Venture Global Inc (VG) 2006 Q3 法說會逐字稿

Good day, and welcome to the Vonage Holdings Corp. third quarter 2006 earnings conference call. Today's conference is being recorded.

At this time, I'd like to turn the conference over to Craig Streem, Senior Vice President of Investor Relations.

Mr. Streem, please go ahead.

Thank you, Jimmy. Good morning, everyone, and welcome to our third quarter 2006 conference call. Speaking on our call this morning will be Jeffrey Citron, Chairman and Chief Strategist, Mike Snyder, CEO, and John Rego, CFO.

Jeff and Mike will begin by reviewing our accomplishments in the quarter, and then John will discuss our third quarter results. At the conclusion of our prepared remarks, Jeff, Mike and John will be happy to take your questions, of course. I want to remind everyone that statements made during this call that are not historical facts or information may be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These and all forward-looking statements are based on management's current beliefs and expectations and necessarily depend on assumptions, data or methods that may be incorrect or imprecise.

Such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially. More information about those risks and uncertainties is contained in Vonage's SEC filings. We caution listeners not to rely unduly on forward-looking statements and we disclaim any intent or obligation to update them.

Now it's my pleasure to turn the call over to Jeff for his opening remarks.

Thanks, Craig. Before we get started today, I thought it would be helpful to share with you some perspective. When Vonage was first formed, we had a simple vision, to help people communicate by allowing them to leverage newly built broadband infrastructure. Our goal was to provide high-quality phone service at very competitive prices, built upon a much more flexible platform.

This in turn would allow our customers to save considerable amounts of money while providing them access to advanced communication services. We started out by replicating the basic underlying experience and functionality that traditional telephony users have come to expect. Even as our customers were adopting this new technology, we were able to minimize any disruptions by allowing our customers to use their existing telephones and home wiring.

At the same time, we provided features like call waiting, caller ID, and voicemail, features that we believe added value to and more importantly, complete the user's telephony experience. Throughout this journey, our goal has remained the same, to help our customers communicate when, where and how they choose. The platform we have in place now allows us to provide next generation communication services such as portability, mobility and many other advanced capabilities.

To realize the full opportunity in front of us, it was clear that Vonage needed additional senior leadership, to bring a more structured approach to the business, which is why we brought Mike Snyder in to lead our organization. Mike and I, together with our senior leadership team, look forward to expanding our reach by generating new and exciting communication experiences for our current and future customers.

It is now my pleasure to turn the call over to Mike.

Thanks, Jeff. Good morning. It's now nine months since I joined Vonage. This is our second quarter as a public company. I'd like to go through the results for the quarter and provide some perspective on the changes in the company and the industry during this period of time.

Financially, it was a good quarter. Our early investments in infrastructure and marketing resulted in dramatic growth in customers, usage and revenues. However, we're still a young company and we're going to experience periods of volatility in certain of our operating metrics. Because of this, it may be difficult to judge our performance by looking at any one metric in isolation. When you look at our company overall, however, we are in great shape.

During the third quarter, we added over 359,000 gross subscriber lines, while more than doubling our revenues year-over-year. This was the seventh straight quarter where our gross additions were above 250,000 and it was our 18th straight quarter of double-digit revenue growth. Our revenues for the third quarter totaled 161 million, versus 143 million last quarter, and our net loss narrowed for the second consecutive quarter to $62 million.

The company's operations are also continuing to improve, with third quarter margins reaching a record 64%, an increase of 10 percentage points from 54% a year ago. The improvement margins is a direct result of the scaling of the business and is principally responsible for the increasing cash flow generated from the existing customer base.

It is this strong combination of revenue growth, coupled with increases in direct margins, that is driving the progress we are making towards our goal of achieving positive adjusted operating income in the first quarter of 2008. Not everything in the quarter went as smoothly as we would like, and we had a number of challenges.

Although we saw a worse-than-expected degree of deterioration in churn, we also saw stabilization toward the end of the quarter and, in fact, exited the quarter with September churn decreasing to 2.4%. Now, this happened as a result of a comprehensive plan to improve our customer satisfaction, thereby reducing churn.

Specifically, we focused our resources and energy on first building and developing a world-class customer care organization and, secondly, improving processes and metrics. We've begun to see positive results from those efforts. Over the past several months, trends have shown improvement in our key customer care metrics. For example, from the second to the third quarter, call abandonment rates fell by 44%. First call resolution improved by 12% and the percent of customers who would recommend Vonage improved by 8%.

We believe customer care and churn have stabilized, but it is still too early to declare victory. We will continue to focus relentlessly on specific improvements in customer care and in the overall customer experience. Over time, we expect to see churn come back down to our historic levels.

