Description

Business Overview

VG is fighting a 3-front war against Twilio, 5-9, and Ring Central in the CPaaS, CCaaS, and UCaaS sectors, respectively.  For those who are unaware, definitions on the acronyms are provided below:

• Communications Platform as a Service (CPaaS): Vendors provide developer API tools to automate messaging through SMS, IP messaging, video, voice.  This market has a $4.6bn TAM growing 40% per annum (per IDC).

• Contact Center as a Service (CCaaS): Companies provide contact center solutions.  This market has a $9bn TAM growing 5% per annum (per IDC). 

• Unified Communications as a Service (UCaaS): Vendors offer phone solutions from the cloud along with collaboration tools such as videoconferencing.  This is a $37.5bn TAM growing 7% per annum (per IDC). 

VG customers either purchase Vonage Business as a subscription to the Applications platform or buy Vonage APIs and receive service through programmable API modules.  Customers can join as a UCaaS, CCaaS, or API customer and then migrate within a common stack to whatever use cases require.  VG calls this the “One Vonage Platform”, a single pane of glass solution that includes integrated voice, messaging, and video functionality and all UC/CC/CP capabilities with an embedded CRM focus.

The Company today is organized under 3 major divisions:

Consumer: This is the legacy VOIP business that will be divested by year end.  This business has been on autopilot for a few years with limited resources from G&A, S&M, and R&D devoted here.  The business has been secularly declining ~15% per annum and VG has been pulling cash out of this business to acquire and organically develop its API and Applications businesses.

Over the last few years, Vonage Group has transformed itself through M&A from a consumer VOIP business in secular decline to become a high growth CPaaS, CCaaS, and UCaaS platform.  Under the guidance of former CEO Alan Masarek, Vonage Group completed several homerun acquisitions, including Nexmo (#2 CPaaS player), Tokbox (#1 video API), and NewVoiceMedia (CCaaS player), that has allowed the Company to pivot from secular decline to growth.

Management is currently conducting a strategic review that will likely result in a divestiture of the Consumer segment by year end (more detail to come in upcoming Q2-20 call).

API (CPaaS): This is Nexmo, an excellent business that provides programable APIs for businesses to send SMS, voice, video, IP (OTT), and email (via partnership with Sendinblue).  The platform operates on a self-serve model where customers pay based on usage tailored to their specific needs.  Developers are directed to an external Nexmo site where they have the option to start building and editing APIs.

The programmable API market is solidifying down to 2 players with scale: #1 Twilio (6mm developers, strong in North America) and Nexmo (1mm developers, strong in EMEA and APAC), followed by a tail of smaller subscale competitors including Plivo (70k developers), MessageBird (15k developers), Bandwidth, etc.

Developer mindshare is critical to establishing a moat and building network effects in the API business.  Most developers don’t want to learn several different APIs for the same purpose so the earlier you capture developer mindshare the more entrenched your product becomes. 

In addition to significant developer mindshare, clients may dual source their communications platform for many reasons: cost, reliability, liability, etc.  Nexmo is most often dual-sourced with Twilio.

There is lots of cross sell potential and management is happy with the current product set.  Management has noted a 950% revenue uplift from clients buying 1 to 4 products. 

The unit economics and growth profile of Nexmo are as attractive as Twilio.  Revenues are growing 40-50% on a constant currency basis.  Dollar based net expansion is 138%, driven by increased usage from existing customers.  Churn rates are 0.8% per quarter (based on Business Segment KPIs).

 Gross margins for Nexmo (approx. 35-40%) are subscale relative to Twilio because:

• VG has high 80% mix of SMS which is the lowest margin product in the portfolio (TWLO is probably 40-60%)

•  ~90% of traffic is terminated internationally

In general, while SMS is a low-margin commoditized solution (with gross margins of ~20% international and ~40% US), VG also has a portfolio of high value APIs that include video, voice, IP messaging.  Gross margins for video can range towards 50%, voice 40-60%, and IP solutions can be as high as 60%.  Going forward, Nexmo aims to expand its gross margin by growing faster in the US and more in higher value apps.  High value APIs include video, voice, IP messaging, which currently comprise ~15% of API revenues, with video ~50% of that amount.  High value apps are growing +70% y/y.

The coronavirus pandemic has created an opening for Vonage Group to break into unpenetrated accounts or steal clients from competitors at attractive win rates.  In certain situations, VG leads with its video API solution, Tokbox, which opens up customers to be cross-sold other products.  From a product point of view, Tokbox is the dominant video API solution in the market and there are many strong current trends accelerating its adoption (e.g. telehealth, remote education, online dating, etc). 

The coronavirus pandemic has led to massive surge in the usage of VG’s Video API.  As a point of reference, overall Vonage video minutes increased by 232% in March over February and 144% in April over March. 

Applications (UCaaS + CCaaS): The Applications division is comprised of Contact Center (CCaaS) and Unified Communications (UCaaS).  The Applications market is not growing as fast as APIs but still provides a strong business case. 

Historically, the Applications segment has been over indexed to micro and SMB customers, which has been growing slower and less attractive unit economics (higher churn, lower LTV, etc.).  Investors penalize the stock because the Applications division is growing 8-10% y/y but this is principally due to the Company’s active decision to let its micro/SMB clients churn off.  In q1-20, Applications segment revenues grew 11% y/y constant currency, led by service revenues from enterprise customers 21% y/y and mid-market 14% y/y, suggesting micro/SMB churn has been quite significant.  In q1-20, bookings from mid-market and enterprise customers represented 64% of total bookings, up from 36% in the prior year quarter.

