Description

Idea

 

At its current “option value” price, Vonage (“VG”) offers a compelling risk / reward special situation with a clear catalyst in the near-term.   Investors are buying a call option with a long expiration date, major upside and the odds in their favor.  The immediate catalyst is the resolution of the patent litigation case between VG and Verizon (“VZ”).  VG is currently appealing the case (see discussion below).  The odds of at least a partial reversal of the VZ case are excellent.  The Company has a strong balance sheet and the liquidity to fight the legal case.  The litigation side itself provides great return potential- we estimate it at 50% in the near-term (based on probability weighting of likely outcome).   But if the Company can also execute on its proposed restructuring the stock could increase to many times its current price.  So investors get an excellent near-term trade on litigation with significant upside potential in the long-term.    

 

VG is among the largest providers of broadband telecommunications services with approximately 2.4 million subscribers as of 3/31/07.  Utilizing voice over internet protocol (VOIP), the Company offers low cost telephone services to customers.  At a cost of $24.99 per months (prices vary based on different offers), customers  receive unlimited local and long-distance calls as well as additional features, such as voice mail and customer ID.  The Company went public in May 2006 for $17 per share.  The stock has since declined over 80% to $3, due to disappointing operating results and, most recently, the loss of a potentially devastating patent litigation suit with Verizon (“VZ”).        

 

Legal Situation / Catalyst

 

Probability / Catalyst

 

Vonage has a far greater than 50% chance of winning its appeal or reaching a more favorable negotiated settlement with Vonage.  Such a victory would be a major positive catalyst for stock as it would: 1) eliminate the specter of injunction which currently hangs over the Company and threatens VG with insolvency and 2) potentially lower the cash damages and royalties payable to VZ.  While a decision by the Appeals Court, which will likely occur in 3Q 07, is unlikely to result in a complete victory for VG, the decision should greatly strengthen VG legal position.   As a general rule, the defending party stands an almost even chance of having a patent defeat over-turned.  In cases where claim construction is a primary issue, the defendant has an even greater chance.  While the Appeals Court generally shows deference to the District Court, which issues the initial verdict, in matters of fact, in matters of law the Appeals Court frequently disagrees with the lower court.  (The logic being that the District Court heard the case so it has greater understanding of the actual events involved.  In matters of law, the Appeals Court must do its job and determine the law on a de novo basis.)   The Vonage appeal centers on claim construction.  Based on our reading of the appeals and legal due diligence, VG has a strong and credible case. 

 

Background

 

The patent case is proceeding at an expedited basis with oral arguments beginning this week.  In March 2007, Vonage lost a patent cased filed by Verizon.  Verizon sought an injunction against VG from continuing offering its product and damages totaling almost $200 million.  The jury awarded Verizon $58 million plus interest (a total of $66 million).    The Court also issued an injunction against Vonage.  The Appeals Court issued a temporary stay on the injunction.  At this point, VG is proceeding with its appeal and has deposited $66 million in escrow pending the appeal.  VG also pays 5.5% of telephony revenue into escrow on a go-forward basis.  The table below summarizes the key dates in the case:

 

Court Matter / Decision	Date
Verizon files initial compliant	6/12/06
Jury upholds 3 of 5 patent violations	3/8/07
Appeals Court issues temporary stay of injunction	4/6/07
Oral arguments for Appellate Court begin	6/25/07
Appellate Decision	Projected July / August 2007

 

During this time, VG has also announced it has completed work-around solutions for 2 of 3 patents it has violated and will soon complete a work around for the 3^rd patent.  If the work-arounds (which will almost certainly be legally contested by VZ) are successful, the case becomes moot except for past damages (royalties will no longer apply as the Company is not using VZ patents).   Work-arounds involve risk as they may not offer as appealing a customer experience as the current technology, which has been shown to work effectively.  But they are viable option if the legal situation goes against the Company.

 

Possible Legal Outcomes

 

Outcome	Probability	Est. Price	Return
District Court Over turned	10%	$7.50	150%
Districted Court Affirmed	10%	$1.50	-50%
Case Remanded	50%	$4.50	50%
Work Around	10%	$3.50	17%
Settlement	20%	$4.50	50%
Expected Price: $4.40   Expected Return: 47%

 

§         District Court Overturned- The most favorable outcome.  A rare legal occurrence

§         District Court Affirmed- Based on our legal due diligence, VG has a strong case and there are real questions about lower court claim construction.  Result seems very unlikely.

§         Case Remanded-  The most likely outcome.  Would likely lead to a settlement in the long-term as VZ would now have more to lose as their victory is in jeopardy.  Decision would give VG a new lease on life with a “do over”.  VG stock traded at over $5 days prior to loss in District Court.

§         Work Around-  Not likely to be the final answer for the case, but could be used if no settlement.  Stock would likely stabilize.

§         Settlement-  Issue would be resolved.  Could happen during appeals process, more likely if remanded as VZ would likely become more flexible at this point.

 

Balance Sheet

 

VG has a strong balance sheet and can survive through the appeals process.  The Company has over $2 per share in cash.  The table below summarizes the Company’s capitalization proforma for the escrow payments and estimates the Company’s liquidity based on its cash burn rate as of 1Q 2007 (a worst case scenario) and proforma for its restructuring plan:

 

Stock Price	$3.05
Share	155.4
Market Capitalization	474.1
Convertible Notes (due December 2008)	253.3
Capital Leases	23.0
Cash	344.3
TEV	406.1
1Q 07 Annualized (EBITDA less CX)	(233.2)
Quarter of Cash	6
2007 EBITDA less CX (Model)	(156.0)
Quarter of Cash	10

 

Based on any reasonable timeline of the case and even dire operating scenarios, the Company will be able to survive and see its legal case through to a likely successful conclusion.

