has improved the value of the Consumer business considerably.

Churn Reduction

In his first three full quarters, Masarek has driven a meaningful reduction in churn. This was achieved by shifting Vonage’s retail strategy to grab-n-go and away from assisted selling. The Company also de-emphasized basic-talk in order to focus on higher quality subscribers. The net effect has been to bring churn from 2.6% to 2.3% as early-life churn is reduced. Going forward, management expects to further stabilize churn through product and feature enhancements, including certain UCaaS features.

We estimate that the 12% reduction in realized churn has added close to $200m of gross profit to the Consumer segment by extending the average subscriber life by 5 months. At an ARPU of $27.38 and gross margin of 69%, the average subscriber gross profit contribution has increased by an implied $95. With 2.0m subscribers, the increase represents $189m of additional gross profit. Further, according to management, the Consumer segment has a greater than 50% pre-marketing operating income (PMOI). Over time then, the existing customer base will generate an additional $104m of operating income just through the actions taken in the last three quarters. Thus, we think that the Consumer segment is worth considerably more than it was last year when Masarek joined.

EBITDA Growth

In addition, management has deemphasized inefficient media channels, thereby reducing Consumer sales and marketing spend by an incremental $27m since Masarek has been at the helm. Along with other expense reductions, Vonage’s overall EBITDA has grown by 28% to its highest level in three years while simultaneously reducing Consumer churn and supporting VBS’ modest loss.

Vonage’s filings don’t break out contribution margin by segment, but management commentary is that the Consumer segment represented roughly 110% of overall EBITDA, implying VBS is on an annual burn rate of $15m. If we add VBS’ burn rate back to Consumer EBITDA we arrive at a $160m TTM figure for the Consumer segment.

Vonage Consumer Valuation

Free Cash Flow Yield, EBITDA Multiple

Vonage’s EBITDA to cash conversion is efficient. With $6.3m of annualized interest expense, an $850m NOL tax shield, and $30m projected 2015 capital expense, we expect that the Consumer business will generate $124m of free cash flow (>$100m for the firm after VBS burden). A 15% yield on this cash flow implies $825m of value, or $3.66 per share. This would translate to 5.2x EBITDA.

Pre-Marketing Operating Income

Further, we believe it is telling that management is quick to point out the attractive PMOI of the Consumer business. If VG were to be shopped for the value of its VBS segment, a potential acquirer might otherwise be deterred by the Consumer segment. Looking at the Consumer business from a PMOI standpoint is effectively contemplating runoff mode, a scenario that a potential acquirer could consider. If an acquirer allowed Consumer subscribers to churn to zero over a 2-3 year span, this segment would generate more than $3/share of cash flow which would be shielded from taxes. While this scenario is extreme, it’s illustrative of the notion that VG can be seen as a strategic asset based on VBS without the Consumer segment acting as a deterrent. In the meantime, the Consumer business provides VBS with a structural advantage given its supportive cash flows and recognizable Vonage brand.

Recent Market Value

Finally, as we alluded to in the previous section, the market was assigning an $818m average enterprise value to Vonage during 2014 when it was a predominantly Consumer VoIP Company. If anything, we believe the business is worth more than it was then. However, to remain conservative, we assume that EBITDA drops to $150m in 2016, and free cash flow moves to $114m. A 15% yield on this cash flow represents $758m of value, or $3.37 per share representing 5.1x EBITDA.

Sum-of-the-Parts Valuation and Target

VG currently has a $1.1b market cap and is modestly levered with $183.5m of net debt (1.3x total EBITDA) for an enterprise value of $1.3b. We value Vonage by assessing each segment individually, and then tie them together into a single capital structure.

As we discussed in the immediately preceding section, we believe Vonage consumer is somewhat conservatively worth $3.37 per share based on a reasonable 15% FCF yield resulting in a 5.1x multiple to EBITDA.

For VBS, we contemplate a scenario whereby VG draws the remaining $121m revolver capacity to acquire Broadsoft-based regional service providers for an average of 1.4x revenue. We think there is reasonable line of site to this outcome given the size of the M&A pipeline and management’s commentary suggesting they’re planning to close transactions sooner than later. The one difference between the chart below and the one provided in the discussion on VBS is that we applied the average multiple of public pure plays (RNG & EGHT) to the 100% revolver drawdown scenario rather than the high end of the multiple range demonstrated previously. The result is $6.67 per share for the VBS segment.

To arrive at Vonage’s market value, we model free cash flow for the next five quarters (including 4Q15) offset by the assumed revolver drawdown.

Putting it all together, we arrive at an equity value of $2.1b, or $9.30 per share [$6.67 + $3.37 - $0.73] representing 84% upside based on next year’s operating performance before giving full credit to the value of the $850m NOL. However, as we said in the opening summary, we believe that Alan Masarek is building a strategically valuable asset and that the ultimate outcome is likely a sale of the business.

Strategic Value of VBS

We think VBS can be a $1b+ revenue business over the next few years through organic growth and continued acquisition activity. As discussed above, VBS has been able to market to the underpenetrated and underserved SoHo and smaller SMB market. Tier 1 telcos and increasingly pure play UCaaS providers have been content to let this market languish as the economics aren’t there. Cable providers are marketing to attract these customers but they’re doing so largely based on price competition with ILECs, offering little to no unified communications features or functionality.

