|Shares Out. (in M):||255||P/E||0||0|
|Market Cap (in $M):||1,910||P/FCF||0||0|
|Net Debt (in $M):||490||EBIT||0||0|
|TEV (in $M):||2,400||TEV/EBIT||0||0|
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Vonage is no stranger to VIC- this will be its 6th appearance. For what the idea lacks in originality, I hope it makes up for in performance. At under $8, I think one has very good odds of making money on Vonage and potentially a lot of it. For those unfamiliar with the story, Lukai’s 2016 writeup and ATM’s 2016 and 2018 writeups do a very good job of illustrating the company’s transition from a consumer-oriented VoIP provider to a business communication software company. While the company has made a lot of progress and a few smart strategic moves (most notably the acquisition of Nexmo), execution has been choppy and messaging has been poor leading to the stock round-tripping between $7 and $14 twice. I think those issues are more than baked into the current price and the return skew looks good even without assuming any material inflection in the problem areas. This writeup is structured as: a brief overview of the company’s business lines, what’s gone wrong, and how I am thinking about valuation. I will try to keep the use of UCaaS, CPaaS, CCaaS, and all other ‘aaS’ acronyms to a minimum.
Vonage’s consumer segment represents its legacy voice-over-IP product for consumers. The business has been in decline for over a decade, though at a steady rate and provides predictable high margin cash flow which management has used to reinvest in the business segment. The consumer segment did ~$380m last year with revenue declining ~13%. The segment has high a 70%s gross margin with service gm in the 90% range. The company has shifted nearly all of its opex budget to the business segment so most of this drops through to the EBITDA line. I expect continued declines in the mid-teens range with the company remaining harvest mode. On the 4Q18 call, management said that they expect the consumer segment to generate over $600m in free cash flow over the next five years with material terminal value after that. Guidance for the segment given at the beginning of the past two years has been pretty much spot on so I think trajectory is predictable and the longer-term guidance should be taken as credible.
Vonage’s business segment develops and sells cloud-based communication software to companies of all sizes. This includes cloud-based PBX phone solutions, collaboration tools like video conferencing, contact-center software, and programmable communication APIs. The TAM across these areas is significant at $55bn today and is expected to grow considerably (44%) over the next 3 years. Programmatic communications is the fastest growing segment- expected to grow from $5bn to $18bn.
Vonage built this segment through a long string of acquisitions beginning in 2013. The company first built out its UC platform and then in 2016 bought Nexmo to add programmable communications. In late 2018, the company added contact center-as-a-service with the acquisition of New Voice Media. With a product portfolio now able to address the entire cloud communication TAM, future M&A should be limited to smaller tuck in deals.
Management often highlights the strategic value in having one integrated platform across unified comms, contact center, and programmable APIs. This should allow Vonage to more tightly integrate the solutions and control the product roadmap in a way that benefits the entire platform. While this makes logical sense, I don’t think we have really seen this play out in the results- the more focused solution vendors (and their shareholders) i.e. TWLO, ZM, RNG, FIVN, BAND seem to be doing pretty well- but perhaps this may provide some competitive differentiation in the future or be strategically important if the industry consolidates.
Within its business segment, Vonage breaks outs its Application products and its API platform. API is made up primarily of the Nexmo business. Years ago, Nexmo revenue was largely composed of just SMS and was primarily international. Vonage has successfully added new products and now offers the full programable comms stack including video, audio, messaging, and email. These newer products are higher margin and are growing faster than SMS. Overall the business is humming. On a TTM basis, the API platform did $278.7m in revenue and is growing close to 50% constant currency. On a recent call management stated that VG has over 900k developers registered on the platform and net expansion rate is in the 130%s.
Vonage’s Applications product group is made up of its unified communications and contact center products. This has been the problem area. In large part due to how the Applications business was pieced together over time, Vonage is over indexed to the micro and SMB end of the customer spectrum. This part of the market is growing slower and customers offer less attractive economics (higher churn, lower LTV, etc). Recognizing this, Vonage has been trying to push up market to address the accelerating enterprise opportunity. This shift has been bumpier and taken longer than most investors expected leading to the share price volatility over the past two years.
Down ~45% over the 5 months…what happened?
In the beginning of 2019, management stated that they expected business services revenue to accelerate throughout the year and exit 4Q at close to a 30% organic rate. This would position the company to do $1bn in business revenue in 2020. 2Q19 results began to show some cracks in the outlook. On an organic basis, Applications Service revenue growth decelerated from 13% in 1Q to 11%. I suspect this item, combined with overly optimistic profitability expectations for 2020, led to the stock to move from $13 to $10. The big plunge in November happened with the company’s 3Q release. Business services revenue slowed to 23% (down from 25% in 2Q) due to further deterioration in the company’s Applications product group, which grew only 8% on a constant currency organic basis. These results shattered any hopes for $1bn+ in business revenue next year and also damaged management’s credibility.
Management identified a few items responsible for the slow down in the Applications business. First, the company reallocated sales and marketing dollars away from the SMB/micro into the enterprise end market. The SMB/Micro cohort still accounts for 48% of Application revenue and grew 5% in the quarter vs enterprise which grew 12%. The sales cycle for enterprise deals is much longer so the reallocation of S&M dollars will take some time before paying off. Second, the company transitioned from selling a legacy Broadsoft-powered enterprise unified comms solution to only selling its Vonage Business Cloud product. The transition happened in April and caused more disruption than management expected. It seems that Vonage Business Cloud (VBC) may not have been totally ready for prime time. At recent conferences, management has called out a few product enhancements which should solidify VBC as a legitimate enterprise grade offering going forward. Finally, the company rebranded to bring all its product lines under the Vonage brand which may have caused some disruption with the contact center product (formerly New Voice Media).
