May 24, 2006, 7:38 am


The following was available to subscribers last Friday well before deciding on allocations:

VG - Vonage

VG, Vonage plans on offering 36 million shares (assuming over-allotment) at a range of $16- $18. Citigroup, Deutsche Bank, and UBS are lead underwriting the deal. Post-offering VG will have 160 million shares outstanding (again assuming over-allotment) for a market cap at $17 of $2.72 million. IPO proceeds will be used to expand business and in a rare sign of company straight talk, to 'fund losses'.

Founder and Chairman Jeffrey Citron will own 33% of VG post- offering. Mr Citron has a rather colorful past. While employed with Datek Securities he was charged with fraud by the SEC related to improper order execution and filing false reports with the SEC and he paid nearly $23 million in penalties.

Of note: VG has set aside up to 13.5% of the shares offered in the deal to customers who opened an account with Vonage America prior to Dec. 15, 2005.

From the S-1:

“We are a leading provider of broadband telephone services with over 1.6 million subscriber lines as of April 1, 2006. Utilizing our innovative Voice over Internet Protocol, or VoIP, technology platform, we offer feature-rich, low-cost communications services that offer users an experience similar to traditional telephone services.”

VoIP technology converts voice signals into data packets which travel through the internet before being converted back to voice at other end of line.

VG is currently the leading US provider of VoIP services. Customers in the US currently account for 95% and VG has seen hypergrowth in the US. In 2005 alone subscriber growth tripled for VG's VoIP service. This is exactly what one wants to see in an IPO. However VG's growth has not gone unnoticed and massive competition is aligning against VG.

VG offers its VoIP service at a fixed monthly price of $24.95 for unlimited calls in the US/Canada and $14.95 for 500 minutes of calls in US/Canada. Plans include caller ID, call forwarding and voice mail. The Vonage VoIP system enables customers to utilize a standard phone to make/ receive VoIP calls. Main VoIP competitor Skype does not offer this feature, calls using Skype must be placed through computer/laptop. However the Vonage service does require a broadband connection.

VG delivers its service over existing broadband infrastructure avoiding the need to build-out or lease from telco/ cable expensive last mile connections. These 'last-mile' buildouts are what eventually did in the pureplay broadband companies of the '90's all of whom spent massively on broadband infrastructure leveraging themselves heavily....That leverage bankrupted nearly all of them in the early 2000's. VG's system also bypasses expensive telcom switches. The result is that VG has a pretty nimble infrastructure which does not require immense capital investments and can be scaled rather rapidly and relatively cheap. Relative being the key word and is in comparison to the traditional telco capacity buildouts.

VG has a roughly 2% churn per month which really is pretty good. However note that this number does not include those that cancel service within 30 days of subscribing.

VG brings in new customers by spending heavily on advertising and marketing. Nielsen/Net Ratings have stated that Vonage was the top internet advertiser in the world in the past 15 months. What VG is not spending on network buildouts, it is plowing into advertising.

Okay those are the basics. Before we get into the financials let us look at the immense pricing pressure coming into the VoIP space. VoIP offers a potentially much cheaper form of communication. VGs hyper growth and the overall cost structure of VoIP to providers has recently brought in both more competition and pricing pressure. Pricing pressure is an understatement. Let us instead say massive pricing pressures from all corners of the communication provider sector. Skype, [who Ebay purchased for $2.6 billion in 2005] has recently announced FREE calls to anywhere in the US/ Canada through the end of 2006. Free beats Vonage by $24.99 monthly. No catch either, apparently Ebay is willing to use Skype as a loss leader the remainder of 2006 to bring in new customers for the Skype service. As noted above with the Skype service a customer makes a call through their computer using headset/ microphone not a traditional phone set. However the free Skype offer does include calls made to traditional phones, phone lines and wireless. In addition Verizon just introduced VoIP service at a price that matches or beats Vonage, Cablevision recently doing similar and only a matter of time before the other telcos/cable offer prices that beat Vonage.