VBS + Cable

In essence cable cos are marketing a price competitive brick phone while UCaaS is a similarly priced smartphone with a large and growing selection of integrated apps. To that end, VBS’s gUnify middleware layer ties together its Broadsoft-based cloud services to a wide range of SaaS business applications thereby embedding itself into the business processes of SMB customers. This deep integration capability coupled with a large base of subscribers would fit nicely into an evolutionary offering for cable service providers (or ILECs).

VBS + Google

As Microsoft looks to capture an increasing share of a business’ process, Google will likely be compelled to respond. The VBS roadmap puts it in position to be an attractive target, and Masarek sold his previous company to Google.

Masarek was hired as head of Chrome and Apps in 2012 when Google acquired Quickoffice. He founded Quickoffice to help business users work with Microsoft Office files across any device/OS and by 2011 it was in the top ten paid apps for 300+ days. Google initially licensed Quickoffice to put it on one of the first Android phones. As Google Apps developed, Google again licensed Quickoffice to help with file conversion. As Chrome/Chrome OS developed, Google looked to Quickoffice to integrate into the operating system and ultimately acquired it. VBS’ middleware layer is effectively a Chrome extension integrating carrier grade hosted voice services with UC and SaaS applications. Thus, an integration path is evolving.

Google Reacted to Microsoft Office365 With Quickoffice

The early decade timeline for Office365 (Office in the cloud) corresponds nicely with Google’s acquisition of QuickOffice. Whether viewed as competing to win or attempting to remain relevant, Google was struggling with the dual problems of file conversion and business adoption and the Quickoffice acquisition seemed to answer both: Quickoffice’s technology solved the former while Masarek at the helm drove mid-teens penetration before his departure.

Microsoft Recently Introduced Skype for Business

The announcement of Skype for Business (formerly Lync) is Microsoft’s attempt to integrate carrier-grade hosted communications with the rest of the Office ecosystem. Industry pundits are quick to point out that Skype for Business will be functionally deficient for several years and its 15-hour outage in September didn’t do it any reputational favors; thus it’s not a seemingly salient threat yet.

Nonetheless, if/when Google responds, Vonage is an attractive target. VBS is the largest nationwide MPLS IP network of any US-based provider focused on hosted communications. Moreover, VBS’ hundreds of thousands (eventually millions) of users are already sitting on top of middleware that is effectively a Google Chrome extension, and they’re communicating over the Broadsoft platform which Masarek integrated into Google before he left.

Masarek Incentives

Ultimately, we think VBS could be an excellent strategic fit for a variety of players (even CSCO or ALU). Masarek is an entrepreneur who built/partnered/sold his last business and we don’t think he has visions of being the CEO of standalone Vonage for the rest of his career. While his initial cash comp is a healthy $800k per annum, Masarek’s 3m options and 860k RSUs align his interests with investors and suggest that an eventual sale reflects the greatest upside.

Risks and Other Considerations

1. Rollup Strategy: Part of the Vonage thesis rests upon its rollup strategy. While this can often discourage investors, the deterrent tends to be based on one (or both) of two things: a) integration execution; b) lack of organic growth. Vonage management however, is cleanly integrating its acquisitions and its organic growth is substantial on both an absolute and relative basis.

2. Consumer Turnaround: Vonage is often discussed in the context of a turnaround of its Consumer segment. Turnarounds can be risk-laden and investors typically assign a deservedly low/medium probability of success. In Vonage’s case however, we argue that the turnaround is largely complete, and has been successful.

3. Competition: The expectation that competition will slow subscriber additions and introduce price pressure is reasonable. In Vonage’s case however, its pure play UCaaS competitors have specifically indicated their intent to move continuously up market. Incumbent cable cos, while competing on price, have still observed Vonage growing at super-normal rates. What’s more, they offer little in the way of unified communications whereas VBS’s gUnify layer enables a fully integrated unified communications experience creating a stickier customer and ultimately a measure of protection from pricing pressure.

4. Jeffrey Citron Selling: One of the first things an investor might notice is that the GPTR <GO> Bloomberg function is a sea of red, primarily due to sales by Jeffrey Citron. Citron is the founder and current Chairman of Vonage and owns 11% of the equity. Other than an interim stint as CEO, Citron hasn’t been operationally involved in the Company since leaving the CEO post in 2006. He has been selling consistently since 2009. In fact, the only notable break in selling was from the time that Masarek took office in November 2014 until a handful of sales in November 2015. These sales spooked investors sending shares down almost 20%. Citron’s consistent previous sales suggest that they’re not indicative of his belief in Masarek’s strategy or the current direction of the business. If he sells another 13m shares (8 average trading days), he’ll be below the 5% threshold at which time the unnerving insider sales headlines should abate.

5. Investors Cool on the UCaaS Market: If one of the pure plays has a meaningful misstep along its growth path, it could pull related names down with it, including Vonage. In order to reduce exposure to general UCaaS sentiment and distill the unique value aspects of VBS, one could look to sell short either a pure play UCaaS provider like EGHT or RNG, a hybrid like SHOR or MITL, or a more general service provider prone to the liberal use of the term UCaaS.

[Note: Previous post elsewhere didn’t generate any discussion; would welcome community feedback]

Catalyst

1. Future acquisitions: expected near-term.

2. Continued VBS organic growth: 2016+

3. Investors become aware of the Vonage opportunity as VBS becomes an increasingly larger part: 2016+

4. Potential takeout candidate