Looking out at the marketplace, the demand for digital voice services has never been greater. We saw a shift from the early adopters to the early majority and, now, to the mainstream customer market. This is great news for us, because it expands the market opportunity for our services.

We fully anticipated that the VOIP market would, over time, shift in this direction, but, frankly, we've been surprised at how quickly this has happened. Now, this requires an adjustment in our marketing efforts to reach these new customers. It brings into focus the significant opportunity that the mainstream market segment represents.

Further, our research suggest that while most people how who Vonage is, many still do not fully understand the benefits associated with our service, so our strategy here is to change our advertising to include a [presentment] that is far more descriptive and educational and one that will clearly articulate the nature and the value of our products and services.

This will be even more important in the future, as we introduce new features and products to existing and potential customers. The next critical component will be the investment we make in our brand. During the past two quarters, we have dramatically expanded our branding efforts through key sponsorships with the World Cup, the WNBA, the Ryder Cup, the NBA's New Jersey Nets and Notre Dame Football. We believe that such investments are a cost-effective way to build brand awareness and one that we will continue to evaluate for effectiveness.

In terms of distribution, we're going to continue to expand channels as an essential element for future growth. In September, we announced a relationship with Hewlett-Packard whereby customers purchasing an HP-Compaq computer will receive a special offer on their desktop screens.

We're also exploring strategies for broader retail distribution, which could include a Vonage retail presence. Authorized reseller programs and a variety of affinity marketing relationships are also being developed to give us broader reach in the marketplace. Now, you all know that you can take your Vonage service with you almost anywhere there's a broadband connection, but we also know that many customers want local phone numbers.

To satisfy these customers, Vonage was pleased to announce that in the third quarter we continued to expand our inventories to include local phone numbers in the areas of West Virginia, Virginia, Delaware, Kentucky, Michigan, Idaho, North Carolina, Florida and Montana.

In addition, we are focusing on a customer that is maybe too busy or doesn't want to personally install their own Vonage service. To accommodate this growing segment, we will continue to roll out professional installation services. Today, we are currently handling about 1,000 such installations per week, and we expect that to increase over time as we continue to move more mainstream.

Finally, it's important to note that I've spent a great deal of my time here recruiting and hiring best-in-class talent to deal with the issues and challenges created by high growth and the maturing of the company. The team that we are assembling has individuals recruited from the largest and best companies in the world, and it is their experience that will allow us to expand our business and take full advantage of the opportunities that lie ahead.

Now, I'd like John to take you through the financials.

Thank you, Mike, and good morning everyone. Now, I'll go through the detailed financial results for the quarter, but I want to highlight some key points on our progress in positioning the business for growth. First, we are executing against our plan and our financial metrics are sound and are improving.

For the second consecutive quarter, we narrowed our loss, bringing the net loss for the quarter down to 62 million from 74 million on the prior quarter and $66 million last year. In addition, we more than doubled year-over-year revenue to $161 million as we added nearly 1 million net subscribers over the past 12 months. And by aggressively managing direct cost and achieving benefits of scale, our direct margin percentage increased to a record-level 64%, up from 54% a year ago.

This improvement was driven by continued optimization of our traffic flow, grooming of our network and diversification of our PSTN partners. The business model is proving out, and we continue to increase cash flow from the existing customer base and are making progress toward our goal of achieving positive adjusted operating income as early as the first quarter of 2008.

As I mentioned, we are generating significant cash flow from the installed base, meaning that we can continue to invest in marketing for customer acquisition while improving our financial position. In Q3, our installed base generated pre-marketing operating income, a proxy for the cash flow from our existing user base, of $8.44 per line, or $50 million, up from $7.68 per line, or $40 million, in the second quarter. This increase, largely attributable to aggressive cost control, is even more significant in light of our incremental investment in customer care, as well as increased legal fees in connection with recent litigation. We have reached a point where pre-marketing adjusted operating income for every incremental line we add is now over $16, as more than 55% of our G&A is relatively fixed.

This is a key metric for the company and is quite important in our decisions about making incremental investments for growth. Now, let's go through the results for the quarter. On a GAAP basis, our net loss was $62 million, an improvement of 16%, or $12 million, from the second quarter, and 6%, or $4 million, from a year ago.

On a per share basis, this loss was $0.40. This is the first time in Vonage's history that the GAAP net loss has declined year-over-year, clearly a significant milestone for any startup. If we were to isolate the $7 million of non-cash compensation expense in the third quarter, our year-over-year net loss narrowed by $11 million, or 17%. The strong improvement in financial performance is principally driven by improvements in our cash flow from our existing user base.

