VONAGE HOLDINGS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion together with our consolidated financial statements and the related notes included elsewhere in this Form 10-Q and our audited financial statements included in our Annual Report on Form 10-K.

This discussion contains forward-looking statements. These forward-looking statements are based on information available at the time the statements are made and/or management's belief as of that time with respect to future events and involve risks and uncertainties that could cause actual results and outcomes to be materially different. Important factors that could cause such differences include but are not limited to: the competition we face; our ability to adapt to rapid changes in the market for voice and messaging services; our ability to retain customers and attract new customers; our ability to establish and expand strategic alliances; our dependence on third party facilities, equipment, systems and services; system disruptions or flaws in our technology and systems; intellectual property and other litigation that have been and may be brought against us; failure to protect our trademarks and internally developed software; our ability to obtain or maintain relevant intellectual property licenses; results of regulatory inquiries into our business practices; uncertainties relating to regulation of VoIP services; increased governmental regulation, currency restrictions, and other restraints and burdensome taxes and risks incident to foreign operations; our dependence upon key personnel; our history of net losses and ability to achieve consistent profitability in the future; fraudulent use of our name or services; our ability to maintain data security; security breaches and other compromises of information security; our dependence on our customers' existing broadband connections; differences between our service and traditional phone services, including our 911 service; any reinstatement of holdbacks by our vendors; our ability to obtain additional financing if required; restrictions in our debt agreements that may limit our operating flexibility; the Company's available capital resources and other financial and operational performance which may cause the Company not to make common stock repurchases as currently anticipated or to commence or suspend such repurchases from time to time without prior notice; and other factors that are set forth in the "Risk Factors" in our Annual Report on Form 10-K, in our Quarterly Reports on Form 10-Q and in our Current Reports on Form 8-K. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, and therefore, you should not rely on these forward-looking statements as representing our views as of any date subsequent to the date this Form 10-Q is filed with the Securities and Exchange Commission.

Financial Information Presentation For the financial information discussed in this Quarterly Report on Form 10-Q, other than per share and per line amounts, dollar amounts are presented in thousands, except where noted. All trademarks are the property of their owners.

Overview We are a leading provider of communications services connecting people through cloud-connected 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 features around the world.

In 2009, we shifted our primary emphasis from the domestic 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 leveraging 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, eliminating 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 application's multiple invitation system.

25-------------------------------------------------------------------------------- Table of Contents We had approximately 2.4 million subscriber lines for broadband telephone replacement services as of September 30, 2012. We bill customers in the United States, Canada, and the United Kingdom. Customers in the United States represented 93% of our subscriber lines at September 30, 2012.

Trends and Key Operating Data A number of trends have a significant effect on our results of operations and are important to an understanding of our financial statements.

Broadband adoption. The number of United States households with broadband Internet access has grown significantly. On March 16, 2010, the Federal Communications Commission ("FCC") released its National Broadband Plan, which seeks, through supporting broadband deployment and programs, to encourage broadband adoption for the approximately 100 million United States residents who do not have broadband at home. We expect the trend of greater broadband adoption to continue. We benefit from this trend because our service requires a broadband Internet connection and our potential addressable market increases as broadband adoption increases.

Competitive landscape. We face intense competition from traditional telephone companies, wireless companies, cable companies, and alternative voice communication providers. Most traditional wireline and wireless telephone service providers and cable companies are substantially larger and better capitalized than we are and have the advantage of a large existing customer base. In addition, because our competitors provide other services, they often choose to offer VoIP services or other voice services as part of a bundle that includes other products, such as video, high speed Internet access, and wireless telephone service, which we do not offer. In addition, such competitors may in the future require new customers or existing customers making changes to their service to purchase voice services when purchasing high speed Internet access.

Further, as wireless providers offer more minutes at lower prices, better coverage, and companion landline alternative services, their services have become more attractive to households as a replacement for wireline service. We also compete against alternative voice communication providers, such as magicJack, Skype, and Google Voice. Some of these service providers have chosen to sacrifice telephony revenue in order to gain market share and have offered their services at low prices or for free. As we continue to introduce applications that integrate different forms of voice and messaging services over multiple devices, we are facing competition from emerging competitors focused on similar integration, as well as from alternative voice communication providers.

In addition, our competitors have partnered and may in the future partner with other competitors to offer products and services, leveraging their collective competitive positions. We also are subject to the risk of future disruptive technologies. In connection with our increasing emphasis on the international long distance market, we face competition from low-cost international calling cards and VoIP providers in addition to traditional telephone companies, cable companies, and wireless companies.

Regulation. Our business has developed in a relatively lightly regulated environment. The United States and other countries, however, are examining how VoIP services should be regulated. The November 2010 order by the FCC in response to a request by Kansas and Nebraska that permits states to impose state universal service fund obligations on VoIP service, discussed in Note 6 to our financial statements, is an example of efforts by regulators to determine how VoIP service fits into the telecommunications regulatory landscape. In addition to regulatory matters that directly address VoIP, a number of other regulatory initiatives could impact our business. One such regulatory initiative is net neutrality. In December 2010, the FCC adopted a revised set of net neutrality rules for broadband Internet service providers. These rules make it more difficult for broadband Internet service providers to block or discriminate against Vonage service. Several broadband Internet service providers have filed appeals of the FCC's new rules at the D.C. Circuit Court of Appeals alleging that the FCC lacks authority to apply its rules to broadband Internet service providers. In addition, on February 9, 2011, the FCC released a Notice of Proposed Rulemaking on reforming universal service and the intercarrier compensation ("ICC") system that governs payments between telecommunications carriers primarily for terminating traffic. The FCC's adoption of an ICC proposal will impact Vonage's costs for telecommunications services. On October 27, 2011, the FCC adopted an order reforming universal service and ICC. The FCC order provides that VoIP originated calls will be subject to interstate access charges for long distance calls and reciprocal compensation for local calls that terminate to the public switched telephone network ("PSTN"). The termination charges for all traffic, including VoIP originated traffic, will transition over several years to a bill and keep arrangement (i.e., no termination charges). We believe that the order will positively impact our costs over time.