Here is the problem for Vonage. Traditional carriers like Verizon and the cable companies offer multiple services. VoIP's low cost structure will allow the Verizons and Comcasts of the world to bundle VoIP with cable, broadband and wireless services at a price point that makes unlimited VoIP calling essentially free to the consumer. Vonage has nothing to bundle and needs a strong price point for their VoIP service in order to survive.

In addition Ebay, with very deep pockets, can also afford to offer the Skype service free to 1) build the customer base and 2) utilize the service as a loss leader and entryway into add-on services such as pricier worldwide calling. Again VG cannot do this, they absolutely need a strong price point for their VoIP service.

Wireless also offers stiff competition as many households (including mine) have eschewed wireline service for wireless only. I'm not alone either as the traditional telcos are seeing their landline count drop annually. VG is essentially a landline telco, just one with a lower cost basis due to the cost structures of VoIP. Not only will the telcos/ cable/ skype price them out of the market, they've got to deal with the 'wireless trends.'

Before the IPO, VG tried to sell themselves to a larger communications player. Why? I think they realize what they're up against here. This is the big issue with this offering: The lower cost structure for providers of VoIP allows VG's competitors to offer VoIP at a very low price point in order to sell-in additional higher margin products/ services such as cable, broadband, digital content, and in the case of Skype, products such as worldwide VoIP calling. VG has only VoIP and to keep its customer base in the long run, VG will face heavy industry-wide pressure to significantly reduce its service price point.

The odds are really against VG ever being able to turn their VoIP service into a profitable enterprise due to increased massive pricing pressure. Frankly I don't see VG ever becoming profitable due to pricing pressures. VG has a greater chance of being bought out for their customer base then of turning a profit I think.

I believe a reason that VG is offering IPO shares to customers is to assist loyalty to the Vonage brand. Going forward loyalty is going to be crucial to keeping customers as they won't be able to compete on price.


$3 a share in cash minus debt post-offering. VG will most likely burn through this cash by first quarter 2007 and need to come back to the market for more capital. Revenue has ramped massively since start-up stage in 2002. In '04 VG had $79.8 million in revenue. In '05 that revenue increased nearly 240% to $269.1. First quarter 2006 showed another rapid revenue rise.

Gross margins are strong, reflecting the lack of extensive infrastructure costs. For the 15 months covering 2005 and first quarter of 2006 gross margins hit 54%.

Operating expenses are massive, reflecting the heavy commitment to adverstising/ marketing(A/M). A/M expenses grew 335% in 2005 to $243 million. Keep in mind revenues increased 240%, meaning VG is most definitely 'buying' revenue through hefty advertising. That can be acceptable assuming that you're able to retain new customers over time, bringing in a continual revenue stream. As I've noted though, I don't see any way VG can keep their current pricing points. I'm always wary of companies obviously 'buying' revenue through 1:1 ad/ marketing expenses and I'm even more so when looking at the competition coming VG's way.

All this has resulted in heavy losses to date for VG. In fact the losses are increasing even as VG has swiftly grown their customer and revenue base. In 2004 VG lost 35- 40 cents a share, in 2005 they lost $1.60 and are on a pace in 2006 to lose $2.50 per share.

So we've a company facing massive pricing pressure that seems to have an ability to steepen losses as they grow customer base and revenues. What happens the next 3 quarter going head to head with FREE service from Skype? I don't think it will be pretty at all. Not at all.

Conclusion- A number of IPO websites are high on this offering. I'm not. VG is about to face overwhelming competition and I feel they'll need to lower their price point in an attempt to compete. This will steepen already heavy losses and I think this means the odds are small of VG ever reaching profitability. The hope here for those buying VG is that Google or Yahoo make overtures to buy them out. I don't know how realistic that is, although since Ebay purchased Skype for $2.6 billion is stands to assume any buyout price for Vonage might be fairly hefty. That is it though in my eyes and that in itself is not enough of a reason to own VG. Heavy losses and heavy competition leading to eroding price points lead me to pass here. Hype may help this one early, but I've no interest in the Vonage IPO

May 19, 2006, 1:55 pm

Week of 5/22

A big week of offerings coming up with the large MasterCard and Vonage ipos as well as three smaller deals. MasterCard and vonage analysis available on the site:

DCP - DynCorp International

DCP - DynCorp International plans on offering 25 million shares at a range of $15- $17. Credit Suisse and Goldman Sachs are lead managing the deal, Bear Stearns co-managing. Post-offering DCP will have 57 million shares outstanding for a market cap mid-range of $912 million. 2/3 of the IPO proceeds will be used to purchase preferred shares, 1/3 will be paid as a dividend to insiders, predominantly Veritas Capital Management.