Vonage recorded revenues of $161 million in the quarter, a 12% increase from second quarter revenue of $143 million and a 118% increase from $74 million in the year-ago quarter. The sequential growth was driven by the growth in customer lines, while the year-over-year increase was driven by the addition of approximately 1 million net subscriber lines, coupled with an increase in ARPU to $27.40 from $25.79 in the year-ago quarter.

Telephony services ARPU came in at $26.33 for the quarter, up $1.49 from the year-ago quarter. They year-over-year increase reflects our continued success in adding customers on our premium calling plans and to a lesser extent, changes in our regulatory fee structure. This now reflects seven consecutive quarters in which our telephony services ARPU has remained relatively stable, or has increased.

Direct margin percentage for the third quarter of this year grew to 64%, our highest ever, up from 54% year-over-year. This resulted in a decrease in the cost per line to $6.86 for the third quarter, as compared with $7.52 in the second quarter and $8.56 in the year-ago quarter. Cost of goods sold was $17 million in the current quarter, up from 16 million in the prior quarter and 10 million in last year's third quarter.

A key element in reaching profitability as we see it is managing our SG&A expense, and we are doing a very effective job. Our fixed costs as a percentage of total SG&A are declining, even more so if we exclude the incremental customer care and litigation costs.

SG&A expense was $72 million in the quarter, which includes $7 million in non-cash compensation expense. SG&A declined as a percentage of revenue to 45%, versus 46% in the second quarter and 61% in the year-ago quarter. If we exclude the non-cash stock compensation expense, adjusted SG&A in the current quarter was 40% of revenue. Clearly, the business is scaling.

Total marketing cost as a percentage of revenue declined to 57% of revenues, or $91 million in the third quarter of 2006, versus 63% of revenues, or $90 million, in the second quarter 2006, and 80% of revenues, or $59 million, in the year-ago quarter. Marketing cost per gross add was $254, compared to $239 in the second quarter. This increase of $15 can be attributed to increasing competition and our investment in brand.

As Mike discussed, the company is adjusting its marketing mix and message to better connect with our target audience. Brand marketing and, more specifically, carefully targeted sponsorships, which accounted for 5 to 6% of our marketing spend in the second and third quarters, is an essential component of our long-term strategy. By comparison, sponsorship activity in last year's third quarter was less than 1%.

Marketing cost per gross add for the first nine months of 2006 were $233, as compared with $214 a year ago. GAAP loss from operations was $66 million, down 11%, or $8 million from the second quarter, and down 2%, or $2 million, from the year-ago quarter. Turning to the balance sheet, our cash and cash equivalents position at September 30th, 2006, was $544 million.

During the third quarter we utilized $42 million to fund our operations and $5 million to fund CapEx. In conclusion, we will periodically reevaluate and adjust our marketing tactics according to how the market evolves, but remain steadfast in our strategy to achieve profitability as quickly as possible.

We will continue to work on improving customer care and churn, yet, even still, our business continues to scale and the existing customer continues to drive increasing cash flows. And now we would be very pleased to take your questions.

[OPERATOR INSTRUCTIONS].

And we'll take our first question from John Hodulik with UBS.

Okay, thanks, good morning, guys.

Good morning.

Just a couple questions on some of the growth metrics. First, the subscriber acquisition costs were a little bit higher than we'd thought, coming off what I would think what is traditionally a higher second quarter from a seasonality standpoint. How do you expect that to trend, and -- do you think this is just the beginning of sort of changes that you've seen in the overall market for voice over IP-based services, or voice services in general?

I mean, is it getting more competitive out there or is it a function of sort of your advertising costs getting more expensive? Or just talk a little bit about some of the trend there. And then, maybe, if you could dive a little bit deeper on ARPU. It looks like it was down sequentially. It's a little bit below our numbers. If you could just sort of look at some of the piece parts, our are sort of the base or voice ARPU trends shaping up and how do you expect that to continue for the next, say, 12 months?

This is Mike, and I think to start, that was a long question. That was probably longer than my attention --

Yes, sorry about that. It was almost as long as your prepared remarks.

Exactly. I think, in general, we did see [slack] move a little higher in the quarter. Part of it was -- we think a small part was certainly competition. We think, however, we also saw back-to-school sales not strong as we thought they would be. And we saw the advertising not pull as hard as we had thought, and we think a lot of that is caused by the change in the marketplace. And we really do feel that as we move forward, we will be concentrating, as we said, on a change in our ad mix into two parts -- one, dedicated to brand and the other dedicated to more educational and informational advertising that has distinct calls to action, which we think appeal more to the mainstream market.

Thirdly will be a broadening of our distribution. And we think that the combination of those factors will continue to move -- or keep slack in line with what you've seen historically from us, and, in fact, our goal is to take it as low as we can go, because we're happy with the ROIs we get at this level.