 

Operating Results / Valuation

 

Operating Results

 

While VG currently burns cash, the Company has announced a restructuring plan that will take it closer to cash flow break even by cutting S, G & A and marketing spending.  The Company has aggressively built up its infrastructure and spent heavily on marketing to grow its subscriber base.  With a previous strategy the emphasized growth over cash flow, VG has ample room to cut cost.  On its most recent conference call, management announced its intent to cut S, G & A by $30 million and marketing costs by $110 million.  While VG has generated significant negative EBITDA on a customer base of almost 2.5 million.  Lingo, a subsidiary of publicly traded, Primus, has dramatically cut marketing and expenses and moved very close to break-even EBITDA with a customer based less than one tenth of Vonage.    The Company enjoys strong gross margins and its business requires minimal capital expenditures.  The tables below summarize key historical and projected operating metrics and provide an EBITDA sensitivity based on different customer add and churn assumptions.  PF EBITDA excludes royalties resulting from the case and legal costs.  Our model assumes slower gross ads during the remainder of 2007 due to lower advertising spending with churn up slightly but stable, based on improved customer service and increased management focus.

 

	07 Proj	LTM	1Q 07	4Q 06	3Q 06	2Q 06
Revenue	$816.9	$681.5	$195.9	$181.5	160.7	143.4
Royalties	43.8	10.4	10.4	0	0	0
S,G&A	290.0	294.9	81.0	75.8	72.1	66.1
Marketing	310.0	367.9	90.9	95.6	91.3	90.2
EBIT	-162.5	-279.8	-73.1	-67.3	-65.8	-73.6
EBITDA	-111.0	-223.8	-58.3	-53.3	-52.5	-59.7
PF EBITDA	-27.1	-197.4	-37.9	-47.3	-52.5	-59.7
CapEx	45.0	43.2	12.3	15.0	4.5	11.4
Subscribers	2.5	2.4	2.4	2.2	2.1	1.9
Churn	2.5%	2.2%	2.4%	2.2%	2.6%	2.3%

 

 

PF EBITDA Sensitivity
	Gross Adds
Churn	150.0	125.0	100.0	75.0	50.0	25.0
4.0%	-$12.8	-$26.4	-$39.9	-$53.4	-$66.9	-$80.5
3.5	-3.6	-17.4	-31.1	-44.9	-58.6	-72.4
3.0	5.8	-8.2	-22.1	-36.1	-50.1	-64.1
2.5	15.5	1.3	-12.9	-27.1	-41.4	-55.6
2.0	25.4	10.9	-3.5	-18.0	-32.4	-46.8
1.5	35.5	20.8	6.1	-8.5	-23.2	-37.9
1.0	45.9	31.0	16.0	1.1	-13.8	-28.7

 

The Company also has almost $600m of NOLs.  So any turnaround would have even higher cash flow potential.  The NOLs also provide value (albeit limited by tax law) for any acquirer. 

 

Valuation

 

With an enterprise value of approximately $400 million, VG trades at only .6x LTM revenue and $170 per subscriber.  While it is difficult to find close comps, previous transactions (privately held SunRocket raised money in a venture round with a valuation of $533 per subscriber in 8/06, IDT acquired Net2Phone in 12/05 for 1.7x revenue, EBAY acquired Skype for an astronomical price of $2.6 billion) suggest the Company could be valued at 3x its current price in a transaction.  8x8x, Inc. a micro cap VOIP company, trades at almost 1.5x revenues, again suggesting VG is under valued. 

 

If the Company can contain its customer acquisition costs, control churn and continue to grow, it has the potential to produce significant free cash flow in the future.  It has strong gross margins, minimal capex requirements and a leverageable infrastructure.  Much of its marketing spending has been directed a brand building.  With its name clearly established, VG can reduce this spend.  If the litigation over-hang ends, the Company’s results will also improve due to lower legal spending and, more importantly, more growth.  Customers are clearly wary of signing on with carrier that faces an injunction.    

 

Catalyst

Conclusion / Risks:




VG is best seen as a cheap option with a long expiration. We believe the resolution of its litigation will provide a 50% return. Investors get this return, plus the possibility of a multi-bagger in the long-run if the Company can execute on operations. There is perhaps $1.50 in downside risk.



The greatest risk facing the investment is a loss on the legal front. While we believe this is unlikely, the Company’s would be materially impaired (though a potential workaround could stave off bankruptcy so the stock would likely trade down to the $1-$2 range). VG also faces a potential liquidity crisis if it can not resolve its legal situation and must redeem its convertible bonds. Again, we believe these bonds will be re-financeable if the legal situation is resolved and there is significant time for such resolution. VG also faces strong competition from large telecommunication companies and from the “triple play” offered by cable companies. Based on our market study, it is cheaper for consumers to purchase Vonage and combine it with other offerings than to sign up for the triple play. Most advertisements implying the triple play is cheaper involve only basic cable service (which it is doubtful most triple play subscribers use) or are only for a limited time (triple play is cheaper for first year but then more expensive every year thereafter).