Is Vonage Still Undervalued?

Since Vonage's (NYSE: VG  ) IPO, the stock has been on a near-constant downward slide that destroyed early investors' positions in the business. Analysts and investors blamed management for failing to adapt to new trends in the industry, spending too much on marketing, and a drastically overvalued IPO price. But the last six months have been a great turnaround for the voice-over-Internet pioneer, and the stock has responded with a near-30% climb. In the recent earnings release, the company proved it remains competitive in the Skype era and that a strong marketing campaign can yield big results. Let's take a look at the earnings and see if Vonage still has room to run.

Cheap!
At less than nine times forward earnings, Vonage would appear to be a relatively inexpensive business for one deeply involved in the Internet industry. And this is even after the company's aforementioned 30% run-up in the past few months. Does Wall Street ignore the company, or does Mr. Market just not believe in the long-term vitality of voice-over-Internet?

Realistically, it's because many investors decided the company just wasn't worth their time after years of dismal stock performance. Since its IPO in 2005, the stock has lost 80% of its value, at one point bottoming out at $0.43 per share from an initial price of $13. Vonage went public at an inopportune time, just as Microsoft's Skype was taking off and offering a similar product for free. It crushed Vonage's business.

But let's fast forward to last week, when the company released its fourth-quarter and full-year 2012 earnings. Management was thrilled to announce that the company is nearing completion of its transformation aimed at bringing the company back to relevance. Major cost restructuring efforts have yielded tens of millions in savings over the last few years, and free cash flow has increased greatly along the way. The company also re-evaluated its credit situation and came out paying substantially lower interest rates this past year.

The earnings scoop 
Starting with the full year, the company generated $123 million in EBITDA, a major improvement on its net losses in prior years. Churn rates are coming down, with only 15,000 line losses in 2012, down from 30,000 in 2011. Even when the company was failing in the markets, it was generating plenty of cash flow -- $350 million for the past three years. The free cash flow was a big reason that some top-tier value fund managers, such as Bill Martin of Raging Capital, bought the stock like crazy in recent years.

Quarterly revenue was up just a couple of points (but above Wall Street expectations) based on increased call traffic and a major effort toward international expansion. The company has recently minted agreements with affiliates in the Philippines and Brazil to help drive growth among low-price-point-oriented clients abroad. International calls from North America were up 40% at year's end.

In addition to an international focus, the company is wisely pouring lots of resources into refining its mobile app. Management says download numbers are growing at an accelerating pace along with more and more usage.

Overall, management has been effective at turning the company around and generating the all-important free cash flow via organic revenue growth.

Let's talk value
Vonage is not the uber-cheap buy it was just a few short months ago, but there is still room to run. The company is no longer in deep turnaround territory, but perhaps approaching a major growth run. It's successfully turned the corner and is adding subscribers while forecasting much more for the future.

The company's most massive expense, beyond direct costs, is its marketing. If you have your TV on for more than three minutes, you've likely seen a Vonage ad. While some investors and analysts have complained about this major expense, it has paid off lately. If you remove the marketing spend from the income statement, the company is making a bundle of cash at a very low ratio. Not to suggest that the company will discontinue its massive ad spending, but even a slight reduction going forward would boost profits substantially.

I find Vonage to be slightly undervalued given its growth prospects. Management believes its new initiatives can contribute $100 million in annual revenue by 2014. That would potentially push Vonage's annual take over $1 billion while its current market cap is just $560.95 million.

Vonage is in prime position to offer the new equivalent of calling cards to lower-income customers in developing areas all over the world while attracting other, more affluent customers via its new mobile offerings and international calling packages. Management has been extremely effective in creating a leaner, more cash-generating business and I believe they will continue to do so going forward. As always, invest only in that which you are knowledgeable and comfortable.

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