Focusing up market required retooling of the sales organization – Vonage has been investing in its sales force to focus upmarket and turned over >80% of its direct sales force between the summers of 2017 and 2018.  Moving upmarket requires longer sales cycles/lead times but have more attractive unit economics (enterprise ARR: ~$120K, mid-market ARR: ~$12K).  As a reference point, Five9 reports an LTV/CAC of 6x for its enterprise customers.    

Previously, VG relied on reselling inContact’s CCaaS solution (RingCentral does the same), but management realized that having an in-house CCaaS solution would be critical for the long run, and acquired NewVoiceMedia in 2018, the largest private CCaaS player at the time, which equipped VG with an advanced contact center solution to move upmarket and compete against legacy contact center giants (e.g. Cisco, Avaya, Genesys) that are now facing secular headwinds from clients migrating to the cloud.

Management is now happy with the product suite and focused on execution going forward.  The playbook has been (1) integrate, (2) revamp sales and marketing to penetrate mid-market and enterprise, and (3) execute.  While Vonage’s push up market has been bumpy, the Company is beginning to demonstrate progress.  Most notably, VG is bringing in large enterprise 7-figure TCV wins, most notably last quarter with 15 deals >$1mm (typical contract life 3 years), up from 7 deals in q4-19 and 5 deals in q3-19.  This pace of enterprise wins is similar to the success we saw in Everbridge a few years ago and an extremely bullish signal I believe that the street underestimates.  New wins generally take 6-9 months for revenue to ramp so we should see the impact of these wins in late FY20.  As a reference point, Five9 has gained a total of 59 enterprise customers with $1mm+ ARR enterprise customers from Q2-14 (IPO) to Q4-19.

VG’s competitive advantage within Applications comes from its deep integration with CRM providers (e.g. Salesforce, ServiceNow, MSFT Dynamics) along with its customizable and fully integrated UC/CC suite.  The Company wins in two ways:

1. Programmability (Platform approach): The contact center product can leverage APIs for customization.  VG has a fully built out contact center and for most parties this solution is 100% complete.  However, for clients with more sophisticated needs, VG’s contact center product can meet ~85% of standard needs and then clients can leverage VG’s APIs for further customization.  Twilio is also moving in this direction with its FLEX product.  Programmability / customization is becoming especially important as traditional standalone UCaaS solutions are commoditized and have little technological differentiation across vendors.  

2. Integrations with CRMs: Customers are increasingly demanding integration of contact centers CCaaS for agents and communications UCaaS for employees.  Both systems need to be integrated into a client’s CRM.  VG has noted high win rates when customers use Salesforce (credit goes to NewVoiceMedia for its focus on pursuing an embedded strategy) and reached “Summit Status,” which is awarded to Salesforce’s top 25 software vendors where VG is the only UCaaS, CCaaS, or CPaaS vendor to have such a designation.  The Company also recently announced a new partnership with ServiceNow, extending a similar playbook, and has 2K sales reps and engineers currently in certification.

Capital Allocation / Margins

At 2.5-3.0x 2021 revenue, VG trades at a substantial discount to its peers due to a number of business challenges.  Margins are likely to remain depressed in the near future as management makes investments to overcome these business challenges.  A significant number of areas require further investment, including incremental investment spend to support more countries internationally (VG targets adding service to 20 countries by 2020), marketing spend to change the brand image away from its traditional SMB focus (including launching the Vonage brand and sunsetting all legacy brands e.g. Nexmo, Tokbox, etc.), and maturing the One Vonage platform along with VG’s suite of in-house solutions will require further R&D.  Analysts have expressed concern regarding the VG’s profitability/sustainability post-divestiture of the cash flowing Consumer segment, but I would note that with nearly ~$900mm of revenues that are growing quickly, the operating leverage of the API and Applications businesses will solve VG’s cash flow / expense issues.

Conclusion / Valuation

VG has undergone several major business transformations that should lead to a valuation re-rating of the stock.  I believe much of the strategic repositioning is done and the product set is complete.  Going forward, the key is to execute.  In this regard, VG recently brought in a new CEO, Rory Read, from Dell, a more operational and execution focused CEO. 

The API business is growing nicely and I believe investors will eventually re-rate this business with investor communication.  The Applications business is starting to turn around and I believe demonstrating continued enterprise and mid-market wins will lead to greater investor confidence (and eventual re-rating).  As such, I believe valuing the business on CY 2021 makes the most sense, where (1) the Consumer segment will be divested, (2) Applications can demonstrate several quarters of sustained mid-market and enterprise wins, (3) the API segment gains greater scale, and (4) the coronavirus pandemic will have lapped nearly a full year.

Depending on analyst estimates, VG currently trades at 2.5-3.0x EV / 2021 revenue, which is too cheap relative to peers TWLO, FIVN, and RNG at 18.8x, 16.6x, and 18.1x 2021E revenue, respectively.  If we assume a 20% discount to VG’s peers, this would imply a $46.25 share price based on a sum of the parts valuation, or nearly ~4x MOIC from today’s share price of $11.73.

Catalyst

Divestiture of Consumer segment

Continued strong growth of API business

More mid market and enterprise wins >$1mm in Applications business

Enhanced investor communication