26-------------------------------------------------------------------------------- Table of Contents The table below includes key operating data that our management uses to measure the growth and operating performance of our business: Three Months Ended Nine Months Ended September 30, September 30, 2012 2011 2012 2011 Gross subscriber line additions 171,628 170,344 500,431 503,736 Change in net subscriber lines 9,440 (8,939 ) (9,363 ) (16,162 ) Subscriber lines (at period end) 2,365,524 2,388,721 2,365,524 2,388,721 Average monthly customer churn 2.5 % 2.7 % 2.6 % 2.6 % Average monthly operating revenues per line $ 29.31 $ 30.16 $ 29.79 $ 30.35 Average monthly direct cost of telephony services per line $ 7.80 $ 8.25 $ 8.21 $ 8.22 Marketing costs per gross subscriber line addition $ 299.26 $ 299.65 $ 319.20 $ 303.05 Employees (excluding temporary help) (at period end) 971 1,035 971 1,035 Gross subscriber line additions. Gross subscriber line additions for a particular period are calculated by taking the net subscriber line additions during that particular period and adding to that the number of subscriber lines that terminated during that period. This number does not include subscriber lines both added and terminated during the period, where termination occurred within the first 30 days after activation. The number does include, however, subscriber lines added during the period that are terminated within 30 days of activation but after the end of the period.

Net subscriber line additions. Net subscriber line additions for a particular period reflect the number of subscriber lines at the end of the period, less the number of subscriber lines at the beginning of the period.

Subscriber lines. Our subscriber lines include, as of a particular date, all paid subscriber lines from which a customer can make an outbound telephone call on that date. Our subscriber lines include fax lines including fax lines bundled with subscriber lines in our small office home office calling plans and soft phones but do not include our virtual phone numbers or toll free numbers, which only allow inbound telephone calls to customers. Subscriber lines decreased from 2,388,721 as of September 30, 2011 to 2,365,524 as of September 30, 2012. For the three months ended September 30, 2012, we added 171,628 subscriber lines. We believe that the decrease in our subscriber lines from the prior year was primarily due to increasing competition, particularly from cable companies and alternative voice communication providers.

Average monthly customer churn. Average monthly customer churn for a particular period is calculated by dividing the number of customers that terminated during that period by the simple average number of customers during the period, and dividing the result by the number of months in the period. The simple average number of customers during the period is the number of customers on the first day of the period, plus the number of customers on the last day of the period, divided by two. Terminations, as used in the calculation of churn statistics, do not include customers terminated during the period if termination occurred within the first 30 days after activation. Our average monthly customer churn decreased from 2.7% for the three months ended September 30, 2011 to 2.5% for the three months ended September 30, 2012 and remained flat compared to the three months ended June 30, 2012. The decline from September 30, 2011 is the result of improvements in overall customer satisfaction, as well as changes in retention processes and the impact of service agreements, which were put in place in February of 2012. Our average monthly customer churn was flat for the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011. During the fourth quarter of 2012, we expect stable sequential average monthly customer churn, with the potential for mild upward pressure on churn due to the removal of Pakistan from our Vonage World plan as a result of significant increases in call completion costs to Pakistan imposed by regulatory authorities in Pakistan. We monitor churn on a daily basis and use it as an indicator of the level of customer satisfaction. Other companies may calculate churn differently, and their churn data may not be directly comparable to ours. Customers who have been with us for a year or more tend to have a lower churn rate than customers who have not. In addition, our customers who are international callers generally churn at a lower rate than customers who are domestic callers. Our churn will fluctuate over time due to economic conditions, competitive pressures, marketplace perception of our services, and our ability to provide high quality customer care and network quality and add future innovative products and services.

Average monthly revenues per line. Average monthly revenues per line for a particular period is calculated by dividing our revenues for that period by the simple average number of subscriber lines for the period, and dividing the result by the number of months in the period. The simple average number of subscriber lines for the period is the number of subscriber lines on the first day of the period, plus the number of subscriber lines on the last day of the period, divided by two. Our average monthly revenues per line decreased slightly to $29.31 for the three months ended September 30, 2012 compared to $30.16 for the three months ended September 30, 2011 due primarily to plan mix, resulting from the expansion of plan offerings to meet customer segment 27-------------------------------------------------------------------------------- Table of Contents needs, and lower activation fee revenue. We expect selected pricing actions and higher priced rate plans in the fourth quarter may offset this reduction in average monthly revenues per line.

Average monthly direct cost of telephony services per line. Average monthly direct cost of telephony services per line for a particular period is calculated by dividing our direct cost of telephony services for that period by the simple average number of subscriber lines for the period, and dividing the result by the number of months in the period. We use the average monthly direct cost of telephony services per line to evaluate how effective we are at managing our costs of providing service. Our average monthly direct cost of telephony services per line decreased to $7.80 for the three months ended September 30, 2012 compared to $8.25 for the three months ended September 30, 2011, due primarily to the decrease in domestic termination costs due to a lower customer base and more favorable rates negotiated with our service providers and the decrease in our network costs and in our E-911 costs, offset by the increase in international calling by our growing base of Vonage World customers and the increase in regulatory fees. Direct cost of telephony services both overall and on a per line basis is expected to experience upward pressure from increased international calling by our base of Vonage World customers offset by intelligent call routing, peering relationships we are implementing, and improved pricing from various carriers.

Marketing cost per gross subscriber line addition. Marketing cost per gross subscriber line addition is calculated by dividing our marketing expense for a particular period by the number of gross subscriber line additions during the period. Marketing expense does not include the cost of certain customer acquisition activities, such as rebates and promotions, which are accounted for as an offset to revenues, or customer equipment subsidies, which are accounted for as direct cost of goods sold. As a result, it does not represent the full cost to us of obtaining a new customer. Our marketing cost per gross subscriber line addition was down slightly at $299.26 for the three months ended September 30, 2012 compared to $299.65 for the three months ended September 30, 2011.