And this is John Rego speaking, John. To the ARPU question, ARPU on the second quarter, a little bit down. Principally, that relates to less gross adds from which we generate CPE and shipping revenue from. On the telephony services side of the house, I think it's sort of a little bit of a drag from second quarter promotions. The most significant promotion in Q2 of this year was the second line free promotion, so you have some of those free lines coming into the third quarter.

Okay, got you. Thanks.

We'll take our next question from Michael Rollins with Citigroup.

Hi, good morning.

Hey, Mike.

A couple questions. I guess the first one, just a broad question. I think you touched on some of this in terms of talking about the effectiveness of your advertising, but do you see the type of customer behavior or prospective customer behavior changing from you thought in terms of what it would take for that customer to adopt service? And within that context, is it just that there's a barrier to adopting the technology that people have to get through? Is it a cost issue, is it a technology issue?

If you could talk a little bit about that, and then maybe some of the specific things that you're doing to address those issues and observations that you've seen. And then just a quick second question on the churn, when you look at your waterfall analysis on churn, where do you see the spikes? And do you see improvements anywhere in that waterfall?

That would be great. Thank you.

Okay, again, trying to remember all of those things, but this is Mike. And I think in terms of behavior, the early adopter segment were ones who are tech savvy, VOIP savvy, knew the benefits and were looking for a place to go take advantage of VOIP.

And, in that case, the early branding campaigns, or the early marketing campaigns from Vonage were tremendously successful at identifying Vonage as the company to turn to, and one that was synonymous with VOIP, frankly. As that marketplace matures, particularly to the mainstream, these adopters will not be so tech savvy. They're going to want to know very distinctly what it is. Maybe not how it works, but what it offers, what's the value proposition, and what can it do for my life in terms of features?

And we think we're clearly in the mainstream of that. We can really tell a great story that will resonate. The other thing that changes here is that the mainstream market will not go a long way to go get these services, as adopters, so you've got to build out distribution. You've got to be available to the mainstream market, where they want to be, how they want to buy, when they want to buy.

And, in that case, we are building out distribution as we've said today. We will do that aggressively. The third piece will be convenience, and what we're doing now and where you had an early adopter that did not necessarily care about professional installation, because they were tech savvy enough to do it themselves -- in fact, they wanted to do it themselves -- the mainstream market may not want to. Maybe not because it's too techie. It may be because they're too busy. They just don't want to.

In that case, our professional installation becomes a great tool in our arsenal to reach that customer base. Now I'm going to pass it John for the second half of the question, Mike.

Sure. Hey, Mike, John Rego here. So, to the waterfall question, yes, we still do the waterfall analysis, and for those less informed on the call, we've been tracking each crop of customers that we've ever put on since January of 2004, and what we've found with great consistency over time is that most of the churn in that customer experience will happen in the first 90 days, followed by the second 90 days. And once we get past the first 180 days with the customer, churn starts to decline and at some point starts to level off.

So, in a period like this third quarter, when the churn came in at 2.6, clearly, the first 90-day churn was higher than we would like it to be, but the waterfall analysis still seems to be holding true for us. So even at 2.6 churn, we can take that out to a customer life that approaches 60 months, still.

At the risk of just asking for a little bit more of your time on another question, just to follow up, just specifically what are you doing on the distribution side with respect to the kiosk program? Where are you with that? And maybe if you could just specify some of what you've seen on the retail distribution has been either successful or unsuccessful. And then, on the professional install issue, does that raise acquisition costs throughout those customers, but maybe get a better quality sale?

Sorry to ask those follow-ups, but I think they would be just really helpful to get our arms around. Thank you.

Okay. The kiosk program, which was the first question was, as you know, we had a -- we believe it to be a successful test of a kiosk earlier or late in the spring, early summer And we are now currently encouraged enough by that test to move aggressively into a 50-kiosk rollout, and we're in the early stages of that and we'll report more back to you on what we've seen on those stages, but, again, are encouraging.

The second part of the question was --?

The professional install.

The professional install, I'm sorry. It's one of those cases where I wrote it down but I can't read my own writing. The professional installation is one that will pay -- several things. First of all, we do get a large percentage of the customers that do professional install are willing to pay the cost of the professional installation because of the benefit it gives them in solving a problem in their everyday life.

Secondarily, we believe that because the early experience is so great that it will help cause or create longer-term retention, lowered, reduced churn. So I guess the net result of what we've learned from professional installation so far is that we have a lot of options that provide great paybacks for us moving forward.

Thank you.

We'll take our next question from [Munja Shah] with Piper Jaffray.