Pre-IPO DCP has been controlled by Veritas Capital Management, in the form of an entity named DIV Holding. Veritas owns 86% of DIV Holding. In 2/05 DIV Holding acquired DCP for $937 million from Computer Sciences Corporation. As is customary these days, the acquisition was funded by laying hefty debt onto the back DCP. Pre-acquisition DCP had no debt, post-IPO DCP will have $602 million in debt. As near as I can decipher DIV Holding paid roughly $100 million in cash for DCP in 2/05, the rest was leveraged debt. DCP (Veritas Capital) will be repaying themselves that $100 million on offering as a dividend. They will own 55% of DCP post-offering, which will essentially be free shares for them as they've already recouped their $100 million investment. This has been standard operating procedure with these leveraged buyout IPOs. DCP's balance sheet was clean as a whistle until Veritas Capital saw an opportunity for a quick turnaround. Now debt servicing eats up over 50% of operating profits. DCP is yet another IPO that would be quite attractive were it not for someone else (in this case Veritas Capital) having already gotten there first and taken the best looking fruit.

From the prospectus:

“We are a leading provider of specialized mission-critical outsourced technical services to civilian and military government agencies...Our specific global expertise is in law enforcement training and support, security services, base operations, and aviation services and operations.”

Main customers are the US Department of State and the US Department of Defense with roughly 50% of annual revenue derived from each. In the past decade the US government has stepped up outsourcing across a wide range of services. That coupled with a burgeoning US defense budget has been the revenue growth driver for DCP. As of 12/05 DCP had over 14,000 employees in 35 countries, 45 active contracts ranging in duration from three to ten years and over 100 task orders.

DCP has 2 main operating divisions, International Technical Services and Field Technical Services. They've their hands in a lot of cookie jars. Following is a brief summary of the different niches DCP engages.

International Technical Services (ITS) - This area includes: 1) Law enforcement training, specifically international police training and immigrant support; 2) Narcotics, specifically foreign crew and pilot training; 3) Contingency Services, including peace-keeping support, humanitarian relief, and de-mining; 4) Logistics including inventory tracking, property and inventory control; 5) Security including diplomat protection, security systems and personal protection; 6) Military Facility, facility management, administration and maintenance; 7) Marine Services, ship logistics and hazard clean-up; 8) Security Technology, biometrics, smartcards, security systems.

Field Technical Services (FTS) - 1) Aviation services and engineering, including aircraft fleet maintenance, aircraft design specifically cockpit and avionics upgrades; 2) Ground vehicle maintenance, pretty self explanatory; and 3) Range services.

ITS division accounted for 2/3's pf 2005 revenue, FTS 1/3. DCP has a pretty hefty backlog of $2.7 billion. Historically their entire backlog has been converted into revenue. In addition the past 3 years DCP has won 83% of new and/or renewed bid contracts. New contract wins themselves were 70% in FY 2006 (ending 3/06). On re-competing contracts, DCP has a 100% rate past 2 years.

Contracts are usually for a period of 3-10 years with one year guaranteed and multiple annual renewal options at the discretion of the US government. Contracts are reported at a total dollar value assuming all options are exercised. DCP sub-contracts out roughly 10% of their business.

International Civilian Policing accounted for 27% of FY '06 revenues. This has been DCP's revenue driver for a decade and should continue to be same into future. Since the original contract win in 1994, DCP has deployed civilian police officers from the United States to 12 countries to train and offer logistics support to the local police and assist them with infrastructure reconstruction. DCP currently has over 250 civilian police liaison officers in Iraq and Afghanistan.

So we've a pretty large stable operation it appears. One that has it's fingers in many different niches of outsourced Department of Defense contracts.

DCP sees their business going forward propelled by:

1 - The transformation of military forces, leading to increases in outsourcing of non-combat functions.