Employees. Employees represent the number of personnel that are on our payroll and exclude temporary or outsourced labor.

Revenues Revenues consists of telephony services revenue and customer equipment and shipping revenue. Substantially all of our revenues are telephony services revenue. In the United States, we offer domestic and international rate plans to meet the needs of our customers, including a variety of residential plans, mobile plans, and small office and home office calling plans. The "Vonage World" plan, now available in the United States and Canada, offers unlimited calling across the United States and Puerto Rico, unlimited international calling to over 60 countries including India, Mexico, and China, subject to certain restrictions, and free voicemail to text messages with Vonage Visual Voicemail.

Each of our unlimited plans other than Vonage World offers unlimited domestic calling as well as unlimited calling to Puerto Rico, Canada, and selected European countries, subject to certain restrictions. Each of our basic plans offers a limited number of domestic calling minutes per month. We offer similar plans in Canada and the United Kingdom. Under our basic plans, we charge on a per minute basis when the number of domestic calling minutes included in the plan is exceeded for a particular month. International calls (except for calls to Puerto Rico, Canada and certain European countries under our unlimited plans and a variety of countries under international calling plans and Vonage World) are charged on a per minute basis. These per minute fees are not included in our monthly subscription fees.

In addition to our landline telephony business, we are leveraging 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 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 traditional paid international calling to any other phone. This mobile application works over WiFi, 3G and 4G and in more than 90 countries worldwide. The application consolidates the best features of our prior applications, while adding important functionality, better value and improved ease of use including direct payment through iTunes.

We derive most of our telephony services revenue from monthly subscription fees that we charge our customers under our service plans. We also offer residential fax service, virtual phone numbers, toll free numbers and other services, and charge an additional monthly fee for each service. One business fax line is included with each of our two small office and home office plans, but we charge monthly fees for additional business fax lines. We automatically charge these fees to our customers' credit cards, debit cards, or electronic check payments ("ECP"), monthly in advance. We also automatically charge the per minute fees not included in our monthly subscription fees to our customers' credit cards, debit cards or ECP monthly in arrears unless they exceed a certain dollar threshold, in which case they are charged immediately.

By collecting monthly subscription fees in advance and certain other charges immediately after they are incurred, we are able to reduce the amount of accounts receivable that we have outstanding, thus allowing us to have lower working capital requirements. Collecting in this manner also helps us mitigate bad debt losses, which are recorded as a reduction to revenue. If a customer's credit card, debit card or ECP is declined, we generally suspend international calling capabilities as well as the customer's ability to incur domestic usage charges in excess of their plan minutes. Historically, in most cases, we are able to correct the problem with the customer within the current monthly billing cycle. If the customer's credit card, debit card or ECP could not be 28-------------------------------------------------------------------------------- Table of Contents successfully processed during three billing cycles (i.e., the current and two subsequent monthly billing cycles), we terminate the account.

In the United States, we charge regulatory, compliance, E-911, and intellectual property-related recovery fees on a monthly basis to defray costs, and to cover taxes that we are charged by the suppliers of telecommunications services. In addition, we recognize revenue on a gross basis for contributions to the Federal Universal Service Fund ("USF") and related fees. All other taxes are recorded on a net basis.

In addition, historically, we charged a disconnect fee for customers who terminated their service plan within the first twelve months of service.

Disconnect fees are recorded as revenue and are recognized at the time the customer terminates service. Beginning in September 2010, we eliminated the disconnect fee for new customers. In February of 2012 we re-introduced service agreements as an option for new customers.

Telephony services revenue is offset by the cost of certain customer acquisition activities, such as rebates and promotions.

Customer equipment and shipping revenue consists of revenue from sales of customer equipment to our wholesalers or directly to customers and retailers. In addition, customer equipment and shipping revenue includes the fees, when collected, that we charge our customers for shipping any equipment to them.

Operating Expenses Operating expenses consist of direct cost of telephony services, royalties, direct cost of goods sold, selling, general and administrative expense, marketing expense, and depreciation and amortization.

Direct cost of telephony services. Direct cost of telephony services primarily consists of fees that we pay to third parties on an ongoing basis in order to provide our services. These fees include: • Access charges that we pay to other telephone companies to terminate domestic and international calls on the public switched telephone network. These costs represented approximately 51% and 50% of our total direct cost of telephony services for the three months ended September 30, 2012 and 2011, respectively, with a portion of these payments ultimately being made to incumbent telephone companies. When a Vonage subscriber calls another Vonage subscriber, we do not pay an access charge.

• The cost of leasing Internet transit services from multiple Internet service providers. This Internet connectivity is used to carry VoIP session initiation signaling and packetized audio media between our subscribers and our regional data centers.

• The cost of leasing from other telephone companies the telephone numbers that we provide to our customers. We lease these telephone numbers on a monthly basis.

• The cost of co-locating our regional data connection point equipment in third-party facilities owned by other telephone companies, Internet service providers or collocation facility providers.

• The cost of providing local number portability, which allows customers to move their existing telephone numbers from another provider to our service. Only regulated telecommunications providers have access to the centralized number databases that facilitate this process. Because we are not a regulated telecommunications provider, we must pay other telecommunications providers to process our local number portability requests.

• The cost of complying with FCC regulations regarding VoIP emergency services, which require us to provide enhanced emergency dialing capabilities to transmit 911 calls for all of our customers.

• Taxes that we pay on our purchase of telecommunications services from our suppliers or imposed by government agencies such as Federal USF and related fees.

Direct cost of goods sold. Direct cost of goods sold primarily consists of costs that we incur when a customer first subscribes to our service. These costs include: • The cost of the equipment that we provide to customers who subscribe to our service through our direct sales channel in excess of activation fees when an activation fee is collected. The remaining cost of customer equipment is deferred up to the activation fee collected and amortized over the estimated average customer life.

• The cost of the equipment that we sell directly to retailers.

• The cost of shipping and handling for customer equipment, together with the installation manual, that we ship to customers.

• The cost of certain products or services that we give customers as promotions.