Hi, guys. This is Munja for Troy Jensen. A couple of questions. You announced these services for customers, sector traffic and digging. Do you plan to charge for those in the future at some point, and how significant is the cost for providing those services.

Well, we believe that the reason that people chose Vonage originally, as I stated just a little earlier, was not only just cost, which we believe we provide a tremendous value, but also because of a tremendous amount of lifestyle services that we also give them. We help them manage their life by giving them some features, some they won't use, but some they're going to really use and really like, and that over time will build great customer loyalty.

So, as a result, for these features, we do not charge and do not plan to charge. The cost itself is minimal, if not zero, to us, so that we're able to do that. And that's through the great designs that we have and introducing technology into the network.

Okay, and a second question, with respect to churn. You mentioned that the churn was higher for the first 90 days than you would have thought. And is that related to customer care issues? Because one would imagine customer care issues come on later on in the stage, so if you could just explain that.

This is John Rego speaking. On the first part, when I was referring to the first 90 days, we have found over almost three years of tracking that churn in general is higher over the first 90 days of the initial customer experience. So I was specifically speaking to an analysis that we do call the waterfall.

Okay, but you did not necessarily experience that this quarter?

Sure, I think we experience that with every new crop of customers, so it's particularly incumbent upon us to get their issues resolved within the first 90 days, and I think that some of the care fixes that Michael has outlined is one very positive step in doing that.

I think just to put that -- this is Mike, again. Just to put that in perspective, I come from a long history inside a service business, and, as a result, in my history I've benchmarked a lot of service businesses, that early life churn spike is not unusual in any recurring service charge business.

All right, thanks a lot, guys.

We'll take our next question from Richard Greenfield with Pali Research.

Hi, just a couple of questions. One, you talked about churn stabilizing. I assume you're referring to the 2.4% level that you mentioned for the month of September. When we think about churn -- I know you said longer term you would expect it to go back down, but over the next -- call it three to four quarters, should we assume that 2.4% or thereabouts is the new kind of normalized churn level?

Two, could you just give us some sense of the professional install, what you're charging. And I think you said that in most cases consumers are willing to pay. Does that mean sometimes you're actually including free installation? And do you think you'll be able to continue to charge for installation in the face of competitors in the cable industry giving away professional install?

And then the last question, just give us some sense of the cost of opening up retail stores and whether that's something you actually plan to do? Thanks.

Okay, again, writing down the pieces. I think the first part was that we saw churn stabilize. We have addressed earlier that the huge growth in the first quarter caused some issues for us in terms of customer care that resulted in higher than we would like to see churn levels. We think we've identified those through really hard work. We've put teams on the ground, we've built processes and metrics, as I said, and we were happy -- I'm sorry, and in our last quarter, we had announced that we would expect the churn to move to a higher level, stabilize and then move lower. And I think what we saw in this third quarter was that happening.

We saw it move slightly higher, and then we saw it at the end of the quarter stabilize at a lower level. And we expect that stabilization as a place for us to build off of, and that we in time would expect churn to go to our historic levels, which were sub 2%. But let me say on this call, our objective is to take churn as low as we can possibly get it to go. I think the second piece was the pro install. I think right now we're charging I think $99 for a professional installation. We have a great many customers taking us up on that, so we believe that it does present value to the customers. And we are using it from time to time as a method of a test to see what the balance is. Where is the level that customers either pay or come to us more quickly? The economics on either way are very, very strong, and, as I said, it provides some real options for us as an additional offer in the marketplace.

In terms of retail stores, we put together some models. It's really too early to even comment on that and we will be glad to share those things with you on future quarters.

And if I could just follow up on the churn question, I know you had talked about it getting down to sub 2% over time, but when you're a month into the fourth quarter at the end of October, can you give us some sense of what the fourth quarter looks like relative to the September number?

Well, it's a little too early for us, as October is not completed, but we do believe that we are seeing the stabilization that we commented on earlier.

Thanks so much.

Thank you.

We'll take our next question from Clay Moran with Stanford Group.

Thank you, good morning. I have three questions. Can you explain any opportunities that you have for bundling? Are you exploring anything in that regard at this point and what the possible opportunities are there? Second question, based on your waterfall analysis, shouldn't we expect to see a drop in churn in the fourth quarter since the first quarter and the second quarters were the big quarters for net subscriber additions.

And the third question is can you give us the amount of the legal costs incurred in the quarter, and does that become a recurring expense? Thank you.

Sure, hey, this is Jeff Citron, Clay. Your first question, regarding to opportunities in the marketplace around bundling surely do get us a bit excited. We've outlined historically a number of strategies to help improve people's lives by bringing additional products to market. One of the things that we are very excited about really is the opportunity to bundle both wi-fi products and dual modes into our service set. Now, as you are aware, just about every operator -- I'm sorry, handset manufacturer -- has announced dual-mode handsets will be made available in the mid to latter part of next year.

