By Michael A. Tyler, CFA
Consulting Equity Analyst
Super Stock Screener

Vonage Holdings (NYSE: VG – $3.26) is a leading provider of Internet-based telephone services. A pioneer in the field, Vonage has suffered in the past from mismanagement, wasteful spending, and an inability to persuade prospective customers of its value proposition. The balance sheet looked awful, customer desertion was rampant, and cash flew out the door as if a tornado had hit. Small wonder that in the 5 years from the company’s IPO at $17 through the market’s bottom in March 2009, the stock was one of the great shorting opportunities of the decade: It lost 98% of its value over that period.

Investment Opportunity

In the past two years, Vonage has staged something of a recovery, up nearly tenfold from a low of $0.33 to $3.12 yesterday. That’s still down over 80% from the IPO, but it’s progress.

The company has replaced most of its management team and is now in the hands of the talented CEO Marc Lefar. It has revamped its product line into a narrow focus on the few areas where a low-price fixed-wire voice service still makes competitive sense, namely international long distance and mobile, along with some services offered overseas. The company has also focused its marketing efforts more narrowly on demographic segments where it has a defensible niche, such as American ethnic communities with substantial calling volumes to family abroad. Management has dramatically reduced the cost of its online sales and support teams, leading to sharply improved margins. And the balance sheet is in much better shape, thanks to a recent refinancing.

As a result of the operational improvements, Vonage’s financial results have been improving throughout the year. Last week, management announced solid fourth-quarter summary results, and promised more improvement in 2011. For the quarter just ended, Vonage showed positive net customer additions for the first time in over two years, thanks to revived gross sales activity and sharply lower customer defections. The company’s earnings before interest, taxes, and depreciation/amortization, or EBITDA, margin is likely to top 18% for the quarter just ended, compared with less than 5% only two years ago.

Super Stock Screener’s Ranking System loves this stock, giving Vonage a score of 1 – Strong Buy. Yet after a 10x rebound in two years, investors are wise to ask whether all of the company’s improvement is now reflected in the stock price or whether the stock is still appealing.

Valuation – The Bear Case

Vonage is trading at about 5.0 times current EBITDA. That’s about a 10% discount to most American telecom services companies, suggesting that investors remain skeptical of the company’s revival from its near-death experience two years ago. Because reported earnings are still negative, P/E ratios aren’t helpful in evaluating the company’s price relative to past results; but looking ahead, the stock now trades at about 16x forward earnings, broadly in line with its peers.

A pessimistic view of the company’s prospects holds that its early customers – the people who signed up for the first VOIP (voice-over-internet) service they could get – will continue bailing out, choosing instead to use their local cable companies or cutting the cord entirely and using only a wireless phone.

The bears also believe that Vonage won’t make much headway in foreign markets (either for Americans calling abroad or for people calling to the U.S. from overseas), and that its mobile wireless VOIP strategy won’t take off. In this scenario, revenues continue to erode, profits are pressured by lack of high-margin services, and the company burns through its cash without finding a sustainable business model. This ursine assessment assumes that services such as Skype destroy the profitability of international calling services in the same way that the old AT&T One Rate and other national wireless bucket plans ultimately destroyed the profitability of domestic long distance calls.

Maybe so. But here Vonage is the aggressor, not the defender. It’s also the upstart, not the giant incumbent. Even if Skype pushes international rates down (which is likely), there’s still a huge price umbrella for Vonage, and none of the incumbent phone companies has any incentive to retaliate.

Valuation – the Bull Case

Vonage’s prospects are supported by its stature within the industry, so the full bear case seems unlikely to play out. That’s not enough to support a strong bull case, though. So let’s look at three important positive ways that Vonage differs from most of its peers:

• Its balance sheet is getting better. In the past year, Vonage has sliced its net debt in half, a function of both refinancing and positive operating free cash flow. It’s reasonable to see net debt dropping still further, from $93 million in the most recently reported quarter to as little as $30 million in a couple of years. Whether Vonage pays down the debt or lets cash accumulate is up to management, but the company is under no pressure: it has no meaningful debt maturities until 2013. As the balance sheet improves, more of the company’s value flows to shareholders, helping the stock price.

• Vonage’s profits are growing faster than those of its peers. Despite anemic near-term revenue growth, VG should see dramatic profit growth over the next few years, as margins continue to improve. The margin growth comes from a focus on more profitable products while less profitable ones erode away (i.e. international calls replacing domestic VOIP in the product mix), from lower customer churn, and from more restrained marketing expenditures.

• Vonage has a clear path to improving revenue growth. While most companies in the sector are fighting to hold their average customer bills steady, Vonage is one of the few that can benefit from an improving price trend. It’s not that prices for any individual service will rise – that won’t happen – but rather that the product mix is shifting rapidly toward higher-priced services. Combined with effective targeted marketing, this trend should enable Vonage to accelerate its revenue growth in the foreseeable future.

Taking these factors together, it’s reasonable to look for a slight multiple expansion (from 5x to 6x) on sharply higher cash flows in the next couple of years, which can support a valuation of $4.50 to $5.00 per share. Even on a flat multiple, the stock price can grow to $4.00 in the coming year as profits grow and the balance sheet makes further improvement. From today’s prices, that’s a bet worth taking.

Michael A. Tyler, CFA, is the managing member of West Shore Investment Management LLC, an independent investment advisor. He also manages the West Shore Fund LP, a long/short equity hedge fund. The West Shore Fund holds a long position in the shares of Vonage Holdings. This document is not intended as and does not constitute an offer to sell any securities to any person or as a solicitation of any person to purchase any securities. Further information is available by contacting West Shore Investment Management LLC or Mr. Tyler at michael.tyler@westshorefund.com.

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