29 -------------------------------------------------------------------------------- Table of Contents Selling, general and administrative expense. Selling, general and administrative expense includes: • Compensation and benefit costs for all employees, which is the largest component of selling, general and administrative expense and includes customer care, research and development, network engineering and operations, sales and marketing, executive, legal, finance, and human resources personnel.

• Share-based expense related to share-based awards to employees, directors, and consultants.

• Outsourced labor related to customer care, kiosk and events sales teams, and retail support activities.

• Product awareness advertising.

• Transaction fees paid to credit card, debit card, and ECP companies and other third party billers such as iTunes, which may include a per transaction charge in addition to a percent of billings charge.

• Rent and related expenses.

• Professional fees for legal, accounting, tax, public relations, lobbying, and development activities.

• Litigation settlements.

Marketing expense. Marketing expense includes: • Advertising costs, which comprise a majority of our marketing expense and include online, television, direct mail, alternative media, promotions, sponsorships, and inbound and outbound telemarketing.

• Creative and production costs.

• The costs to serve and track our online advertising.

• Certain amounts we pay to retailers for activation commissions.

• The cost associated with our customer referral program.

Depreciation and amortization expenses. Depreciation and amortization expenses include: • Depreciation of our network equipment, furniture and fixtures, and employee computer equipment.

• Amortization of leasehold improvements and purchased and developed software.

• Amortization of intangible assets (patents and trademarks).

• Loss on disposal or impairment of property and equipment.

Loss from abandonment of software assets. Loss from abandonment of software assets include: • Impairment of investment in software assets.

Other Income (Expense) Other Income (Expense) includes: • Interest income on cash and cash equivalents.

• Interest expense on notes payable, patent litigation judgments and settlements and capital leases.

• Amortization of debt related costs.

• Accretion of notes.

• Realized and unrealized gains (losses) on foreign currency.

• Gain (loss) on extinguishment of notes.

• Change in fair value of embedded features within stock warrant.

30-------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth, as a percentage of consolidated operating revenues, our consolidated statement of operations for the periods indicated: Three Months Ended Nine Months Ended September 30, September 30, 2012 2011 2012 2011 Revenues 100 % 100 % 100 % 100 % Operating Expenses: Direct cost of telephony services (excluding depreciation and amortization) 26 27 28 27 Direct cost of goods sold 5 5 5 5 Selling, general and administrative 29 27 28 27 Marketing 25 24 25 23 Depreciation and amortization 4 4 4 5 Loss from abandonment of software assets - - 4 - 89 87 94 87 Income from operations 11 13 6 13 Other Income (Expense): Interest income - - - - Interest expense (1 ) (1 ) (1 ) (2 ) Change in fair value of stock warrant - - - - Loss on extinguishment of notes - (4 ) - (2 ) Other income (expense), net - - - - (1 ) (5 ) (1 ) (4 ) Income before income tax expense 10 8 5 9 Income tax expense (4 ) - (2 ) - Net income 6 % 8 % 3 % 9 % Summary of Results for the Three and Nine Months Ended September 30, 2012 and September 30, 2011 Revenues, Direct Cost of Telephony Services and Direct Cost of Good Sold (in thousands, except percentages) Three Months Ended Nine Months Ended September 30, September 30, Dollar Percent Dollar Percent 2012 2011 Change Change 2012 2011 Change Change Revenues $ 207,584 $ 216,507 $ (8,923 ) (4 )% $ 635,403 $ 654,633 $ (19,230 ) (3 )% Direct cost of telephony services(1) 55,245 59,230 (3,985 ) (7 )% 175,063 177,302 (2,239 ) (1 )% Direct cost of goods sold 10,444 10,711 (267 ) (2 )% 29,565 31,631 (2,066 ) (7 )% 141,895 146,566 (4,671 ) (3 )% 430,775 445,700 (14,925 ) (3 )% (1) Excludes depreciation and amortization of $3,722, $3,864, $11,581, $11,855, respectively.

Revenues. For the three months ended September 30, 2012, revenues decreased by $8,923, or 4%, compared to the three months ended September 30, 2011. This was primarily driven by a decrease of $7,714 in monthly subscription fees resulting from a decreased number of subscription lines, which reduced from 2,388,721 at September 30, 2011 to 2,365,524 at September 30, 2012, and plan mix, a decrease in activation fees of $766, and a decrease in our regulatory fee revenue of $1,118, which includes an increase of $404 in USF fees offset by a decrease in regulatory recovery fees and E-911 fees of $1,522. There was a decrease 31-------------------------------------------------------------------------------- Table of Contents in additional features revenue of $278 due primarily to customers opting for our Vonage World offering, which now includes directory assistance and voice mail to text, and a decrease in other revenue of $854 due to lower rates from our revenue sharing partners. In addition, there was a decrease in overage in plan minutes of $164, a decrease in international minutes of use revenue of $238, and a decrease of $100 in equipment and shipping revenue due to elimination of equipment recovery fees for new customers. These decreases were offset by an increase in fees that we charged for disconnecting our service of $1,055 due to reinstatement of contracts for new customers beginning in February 2012, a decrease in credits issued to subscribers of $1,014, and a decrease of $241 in bad debt expense.

For the nine months ended September 30, 2012, revenues decreased by $19,230, or 3%, compared to the nine months ended September 30, 2011. This was primarily driven by a decrease of $13,349 in monthly subscription fees resulting from a decreased number of subscription lines, which reduced from 2,388,721 at September 30, 2011 to 2,365,524 at September 30, 2012, and plan mix, a decrease in activation fees of $3,228, and a decrease in overage in plan minutes of $783.