Sure, we think that's a nice complement to our already-existing wi-fi phone product. Of course, we're also exploring a number of deals that will allow us to put roaming in place. Now, if you look to what we've done in the United Kingdom, we've actually cut one such deal already with The Cloud, a very large wi-fi operator, where we're now bundling wi-fi service with our wi-fi phones to deliver a unified experience. As it relates to other opportunities in the space, really, there are many out there and we're definitely exploring them.

Okay, John Rego here, Clay. To the waterfall question, I think what the waterfall analysis shows us is that as the base matures, we should see the churn naturally drop. So as the base matures, I fully expect that's what we will see.

To your legal fee question, I won't break out all of our legal fees specifically to you, but I think we're really concerned with the fees relating to litigation, which we've certainly seen a bit of that in the recent couple of months. So quarter on quarter sequentially, litigation fee expense for us was an increase of about $1 million. I would expect to see increased litigation fees the next several quarters as we work through some of the lawsuits.

Clay, this is Jeffrey again. Just one follow-up item on the churn comment. At least as it relates to the fourth quarter, I think Mike has done a great job at already articulating that we believe it's going to stabilize around the levels that we exited the quarter. Of course, it's very early in the quarter to say exactly how things will wind up. A lot what's driving the fourth quarter experience is really around customer care and how quickly we can continue to resolve those issues, but, as John had commented, we do fully expect as the base matures for the churn to drop, and as Mike has already expressed, we expect over longer periods of time to get the number back down to our historical levels.

Yes, if I could follow-up, so on the bundling question you talked about dual-mode phones. How about in regards to Internet access and maybe triple play is a little bit much to ask, but something to compete with the bundled offerings that we're seeing from cable and telephone companies?

Sure. I think the dual-mode experience is really one that's absolutely critical, the ability for customers to take their wi-fi phone from inside the home, outside the home, have it work on the road, and, of course, the bigger strategy for us is creating the one-number experience. Vonage has already made significant inroads on this one-number concept, the ability to have one number for life, the ability to take the number wherever you go, the ability to have that number to ring on multiple devices already, in the future, of course, to have that ring on multiple devices across different network transport layers, whether it be a wi-fi layer, a standard broadband layer, or in the future even a cellular layer. We think that's exciting.

As it relates more directly to some of the broadband bundles, this is something that we're still exploring. There's a lot of changes going on inside the broadband marketplace and we're going to take a little bit of a wait-and-see attitude to see how they materialize. Obviously we've watched with great enthusiasm the rollout of Verizon's FiOS service, we find this very helpful for us and obviously the speeds that Verizon offers is a good positive for our customer base. We've watched what cable has been doing with their broadband deployments. We've been watching what's been happening with EarthLink in regard to their wi-fi deployments.

And, of course, the real big new one is really what's happening in 4G and what's happening with wi-max, and those get us really excited, as we see yet another network coming to the marketplace that will offer customers yet an additional choice to providing broadband access to them in their home and, potentially, on the road.

So there is potential for you guys in the future to try to provide a broadband service? It's just not anything we should expect in the next six months so?

You should definitely not expect any announcements in that area within the next six months as our regards to moving into the sort of becoming a wi-fi -- not wi-fi, becoming a broadband ISP.

Okay, thank you.

Next, from Tier 1 Research, we'll hear from Daniel Berninger.

Thank you. I had a question about direct cost of telephony and if you could sort of add some color, it came down quite a bit year to year, a little bit sequentially. And if you could just talk about what the components of that are and what we could expect as sort of a low -- where we're headed on that. And, related, if there's anything on your product roadmap that would tend to keep people on net, because, ideally, if they don't touch the PSTN that's an especially good deal.

Okay, John Rego speaking, to the direct cost of telephony services, we've spoken about this before. There's five principal components -- cost of leasing phone numbers, cost of leasing collocation facilities, cost of leasing tier one Internet backbone, cost of interconnecting our gateways to someone else's class four or class five switch, and the most significant component, for 57% of our number, cost of terminating access over the PSTN.

Now, we've been doing a lot of work in this area for many, many quarters, and I did have some comments in the presentation about grooming the network and optimization of the traffic, so there's certainly parts in those areas where the folks can do things that will save us some money. Clearly, as the business continues to expand and with well over 2 million lines in service, we're just achieving great benefits in scale on the terminating access piece, which is the biggest component, and in our ability to use multiple partners and to negotiate better rates.

So do expect those numbers to keep coming down over time, can't give you a feel yet as to where I think it can go to, but we're quite proud of $6.86. It took a quite an awful lot of effort to get there.

