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

Company Update

Vonage Holdings (NYSE: VG – $4.64) is a leading provider of Internet-based telephone services.  Readers of this blog know that I thought the stock looked appealing a month ago, at $3.26, based on a rebuilt balance sheet, improving margins, and opportunities for renewed revenue growth. 

So far, so good.  The company reported its quarterly and annual earnings this week, and it was happy reading for investors who hold the company’s stock.  The shorts, on the other hand, were burned badly, as the stock jumped 20% following management’s conference call.

The results were pretty much in-line with management’s guidance: another uptick in gross customer additions, slightly lower churn, improving average revenue per sub, and slight margin improvement compared with the third quarter.  Management also reaffirmed its 2011 outlook, so the casual investor might wonder what caused the stock to rocket forward.

A good chunk of the buying pressure in the last few days is undoubtedly short-covering, as Vonage has long been one of darlings of the bears.  The shorts had anticipated that Skype would siphon off many of Vonage’s international customers, that the core domestic customer base would erode quickly, and that the emerging mobile connectivity products would fizzle.  None of those fears seems to be materializing, and the bears possibly are losing patience. 

Beyond short-covering, the fundamentals also support a richer valuation.  To put things in perspective, remember that the stock price is now more than triple where it was a year ago.  In that time, the company has refinanced its debt to extend maturities and reduce interest expense; it has refined its marketing campaigns to focus more closely on its targeted demographic segments; and it has completed its management transition.

Equally important, the company’s operations have steadily improved.  By focusing only on the international long distance market (where the circuit-switched carriers have the highest price umbrella), Vonage has demonstrated its ability to improve net customer additions without compromising its revenue or expense trends.  And the mobile strategy could be a huge success as smartphones become an ever larger part of the U.S. installed base.  Verizon’s ability to sell the iPhone is a big plus for Vonage.

A month ago, I suggested that the stock might merit an expansion in its EBITDA multiple to around 6x over the coming year – and it’s done so in only a few weeks.  At this point, continued gains in mobile and international long distance could support further appreciation, but the burden is more clearly on the bulls now. 

Super Stock Screener’s rating system acknowledges that the risk/reward relationship has changed, as the stock was recently downgraded from 1 – Strong Buy to 2 – Buy.  I’m comfortable holding the stock here, though I don’t plan to add to my position and I might take some profits at the current price.

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 has a long position in the shares of Vonage Holdings. This document is a general commentary and is not intended to provide specific investment advice.  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. The author has no connection to any advertisers on this website.  Further information is available by contacting West Shore Investment Management LLC or Mr. Tyler at michael.tyler@westshorefund.com.

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