There was a reduction in international minutes of use revenue of $410 and a decrease in additional features revenue of $1,182 due primarily to customers opting for our Vonage World offering, which now includes directory assistance and voice mail to text. In addition, there was a decrease of $1,701 in equipment and shipping revenue due to lower direct customer additions and elimination of equipment recovery fees for new customers and a decrease in other revenue of $1,601 due to lower rates from our revenue sharing partners. These decreases were offset by a decrease of $582 in bad debt expense due to improved customer credit quality and lower non-pay churn, an increase in our regulatory fee revenue of $1,414, which includes an increase of $5,765 in USF fees offset by a decrease in regulatory recovery fees and E-911 fees of $4,351. There was also a decrease in credits issued to subscribers of $502 and an increase in fees that we charged for disconnecting our service of $528 due to reinstatement of contracts for new customers beginning in February 2012.

Direct cost of telephony services. For the three months ended September 30, 2012 compared to the three months ended September 30, 2011, the decrease in direct cost of telephony services of $3,985, or 7%, was primarily driven by a decrease in domestic termination costs of $1,905 due to improved termination rates, which are costs that we pay other phone companies for terminating phone calls, and fewer minutes of use and a decrease in our network costs of $2,230, which includes costs for co-locating in other carriers' facilities, leasing phone numbers, routing calls on the Internet, E-911 costs, and transferring calls to and from the Internet to the public switched telephone network due to improved rates. There was also a decrease in local number portability costs of $193 due to lower rates and a decrease in other costs of $229. These decreases were partially offset by an increased cost of $349 from higher international call volume associated with Vonage World and an increase of USF and related fees imposed by government agencies of $222.

For the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, the decrease in direct cost of telephony services of $2,239, or 1%, was primarily driven by a decrease in domestic termination costs of $7,256 due to improved termination rates, which are costs that we pay other phone companies for terminating phone calls, and fewer minutes of use and a decrease in our network costs of $6,138, which includes costs for co-locating in other carriers' facilities, leasing phone numbers, routing calls on the Internet, E-911 costs, and transferring calls to and from the Internet to the public switched telephone network due to improved rates. There was also a decrease in local number portability costs of $666 due to lower rates and a decrease in other costs of $368. These decreases were partially offset by an increased cost of $6,232 from higher international call volume associated with Vonage World and an increased cost of $5,956 for USF and related fees imposed by government agencies.

Direct cost of goods sold. For the three months ended September 30, 2012 compared to the three months ended September 30, 2011, the decrease in direct cost of goods sold of $267, or 2%, was primarily due to a decrease in amortization costs on deferred customer equipment of $555, a decrease in waived activation fees for new customers of $1,149 due to lower direct customer adds, and a decrease in shipping costs of $250. These decreases were offset by an increase in customer equipment costs of $1,686 from additional customers from our retail expansion started in the second quarter of 2011.

For the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, the decrease in direct cost of goods sold of $2,066, or 7%, was primarily due to a decrease in amortization costs on deferred customer equipment of $2,461, a decrease in waived activation fees for new customers of $3,140 due to lower direct customer adds, and a decrease in shipping costs of $328. These decreases were offset by an increase in customer equipment costs of $3,860 from additional customers from our retail expansion started in the second quarter of 2011.

32-------------------------------------------------------------------------------- Table of Contents Selling, General and Administrative (in thousands, except percentages) Three Months Ended Nine Months Ended September 30, September 30, Dollar Percent Dollar Percent 2012 2011 Change Change 2012 2011 Change Change Selling, general and administrative $ 59,676 $ 59,451 $ 225 - % $ 179,907 $ 176,175 $ 3,732 2 % Selling, general and administrative. For the three months ended September 30, 2012 compared to the three months ended September 30, 2011, there was an increase in selling, general, and administrative expenses of $225, or 0%. This increase was primarily due to higher retail kiosk costs of $896 due to the expansion of event teams and an increase in settlement costs related to litigation of $158. There was also an increase in salary related expense, outsourced temporary labor and severance costs of $1,911 and an increase in in-store support of $520 related to additional customers from our retail expansion. These increases were offset by a decrease in shared based cost of $658, a decrease in credit card fees of $1,097, a decrease in uncollected state and municipal tax expense of $101, and a decrease in facility expense of $100.

There was also a decrease in other costs of $789 and a decrease in professional fees of $519.

For the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, there was an increase in selling, general, and administrative expenses of $3,732, or 2%. This increase was primarily due to higher retail kiosk costs of $2,725 due to the expansion of event teams, an increase in salary related expense, outsourced temporary labor and severance costs of $1,341, and an increase in product awareness advertising of $2,169 related to our new mobile offering launched in February 2012. There was also an increase in web hosting cost of $597, an increase in in-store support of $1,329 related to additional customers from our retail expansion, and an increase in settlement costs related to litigation of $253. These increases were offset by a decrease in uncollected state and municipal tax expense of $210, and a decrease in credit card fees of $3,245. There was also a decrease in facility expense of $330 and a decrease in shared based cost of $859.

Marketing (in thousands, except percentages) Three Months Ended Nine Months Ended September 30, September 30, Dollar Percent Dollar Percent 2012 2011 Change Change 2012 2011 Change Change Marketing $ 51,361 $ 51,044 $ 317 1 % $ 159,739 $ 152,659 $ 7,080 5 % Marketing. For the three months ended September 30, 2012 compared to the three months ended September 30, 2011, marketing expense increased slightly by $317, or 1%, mainly due to the increase in investment in retail to reach targeted ethnic segments and incremental media expenses associated with the market test of our low-priced domestic offer, offset by the decrease in our investment in television.

For the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, the increase in marketing expense of $7,080, or 5%, resulted from increasing our marketing investment in television and retail to reach targeted ethnic segments and incremental media expenses associated with the market test of our low-priced domestic offer.

Depreciation and Amortization (in thousands, except percentages) Three Months Ended Nine Months Ended September 30, September 30, Dollar Percent Dollar Percent 2012 2011 Change Change 2012 2011 Change Change Depreciation and amortization $ 8,110 $ 8,683 $ (573 ) (7 )% $ 25,272 $ 28,413 $ (3,141 ) (11 )% Depreciation and amortization. The decrease in depreciation and amortization of $573, or 7%, for the three months ended September 30, 2012 compared to the three months ended September 30, 2011, was primarily due to lower depreciation of network equipment, computer hardware, and furniture of $539 and lower software amortization of $340 due to certain projects being fully amortized, offset by an increase in intangible asset amortization of $307 from additional intangible asset acquired during the fourth quarter of 2011.