I think these items are all probably transitory/fixable. At a Needham conf in Nov the CEO gave some color on bookings suggesting results should improve going forward:
CEO: So, when I think about – and I think what we missed – we didn't estimate properly, and this is sort of reflected in the investor upset on the deceleration in-year was sort of that frictional complexity – we have a lot of spinning plates in the air. Those plates are again largely behind us, which is very good. But if you look at like bookings, bookings went down Q1 to Q2, kind of flattish in Q3 and coming up in Q4, again, as you move through this frictional dislocation. So – and again, the components of the bookings as well are changing, less down market, more up-market. So, it's heading in the right direction. Again, it's not – it's a subscription business. So, it doesn't come up like a rocket ship by any stretch. So, you think more of it like a U than some sort of V type thing, and I think that's where we are.
Notably, the company just announced a deal with the University of Pennsylvania to provide unified communications for the University’s 14k faculty and staff. The size of this deal gives me some confidence that there was nothing incurably wrong with the product portfolio.
The bigger point, which I will try to elucidate below, is that at current levels one is getting the Applications business (~$400m in TTM service revenue) almost for free. I think any improvement/stabilization of results should lead to a substantial re-rating of the stock.
I think given the different characteristics of Vonage’s business lines, a sum of the parts is the best framework to look at valuation.
· Consumer business
o At the beginning of 2019, management expected consumer to generate over $600m in FCF over the next 5 years with significant terminal value beyond that horizon. If we assume $200m (just a guess) in 2019 that leaves $400m over next 4 years.
o You can play around with discount rates, terminal value, and how you want to split the cash flows up but to keep things simple I am just going to say the PV is $350m
· API business
o TTM revenue was $278 and business posted 48% organic growth in 3Q. I assume growth slows to 35% for the NTM and the business does $375m in revenue.
o What’s the right revenue multiple?
§ It seems to me that the market hasn’t made up its mind on valuing CPaaS businesses. On one hand, it is a huge fast-growing market, customers build the APIs into their applications driving retention and stickiness, and self-serve sales channels should lead to an efficient CAC. On the other hand, revenue is mostly usage based (maybe less resilient in a downturn than a pure subscription) and gross margins are lower than other SaaS categories. Since its IPO in 2016, TWLO, the CPaaS bellwether, has seen its forward revenue multiple go from 16x to 5x back to 15x and now sits at 11x. TWLO has slightly lower organic growth than Vonage’s API business but probably deserves a premium for its execution, scale, and higher margins.
§ BAND, another CPaaS name, is growing much slower (mid-teens %) and trades at ~6x revenue.
§ To be conservative, lets go with a 55% discount to TWLO and a 15% discount to BAND and throw a 5x on it. This puts the API business at $1,875m
· Applications business
o Based on the above assumptions and Vonage’s current EV of $2.4bn, the Applications business’s implied valuation is $175m or 0.4x the TTM service revenue ($393m). Clearly there have been some execution issues, but I don’t think this valuation makes sense. For reference, EGHT trades at 4x, RNG trades at 16x, FIVN trades at 12x. Even AVYA almost gets a 2x EV/rev!
o Assuming continued HSD growth next year (in line with the disappointing 3Q and giving no credit for a rebound) 3x service revenue puts the Application business at $1,300m
o Consumer $350m
o API $1,875m
o Application $1,300m
o Total $3,525m
§ - Net debt $490
§ = Equity Value $3,035 or $11.90 per share for 50% upside
§ Putting closer to peer multiples on VG’s businesses gets you to a high-teens share price.
I realize this analysis is done in broad strokes and relies entirely on revenue multiples. Like most no/low profitability software names, management has said that it expects the business segment to achieve mid-20%s EBITDA margins at scale. Consolidated Adj EBITDA is expected to grow next year slightly (consensus is at +$4m). If we assume 80% decrementals on the declining consumer revenue, the business segment is expected to add ~$45m in EBITDA on ~$150m in additional revenue for a 30% incremental margin. While that 30% number is encouraging, big picture, I think the current price is low enough where the investment works no matter if margins 5 years from now are 15% or 25%.
Vonage’s complexity from its various business lines, multitude of ‘aaS’ acronyms, and differing financial characteristics all undoubtedly contribute to its valuation discount. I recognize that there should be some SOTP discount and the value of the consumer segment depends a lot on whether management will do smart things with the money. Over time the picture should get clearer. In 2020 the business segment will make up ~75% of total revenue. Revenue growth on a consolidated basis should continue to improve over the next few years due to the mix shift even with conservative assumptions around an Application rebound. Should the shares continue to languish, I think Vonage could be an attractive M&A target for a bigger tech company looking to make or strengthen inroads into the large and growing cloud comms TAM. Overall, I see a wide margin of safety at the current price and the potential for considerable upside even with conservative fundamental assumptions.
Disclaimer: The views and opinions expressed in this report are those of the author only and do not reflect the views and opinions of the author’s current employer. This material is being provided for informational purposes and is not to be considered an offer to sell or a solicitation of an offer to buy any investments referred to herein.
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