Hi, Dan, this is Jeffrey. This relates to the on-net call question. We'd say about 5% of all of our traffic is on our network already. Of course, obviously, that has a very low cost to move bits as compared to one that [edges] the PSTN. In the future, as we continue to develop our products, features, services and capabilities, to improve people's lives, to make it easier for them to communicate, we will launch other products that will take advantage of that network and expect to see additional levels of on-net traffic.

And just one quick follow-up -- 911 was a big hit to cost of telephony in the last 18 months or so. Is there anything coming down the pike like that, as far as you can tell?

No, nothing that we can see at this point in time.

Okay, thanks.

[OPERATOR INSTRUCTIONS]

Next we'll hear from James DeStefano with Renaissance Capital.

[Inaudible] have already been answered, but if you can just comment?

Hello?

Hello.

Okay, it was just a little low at first.

Okay, great. Most of my questions have already been answered, but if you could just clarify your outlook for net adds for the remainder of the year, I know you did cut your guidance slightly, and I know part of that is because of the increased churn. But early in the call you commented on how strong the business was in the outlook for adoption of your service, and I just wanted to know if there's anything other than churn that led you reduce your outlook for year-end customers. Thank you.

Well, there are a number of moving pieces in this quarter, which has not been traditionally a strong quarter for us. I think churn -- our outlook for guidance was cut, A, by churn and some loss of our desired effectiveness in terms of the marketing campaigns, and the combination of those two caused us to cut the churn -- cut the line adds.

Thank you.

We'll take our next question from William Mansfield with Millennium Partners.

Thanks, my questions have already been asked.

Next we'll hear from Michael McCormick --

Must be [very] helpful there.

Next we'll hear from Michael McCormack with Bear Stearns.

Hey, guys. Thanks. Maybe you guys can just comment outside of the sort of waterfall chart, but expectations for the seasonal impact in the fourth quarter on your rates of churn. And then two other things, one on cable competition. Have you seen any real change as they roll out voice over IP more aggressively their interest in making it less attractive not to take their voice opportunity? And lastly, on the RBOC side, obviously, they're all offering to some extent naked DSL right now at price points that I think are relatively attractive, meaning higher than the bundled product, but probably in line with what you're seeing from cable model service. Does that create an opportunity for you guys? Thanks.

Sure, hi. This is Jeffrey. In terms of the expectation for Q4 churn, can you repeat that question? I just sort of didn't follow you.

Just trying to get a sense if there is a seasonal impact on churn?

Sure, well, I mean, if you go back and look at the historical churn rates for the company or I should really say SLAC, which is I think also indicative of this issue, Q4 has always been a very challenging quarter for us. SLAC rates in the Q4 timeframe has always been a little higher than previous typical [sets] a quarter, while churn has been relatively volatile, depending on what's gone on in the prior quarters and maturation of the overall customer base. So, again, I think it's very hard to give you any additional guidance on Q4 churn expectations other than the guidance that both Mike and John have already provided to you.

As it relates to cable competition, I think, obviously, the marketplace has been very competitive now for the last couple of years. It's increased a little bit over the last two quarters, or three, as Comcast has entered the market. There's no doubt that's had a small impact on our business. We've seen our SLAC costs increase slightly from the Q2 to Q3 timeframe, but the good news is we're also seeing the market open up quite dramatically. And, as Mike has already expressed, as that market opens up, we will, one, adjust our tactics to get our lion's share of that market, and that provides, we think, the fuel for the kind of growth we're going to look for as we kind of look out to 2007 and beyond.

And the last question was just a question about RBOCs' deployment of naked DSL. I think it's really too early to talk about how the RBOC naked DSL is going to play. Verizon, surely, probably the most aggressive with naked DSL on their rollouts, obviously that coupled with making FiOS available on a standalone basis, has been a big positive for us. We've been very excited about that and it's helping.

Surely, AT&T has been committed to rolling out naked DSL. It's been a bit slower, as they haven't gotten it rolled out in all of their territories yet, a lot that I think principally due to just the integration that's been going on with the prerelease acquisition, and BellSouth has been the slowest with, obviously, again, probably more related to the acquisition by AT&T than anything else in that area.

Does that create opportunities for us? Absolutely, and as I said earlier, we'll continue to explore them.

Thanks, Jeffrey.

You're welcome.

We'll take our next question from Todd Rethemeier with Soleil Securities.

Thanks, good morning, guys.

Good morning.

Just not to beat a dead horse here, but you said that the churn in September closed the quarter at 2.4, and then you said October was stabilizing. Now, am I reading too much into that, or does that mean that it was also 2.4 in October?