33-------------------------------------------------------------------------------- Table of Contents The decrease in depreciation and amortization of $3,141, or 11%, for the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, was primarily due to lower depreciation of network equipment, computer hardware, and furniture of $1,641 and lower software amortization of $2,424 due to certain projects being fully amortized, offset by an increase in intangible asset amortization of $922 from additional intangible assets acquired during the fourth quarter of 2011.

Loss from abandonment of software assets (in thousands, except percentages) Three Months Ended Nine Months Ended September 30, September 30, Dollar Percent Dollar Percent 2012 2011 Change Change 2012 2011 Change Change Loss from abandonment of software assets $ - $ - $ - - % $ 25,262 $ - $ 25,262 * Loss from abandonment of software assets. The loss from abandonment of software assets of $25,262 for the nine months ended September 30, 2012 was due to the write-off of our investment in the Amdocs system, net of settlement amounts to the Company, during the second quarter of 2012.

Other Income (Expense) (in thousands, except percentages) Three Months Ended Nine Months Ended September 30, September 30, Dollar Percent Dollar Percent 2012 2011 Change Change 2012 2011 Change Change Interest income $ 30 $ 33 $ (3 ) (9 )% $ 80 $ 112 $ (32 ) (29 )% Interest expense (1,402 ) (2,926 ) 1,524 52 % (4,719 ) (15,116 ) 10,397 69 % Change in fair value of stock warrant - - - * - (950 ) 950 100 % Loss on extinguishment of notes - (7,985 ) 7,985 100 % - (11,806 ) 11,806 100 % Other income (expense), net 28 (47 ) 75 160 % 5 (5 ) 10 200 % $ (1,344 ) $ (10,925 ) $ 9,581 $ (4,634 ) $ (27,765 ) $ 23,131 Interest income. For the three and nine months ended September 30, 2012 compared to the three and nine months ended September 30, 2011, the interest income decreased slightly.

Interest expense. For the three and nine months ended September 30, 2012 compared to the three and nine months ended September 30, 2011, the decrease in interest expense was due to lower principal outstanding and the reduced interest rate on our credit facility (the "2011 Credit Facility") entered into in connection with our refinancing in July 2011.

Change in fair value of stock warrant. The change in the fair value of our stock warrant fluctuated with changes in the price of our common stock and was an expense of $950 for the nine months ended September 30, 2011, as the stock warrant was exercised during the three months ended March 31, 2011. An increase in our stock price resulted in expense while a decrease in our stock price resulted in income.

Loss on extinguishment of notes. The loss on extinguishment of notes for the three and nine months ended September 30, 2011 was due to the acceleration of unamortized debt discount and debt related costs in connection with prepayments of our 2011 Credit Facility.

Other. For the three and nine months ended September 30, 2012 compared to the three and nine months ended September 30, 2011, net other income and expense increased by $75.

34-------------------------------------------------------------------------------- Table of Contents Provision for Income Taxes (in thousands, except percentages) Three Months Ended Nine Months Ended September 30, September 30, Dollar Percent Dollar Percent 2012 2011 Change Change 2012 2011 Change Change Income tax expense $ (8,191 ) $ (426 ) $ (7,765 ) (1,823 )% $ (12,167 ) $ (1,790 ) $ (10,377 ) (580 )% Effective tax rate 38.3 % 2.6 % 33.8 % 2.9 % 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 net operating loss carry forwards ("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 statement of operations and a corresponding net deferred tax asset of $325,601 that we recorded on our balance sheet on December 31, 2011. Beginning in the first quarter of 2012, we have recognized income tax expense, an expense that had not been recognized prior to the reduction of the valuation allowance.

The effective tax rate is calculated by dividing the income tax expense by income before income tax expense. The effective rate for the nine months ended September 30, 2012 was less than the federal statutory rate due, in part, to our Canadian operations and certain discrete period items, which primarily consisted of adjustments related to stock compensation, including a non-cash deferred tax adjustment totaling $4,077, for certain stock compensation previously considered nondeductible under Section 162(m) of the Internal Revenue Code. The 2012 estimated annual effective tax rate is expected to approximate 35%, but may fluctuate each quarter due to the timing of other discrete period transactions.

The 2011 provision represents the federal alternative minimum tax and state and local income taxes currently payable.

Net Income (in thousands, except percentages) Three Months Ended Nine Months Ended September 30, September 30, Dollar Percent Dollar Percent 2012 2011 Change Change 2012 2011 Change Change Net income $ 13,213 $ 16,037 $ (2,824 ) (18 )% $ 23,794 $ 58,898 $ (35,104 ) (60 )% Net income. Based on the explanations described above, our net income of $13,213 for the three months ended September 30, 2012 decreased by $2,824, or 18%, from net income of $16,037 for the three months ended September 30, 2011.

Based on the explanations described above, our net income of $23,794 for the nine months ended September 30, 2012 decreased by $35,104, or 60%, from net income of $58,898 for the nine months ended September 30, 2011.

Liquidity and Capital Resources Overview The following table sets forth a summary of our cash flows for the periods indicated: Nine Months Ended September 30, 2012 2011 (in thousands)Net cash provided by operating activities $ 58,797 $ 108,141 Net cash used in investing activities (13,461 ) (24,355 ) Net cash used in financing activities (30,128 ) (107,616 ) For the nine months ended September 30, 2012, we generated income from operations. We expect to continue to balance efforts to grow our customer base while consistently achieving operating profitability. To grow our customer base, we continue 35-------------------------------------------------------------------------------- Table of Contents to make investments in marketing, application development as we seek to launch new services, network quality and expansion, and customer care. Although we believe we will achieve consistent profitability in the future, we ultimately may not be successful and we may not achieve consistent profitability. We believe that cash flow from operations and cash on hand will fund our operations for at least the next twelve months.