2 - Increased level and frequency of overseas deployment and peace-keeping operations.

3 - Growth in U.S. military budget driven by operations and maintenance spending.

4 - Increased maintenance, overhaul and upgrade needs to support aging military platforms.


DCP does not expect to pay dividends. Due to the debt, book value will be negative post-offering.

Debt is the story here. As well see just below DCP has a large slowly growing revenue base. Margins are fairly thin as well. When you take a slim margin company that is not ramping revenues appreciably and lay hundreds of million of debt on its back it is bound to destroy net margins. That is what has occurred here. Debt post-offering is roughly $602 million.

Due to the transactions concluding 2/05, revenues are comparable here for just FY 2005 ending 3/05 and FY 2006 ending 3/06. DCP breaks out both years as if the Veritas leveraged buyout happened pre-FY 2005. In addition DCP breaks out numbers for FY '06 as if the IPO had happened before the fiscal year -- These are two things I normally have to break out and model myself, nice that they broke things out for me here.

Revenues for FY '05 were $1.92 billion. Gross margins were 9%, net margins after factoring in debt servicing and depreciation & amortization were a just 1%. Earnings per share for FY '05 were 26 cents a share.

For the just completed FY '06, revenues increased just 2% to $1.956 billion. Revenue was boosted by the growth in International police liaison officers deployed in Iraq and Afghanistan. Growth there was offset by DCP's decision to exit a series of contracts to provide security and protection for a number of US construction projects in Iraq. Appears as if DCP felt the civilian situation on the ground in Iraq was too dangerous for their personnel and they've gotten many of them out.

Gross margins in FY '06 were 10%. Net margins still in the 1% range. Earnings per share were 40-45 cents. At $16 share price DCP will be trading 37 X's trailing earnings.

Let's briefly look at the impact of debt servicing here. Yes depreciation and amortization related directly to the transaction has hurt the bottom line. This is not too much of a concern as it is more an accounting issue than cash flow. Cash flows pro forma in FY '06 were a bit stronger than actual earnings due to that hefty depreciation & amortization number. Pro forma flows for FY '06 (folding out 1 time charges) were approximately 50-55 cents per share. Debt servicing however does harm cash flows here. The margins are simply too slim here for hefty debt payments. Even if depreciation and amortization is completely folded out here, debt servicing still ate up close to 40% of operating earnings. DCP is going to be stuck with this debt for the foreseeable future as it appears they will not be able to pay off via cash flows more than 3%-5% of principal annually.

Looking into FY '07(ending 3/07) I would expect DCP to show mid to high single digit growth. I don't foresee gross margins altering all that much, although net margins should improve a bit. I would not expect net margins to reach 2% in FY 2007. I believe DCP could earn 55-60 cents on the bottom line in FY '07 with cash flows being 15 cents or so stronger. At a share price of $16, DCP would be trading 26 X's current earnings estimates.

There really is not a good public pure play comparison here. Companies such as Haliburton, ITT, Lockheed Martin, Boeing and Geo Group all have overlapping segments. However all of those also have key revenue drivers in segments not matching up with DCP.

That brings us to the big risk here. DCP would be an attractive offering at this valuation if not for the debt placed here by Veritas et al. The gross and operating margins are just too slim for this hefty amount of debt. DCP saw a stagnant revenue year sequentially in FY '06. If they experience any significant declines, they'll be forced to make significant operating expense cuts to maintain debt servicing. Do I think that is likely? Shorter term no, I do not as I expect a solid high single digit revenue gain in FY '07. However, we've seen many surprising events the past few years and DCP's slim margins and thick debt servicing payments leave them vulnerable to any negative revenue event. Factor in that they're not coming public at enough of a cash flow discount really to compensate for the debt risk. Without the debt-load I would recommend this offering even with the flat sequential revenue year just ended. I like the backlog and the contract win rate. I like the strong policing contract, a contract that should generate significant future revenues in an unstable world. However the debt pushed up the risk factor here and I've got to pass in range. This is one to keep an eye on and possibly revisit if they're able to push revenue growth into double digits, which would assist them in paying down principle.

Page :  1