Vonage 2011 Annual Report Download - page 32

ITEM 7. Management’s Discussion and Analysis of Financial
Condition and Results of Operations
You should read the following discussion together with
“Selected Financial Data” and our consolidated financial state-
ments and the related notes included elsewhere in this Annual
Report on Form 10-K. This discussion contains forward-looking
statements, which involve risks and uncertainties. Our actual
results may differ materially from those we currently anticipate as
a result of many factors, including the factors we describe under
“Item 1A—Risk Factors,” and elsewhere in this Annual Report on
Form 10-K.
OVERVIEW
We are a leading provider of communications services
connecting people through broadband devices worldwide. We
rely heavily on our network, which is a flexible, scalable Session
Initiation Protocol (SIP) based Voice over Internet Protocol, or
VoIP, network. This platform enables a user via a single
“identity,” either a number or user name, to access and utilize
services and features regardless of how they are connected to
the Internet, including over 3G, 4G, Cable, or DSL broadband
networks. This technology enables us to offer our customers
attractively priced voice and messaging services and other fea-
tures around the world.
In 2009, we shifted our primary emphasis from the domes-
tic home phone replacement market to the international long
distance market. With Vonage World we offer unlimited calling
domestically and to more than 60 countries, including India,
Mexico, and China, for a flat monthly rate. We believe the value
and convenience provided by Vonage World is particularly
appealing to international long distance callers compared to
offers from our competitors.
In addition to our landline telephony business, we are lever-
aging our technology to offer services and applications for
mobile and other connected devices to address large existing
markets. We introduced our first mobile offering in late 2009 and
have continued to build upon our mobile services strategy with
two product introductions in mid-2011. In early 2012, we
introduced Vonage Mobile, our all-in-one mobile application that
provides free calling and messaging between users who have
the application, as well as low-cost international calling to more
than 200 countries to any other phone. In addition, calls by
users of the mobile application to Vonage home or business
lines are also free. This mobile application works over WiFi, 3G
and 4G and in more than 90 countries worldwide. Vonage
Mobile consolidates the best features of our prior applications,
while adding important functionality, better value, and improved
ease of use. Vonage Mobile users can instantly add calling
credit from within the application through iTunes or the Android
Market for calls to users without the application. Vonage Mobile
uses the phone's existing mobile number and contact list, elimi-
nating the need for unique user names and duplicate identities
for contacts and allowing users to build a free global calling and
messaging network from their existing contacts using the appli-
cation's multiple invitation system.
We have made significant financial progress over the past
four years providing a solid foundation for the future. We have
managed a significant strategic shift while transforming the cost
structure in our core business to drive significant improvements
in profitability. We enhanced the value of our product by inves-
ting in upgraded systems, streamlined processes, and improved
customer experience, which we believe have helped stabilize
our subscriber base while driving structural cost reductions
throughout the company. In addition to reducing ongoing costs,
these structural improvements enabled us to absorb incremental
costs resulting from a growth in international minutes as we
added new customers to our Vonage World plan. By lowering
international termination costs, lowering domestic calling rates,
and reducing the cost of our devices by nearly a third, we have
significantly improved our profitability.
In 2011, our core business generated substantial net
income and cash flow on relatively flat service revenues, driven
by an aggressive focus on driving efficiencies throughout our
operations. Through two refinancings in the past 14 months, we
have reduced our debt by over 50% and lowered interest rates
from highs of 20% to less than 4%, saving $43 million in annual
interest expense from the debt structure in place in 2010.
We had approximately 2.4 million subscriber lines for broad-
band telephone replacement services as of December 31, 2011.
We bill customers in the United States, Canada, and the United
Kingdom. Customers in the United States represented 94% of
our subscriber lines at December 31, 2011.
Recent Developments Net deferred tax assets represent
the temporary differences between the financial reporting bases
and the tax return bases of our assets and liabilities. Our net
deferred tax assets primarily consist of net operating loss carry
forwards (“NOLs”). We are required to record a valuation allow-
ance which reduces these net deferred tax assets if we con-
clude that it is more likely than not that taxable income
generated in the future will be insufficient to utilize the future
income tax benefit from these net deferred tax assets prior to
expiration. We periodically review this conclusion, which
requires significant management judgment. Until the fourth
quarter of 2011, we recorded a valuation allowance which
reduced our net deferred tax assets to zero. In the fourth quarter
of 2011, based upon our sustained profitable operating
performance over the past three years excluding certain losses
associated with our prior convertible notes and our December
2010 debt refinancing and our positive outlook for taxable
income in the future, our evaluation determined that the benefit
resulting from our net deferred tax assets (namely, the NOLs) are
likely to be usable prior to their expiration. Accordingly, we
released the related valuation allowance against our United
States and Canada net deferred tax assets, and a portion of the
allowance against our state net deferred tax assets as certain
NOLs may expire prior to utilization due to shorter utilization
periods in certain states, resulting in a one-time non-cash
income tax benefit of $325,601 that we recorded in our state-
ment of operations and a corresponding net deferred tax asset
of $325,601 that we recorded on our balance sheet on
December 31, 2011. In subsequent periods, we would expect to
recognize income tax expense equal to our pre-tax income
multiplied by our effective income tax rate, an expense that has
not been recognized prior to the reduction of the valuation
allowance and that will reduce our net income and earnings per
share. In the future, if available evidence changes our conclusion
that it is more likely than not that we will utilize our net deferred
tax assets prior to their expiration, we will make an adjustment
to the related valuation allowance at that time.
24 VONAGE ANNUAL REPORT 2011