July 2011 Financing On July 29, 2011, we entered into the 2011 Credit Facility consisting of an $85,000 senior secured term loan and a $35,000 revolving credit facility. The co-borrowers under the 2011 Credit Facility are us and Vonage America Inc., our wholly owned subsidiary. Obligations under the 2011 Credit Facility are guaranteed, fully and unconditionally, by our other United States subsidiaries and are secured by substantially all of the assets of each borrower and each of the guarantors.

Use of Proceeds We used $100,000 of the net available proceeds of the 2011 Credit Facility, plus $31,000 of cash on hand, to retire all of the debt under our prior credit facility entered into in December 2010 (the "2010 Credit Facility"), including a $1,000 prepayment fee to holders of the 2010 Credit Facility. We also incurred $2,697 of fees in connection with the 2011 Credit Facility, which is amortized to interest expense over the life of the debt using the effective interest method.

Repayments For the three and nine months ended September 30, 2012, we made mandatory repayments of $7,083 and $21,250, respectively, under the senior secured term loan.

2011 Credit Facility Terms The following description summarizes the material terms of the 2011 Credit Facility: The loans under the 2011 Credit Facility mature in July 2014. Principal amounts under the 2011 Credit Facility are repayable in quarterly installments of $7,083 for the senior secured term loan. The unused portion of our revolving credit facility incurs a 0.50% commitment fee.

Outstanding amounts under each of the senior secured term loan and the revolving credit facility, at our option, will bear interest at: • LIBOR (applicable to one-, two-, three- or six-month periods) plus an applicable margin equal to 3.25% if our consolidated leverage ratio is less than 0.75 to 1.00, 3.5% if our consolidated leverage ratio is greater than or equal to 0.75 to 1.00 and less than 1.50 to 1.00, and 3.75% if our consolidated leverage ratio is greater than or equal to 1.50 to 1.00, payable on the last day of each relevant interest period or, if the interest period is longer than three months, each day that is three months after the first day of the interest period, or • the base rate determined by reference to the highest of (a) the federal funds effective rate from time to time plus 0.50%, (b) the prime rate of JPMorgan Chase Bank, N.A., and (c) the LIBOR rate applicable to one month interest periods plus 1.00%, plus an applicable margin equal to 2.25% if our consolidated leverage ratio is less than 0.75 to 1.00, 2.5% if our consolidated leverage ratio is greater than or equal to 0.75 to 1.00 and less than 1.50 to 1.00, and 2.75% if our consolidated leverage ratio is greater than or equal to 1.50 to 1.00, payable on the last business day of each March, June, September, and December and the maturity date of the 2011 Credit Facility.

The 2011 Credit Facility provides greater flexibility to us in funding acquisitions and restricted payments, such as stock buybacks, than the 2010 Credit Facility.

We may prepay the 2011 Credit Facility at our option at any time without premium or penalty. The 2011 Credit Facility is subject to mandatory prepayments in amounts equal to: • 100% of the net cash proceeds from any non-ordinary course sale or other disposition of our property and assets for consideration in excess of a certain amount subject to customary reinvestment provisions and certain other exceptions and • 100% of the net cash proceeds received in connection with other non-ordinary course transaction, including insurance proceeds not otherwise applied to the relevant insurance loss.

Subject to certain restrictions and exceptions, the 2011 Credit Facility permits us to obtain one or more incremental term loans and/or revolving credit facilities in an aggregate principal amount of up to $60,000 plus an amount equal to repayments of the senior secured term loan upon providing documentation reasonably satisfactory to the administrative agent, without the consent 36-------------------------------------------------------------------------------- Table of Contents of the existing lenders under the 2011 Credit Facility. The 2011 Credit Facility includes customary representations and warranties and affirmative covenants of the borrowers. In addition, the 2011 Credit Facility contains customary negative covenants, including, among other things, restrictions on the ability of us and our subsidiaries to consolidate or merge, create liens, incur additional indebtedness, dispose of assets, consummate acquisitions, make investments, and pay dividends and other distributions. We must also comply with the following financial covenants: • a consolidated leverage ratio of no greater than 2.00 to 1.00; • a consolidated fixed coverage charge ratio of no less than 1.75 to 1.00; • minimum cash of $25,000 including the unused portion of the revolving credit facility; and • maximum capital expenditures not to exceed $55,000 during any fiscal year, provided that the unused amount of any permitted capital expenditures in any fiscal year may be carried forward to the next following fiscal year, plus a portion of annual excess cash flow up to $8,000.

As of September 30, 2012, we were in compliance with all covenants, including financial covenants, for the 2011 Credit Facility.

The 2011 Credit Facility contains customary events of default that may permit acceleration of the debt. During the continuance of a payment default, interest will accrue at a default interest rate of 2% above the interest rate which would otherwise be applicable, in the case of loans, and at a rate equal to the rate applicable to base rate loans plus 2%, in the case of all other amounts.

State and Local Sales Taxes We also have contingent liabilities for state and local sales taxes. As of September 30, 2012, we had a reserve of $1,742. If our ultimate liability exceeds this amount, it could affect our liquidity unfavorably. However, we do not believe it will significantly impair our liquidity.

Capital Expenditures For the nine months ended September 30, 2012, capital expenditures were primarily for the implementation of software solutions and purchase of network equipment as we continue to expand our network. Our capital expenditures for the nine months ended September 30, 2012 were $14,741, of which $10,184 was for software acquisition and development. The majority of these expenditures are comprised of investments in information technology and systems infrastructure, including an electronic data warehouse, online customer service, customer management platforms, and the new Amdocs billing and order management system. As previously disclosed, we experienced delays and incremental costs during the course of the development and implementation of the new billing and ordering system and the transition of customers to the system. We conducted discussions with Amdocs to resolve the issues associated with the billing and ordering system. Based on these discussions, and after our consideration of the progress made improving our overall IT infrastructure, the incremental time and costs to develop and implement the Amdocs system, as well as the expected reduction in capital expenditures, in June 2012 we and Amdocs determined that terminating the program was in the best interest of both parties. On July 30, 2012, we entered into a settlement agreement with Amdocs terminating the related license agreement. As a result, we determined that a write-off of our investment in the system of $25,262, net of settlement amounts to the Company, was required in the second quarter of 2012. This charge is recorded as loss from abandonment of software assets in the statement of operations. For 2012, we believe our capital and software expenditures will be between $30,000 and $35,000.