Yes, I think you're reading too much into that. We're just giving you a sense that we believed that churn would stabilize at a lower level, and we definitely believe we saw that in September and on into October and pretty much it.

Okay, and then a second question, with all the changes you're making in your advertising and you're offering the installation services and things like that, how much of a lag do you think before we start to see that result in an improvement in gross adds? I mean, is this a month, is it six months, a year?

Well, I think it's a little too early to forecast that. We have to build -- we've got an advertising branding campaign, as well as new direct -- as well direct-response advertising messages and presentment, all of which have been in process and are coming out as we speak, coupled with the knowledge that we've gained in the professional install, but I think you'll see it build up consistently in the quarters to come.

Okay, thanks.

We'll take our next question from [Milan Gupta] with Southpoint Capital.

Hey, guys. On the installation that you guys charge $99 for, is it on average if you average out people who pay for it versus don't pay for it, what is sort of the ARPU for that?

We lost the part of what is sort of.

On a blended basis, how much do you earn from an installation, if $99 is what you charge and some people pay for it and some people don't.

It's not a number I have at the top of mind. We can get back to you on that.

Okay, do you make money on the installation?

At $99 we do.

Okay, thanks.

And we'll take a question from Qaisar Hasan with Buckingham.

Hi, guys, thanks. I wanted to ask a little bit about subscriber acquisition costs. I guess if you look at the trend line from the first quarter through second and now the third quarter, it seems to be moving up quite markedly on a per-gross add basis. Could you talk a little bit about the factors driving this? I guess cable competition is probably one, and then directionally how we should be thinking about these acquisition costs trending going forward? Is there any reason to expect these costs to decline over time?

Yes, I think we tried to cover this and essentially gave you a shift in the market. The SLAC for the year outside past the third quarter, and including the first quarter, has been affected somewhat by competition, to a small degree, somewhat by a shift in the marketing and the marketing mix and somewhat by not having broader distribution as the market mainstreamed.

We do believe that we've got the plans and programs in place to, again, maintain it at this level and improve it on a go-forward basis. And we really do look with the programs we've got in place that this will improve over time.

Now, if I can just follow-up on that, given that cable competition is likely to rise, rather than decrease, over time, I guess if you look at the home service they're marketing their telephony service, that's just going up ever quarter and I guess will continue to go up for next several quarters, especially in Comcast markets.

Why should your acquisition costs, at least the component that relates to competition, show any improvement, at least in the short term?

I think we've seen an intense period of competition over the last year or two. So what we've seen is not going to be any greater than what we've seen, but your question earlier was SLAC impacted by competition? Yes, to a degree, but we think that's all in the number.

Okay, thank you.

[OPERATOR INSTRUCTIONS].

And we'll take a question from [Quincy Lee] with Teton Capital.

Is there a point at which the SLAC costs, if they stay above 250 or some level, which you would materially decrease your spending to bring it back under? I mean, is there a point of pain at which you just will not tolerate SLAC costs?

Hi, yes, so this is Jeff Citron. When we take a step back for a moment and talk about SLAC. We don't look at SLAC and say is it higher or is it lower than any particular quarter from a determination as to what we're going to be spending in the future. We know we're making investments today in a number of our SLAC items and we know that that's going to pay dividends over the long haul. But, for us, the more important element is to look at what the rate of return of that investment is going to look like.

And, surely, we're seeing a very nice rate of return based on the current acquisition costs and based on our expectations for the customer life. A lot of that is driven by both the current levels of free cash flow generated by the existing user base. And, also, quite frankly, the existing level of cash flow generated by an incremental subscriber. I think John had mentioned earlier that we're generating something like $15, $16, of extra incremental free cash flow per new add. And you couple that with the $250 subscriber acquisition costs, that's a very visible rate of return based on our life expectancies. So I think that's how we view the business and that's sort of how we go about measuring our level of investment activity.

So your point of pain is significantly higher than $250 is basically what you're saying?

I didn't say that. The way in which we measure our business is based on a rate of return where we measure the acquisition costs against the incremental cash flow and overall cash flow from the user base to decide what spending levels we are looking for.

We have given guidance on our spending levels for this year and have reaffirmed that guidance in this call.

Okay, thank you.

[OPERATOR INSTRUCTIONS]

And, at this time, we have no further questions coming in. I will hand the conference back to Mike Snyder for any closing or final remarks.

Well, it was, we thought, a very good quarter for us and as we close here I'd like to thank everyone for joining us this morning. If you do have additional questions after this call, please contact, if you would, Craig Streem at our Department of Investor Relations here in Holmdel. So, thanks very much.

And that does conclude our conference. Again, thank you all for your participation. We hope you enjoy the rest of your day.