PSB Monthly Issue March 2014

According to recent Census Bureau data, companies with less than 500 employees made up 99% of all employer firms.  Moreover, firms with 20 and under employees make up 90% of that total.

Small businesses also produced 46% of the country’s GDP in 2008, according to the most recently available data.  And, 65% of net new jobs created between 1993 and 2008 came from small firms.

Perhaps most importantly, businesses with less than 500 people employ nearly 50% of private payrolls.  Companies with fewer than 20 people employ 18% of private payrolls.

As can be seen, small business is clearly a huge, important part of the American economy.

The vast majority of those businesses require basic services to operate, just like any other company.  That means everything from Internet connections to office supplies.

And of course, most small businesses require communication services.  In fact, the voice service market in North America for small and medium businesses is $15 billion.

That means there’s plenty of opportunity for business beyond what traditional carriers offer.  Not to mention, traditional carriers tend to be far more expensive than alternative communication services companies.

And that’s where Vonage (NYSE: VG) comes in.

THE COMMUNICATION SERVICES BUSINESS

Vonage provides communications services which connect individuals and businesses through cloud-connected devices worldwide. The company offers voice and messaging services through session initiation protocol based voice over Internet protocol network.

That’s just a fancy way of saying users can start a session using the internet to talk or text another person.  Basically, VG’s services are home telephone replacements for residential, home office, and small office customers.  Basic features of the services include common items such as call waiting, caller ID, voicemail, and call forwarding.

However, one major advantage to VG’s services is its ability to offer calls to 60 different countries on top of local calling features.  That means for one monthly fee, a customer can call landlines, mobile phones, and international locations without additional costs.  VG also has a mobile app for free calling and messaging between users who have the application.

Here’s the thing…

What I really like about Vonage is the company’s recent acquisition of Vocalocity.

Vocalocity is one of the fastest growing providers of cloud-based communications services to small and medium businesses. The company has focused mostly on businesses with under 20 employees.

VG paid $130 million for Vocalocity which generated $62 million in revenues in 2013 – higher than projected when the company was purchased.  The $17 million of revenue Vocalocity received in the fourth quarter represents a 40% year over year increase.

Most importantly, synergies from Vocalocity’s integration into VG should provide impressive growth opportunities.  Nearly 85% of small and medium businesses still purchase voice service from traditional carriers.  Those services cost 40-50% more than Vocalocity’s services.

Clearly, there’s ample opportunity for VG to capture market share in this space with the acquisition and integration of Vocalocity.  What’s more, Vocalocity recently launched several new mobile and desktop applications to help businesses amplify their customer and business relationships.

These apps include methods to interface with Salesforce.com, use rich call history features, read voicemail transcripts, and more.  Most of these features can be handled directly from a user’s smartphone as well.

Bottom line, by purchasing Vocalocity, VG has wisely expanded their knowledge of affordable communications technology to include small and medium businesses.  With the synergies between these two companies, there’s good reason to be optimistic about future growth prospects.

THE NUMBERS

Overall, Vonage’s financial numbers are mixed.  The company’s 2013 performance didn’t quite live up to expectations.  However, at least part of that was due to the acquisition of Vocalocity – which will benefit the company financially over the long-run.

More specifically, VG’s annual revenues were $829 million, down from $849 million the prior year.  However, churn improved from 2.6% to 2.5% and is a very important metric for communication companies.  In fact, the company reported its first positive year of net line additions since 2008.

Meanwhile, EBITDA was $110 million for the year, down from the previous year’s $135 million.  Net income was $52 million compared to $84 million in 2012.  Keep in mind, the profit numbers were affected by acquisitions and growth initiatives.

VG ended the year with $85 million cash compared to $135 million in debt.  The company’s operating cash flow and free cash flow remain strong.  And, the company is continuing a $100 million stock repurchase plan that will wrap up by the end of 2014.

INVESTMENT RISKS

As with any small cap investment, VG does have a few risks.

A slowdown in global economic growth could lower demand for VG’s services and hurt revenues.

An increase in competition or new players in the market could result in a slowdown in revenue growth.

Finally, changes in technology could make VG’s services less appealing or antiquated compared to newer products.

POTENTIAL RETURN OF 74% OR MORE

Analysts project VG to grow profits by 36% next year on revenue growth of 7%. That’s not bad, but I believe the company will do even better given the potential upside Vocalocity brings to the table.

Even so, a 36% increase in profits is nothing to sneeze at.  Along with the share buyback and new revenue opportunities, VG shares should get a significant bump in 2014.

Vonage also could make for an attractive buyout candidate for a major telecom or other communications company.

Based on our analysis, we see VG climbing to $8.00 a share or more.  Buy the shares now for potential gains of 74% or higher!

ACTION RECOMMENDATION

BUY Vonage (NYSE: VG) up to $5.00 per share.

Don’t forget your position sizing and stop-loss rules.