Common Stock Repurchases On July 25, 2012, our board of directors approved a plan to buy back up to $50,000 of Vonage common stock through December 31, 2013. The specific timing and amount of repurchases will vary based on available capital resources and other financial and operational performance, market conditions, securities law limitations, and other factors. The repurchases will be made using our cash resources. The repurchase program may be commenced, suspended or discontinued at any time without prior notice. In any period, cash used in financing activities related to common stock repurchases may differ from the comparable change in stockholders' equity, reflecting timing differences between the recognition of share repurchase transactions and their settlement for cash. For both the three and nine months ended September 30, 2012, we repurchased $9,137, or 4,090 shares of Vonage common stock.

Operating Activities Cash provided by operating activities decreased to $58,797 for the nine months ended September 30, 2012 compared to $108,141 for the nine months ended September 30, 2011, primarily due to planned investments in our growth initiatives, lower revenues and changes in working capital.

37-------------------------------------------------------------------------------- Table of Contents Changes in working capital requirements include changes in accounts receivable, inventory, prepaid and other assets, accounts payable, accrued and other liabilities, and deferred revenue and costs. Cash used for working capital requirements increased by $32,947 during the nine months ended September 30, 2012 compared to the prior year period primarily due to timing of payments.

Investing Activities Cash used in investing activities for the nine months ended September 30, 2012 of $13,461 was attributable to capital expenditures of $4,557 and development of software assets of $10,184, offset by a decrease in restricted cash of $1,280 due primarily to the return of part of the security deposit on our leased office property in Holmdel, New Jersey.

Cash used in investing activities for the nine months ended September 30, 2011 of $24,355 was attributable to capital expenditures of $8,853 and development of software assets of $16,550, offset by a decrease in restricted cash of $1,048 due primarily to the return of partial security deposit on our leased office property in Holmdel, New Jersey.

Financing Activities Cash used in financing activities for the nine months ended September 30, 2012 of $30,128 was primarily attributable to $21,250 in 2011 Credit Facility principal payments, $1,540 in capital lease payments, and $8,431 in common stock repurchases, offset by $1,093 in proceeds received from the exercise of stock options.

Cash used in financing activities for the nine months ended September 30, 2011 of $107,616 was primarily attributable to $200,000 in 2010 Credit Facility principal payments and $7,083 in 2011 Credit Facility principal payment, respectively, $1,303 in capital lease payments, and $2,697 in 2011 Credit Facility debt related cost payments, offset by $100,000 in proceeds received from the issuance of the 2011 Credit Facility and $4,521 in proceeds received from the exercise of stock options and a common stock warrant.

Summary of Critical Accounting Policies and Estimates Our significant accounting policies are summarized in Note 1 to our consolidated financial statements. The following describes our critical accounting policies and estimates: Use of Estimates Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States, which require management to make estimates and assumptions that affect the amounts reported and disclosed in the consolidated financial statements and the accompanying notes. Actual results could differ materially from these estimates.

On an ongoing basis, we evaluate our estimates, including the following: • the useful lives of property and equipment, software costs, and intangible assets; • assumptions used for the purpose of determining share-based compensation and the fair value of our prior stock warrant using the Black-Scholes option pricing model ("Model"), and various other assumptions that we believed to be reasonable. The key inputs for this Model are our stock price at valuation date, exercise price, the dividend yield, risk-free interest rate, life in years, and historical volatility of our common stock; and • assumptions used in determining the need for, and amount of, a valuation allowance on net deferred tax assets.

We base our estimates on historical experience, available market information, appropriate valuation methodologies, and on various other assumptions that we believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities.

Revenue Recognition The point in time at which revenues are recognized is determined in accordance with Staff Accounting Bulletin No. 104, Revenue Recognition, and Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 605, Revenue Recognition.

At the time a customer signs up for our telephony services, there are the following deliverables: • Providing equipment, if any, to the customer that enables our telephony services and • Providing telephony services.

38-------------------------------------------------------------------------------- Table of Contents The equipment is provided free of charge to our customers and in most instances there are no fees collected at sign-up. We record the fees collected for shipping the equipment to the customer, if any, as shipping and handling revenue at the time of shipment.

A further description of our revenues is as follows: Substantially all of our operating revenues are telephony services revenues, which are derived primarily from monthly subscription fees that customers are charged under our service plans. We also derive telephony services revenues from per minute fees for international calls if not covered under a plan, including applications for mobile devices and other stand-alone products, and for any calling minutes in excess of a customer's monthly plan limits. Monthly subscription fees are automatically charged to customers' credit cards, debit cards or electronic check payments, or ECP, in advance and are recognized over the following month when services are provided. Revenues generated from international calls and from customers exceeding allocated call minutes under limited minute plans are recognized as services are provided, that is, as minutes are used, and are billed to a customer's credit cards, debit cards or ECP in arrears. As a result of our multiple billing cycles each month, we estimate the amount of revenues earned from international calls and from customers exceeding allocated call minutes under limited minute plans but not billed from the end of each billing cycle to the end of each reporting period and record these amounts as accounts receivable. These estimates are based primarily upon historical minutes and have been consistent with our actual results.

We also provide rebates to customers who purchase their customer equipment from retailers and satisfy minimum service period requirements. These rebates in excess of activation fees are recorded as a reduction of revenues over the service period based upon the estimated number of customers that will ultimately earn and claim the rebates.

Customer equipment and shipping revenues include sales to our retailers, who subsequently resell this customer equipment to customers. Revenues were reduced for payments to retailers and rebates to customers, who purchased their customer equipment through these retailers, to the extent of customer equipment and shipping revenues.

Inventory Inventory consists of the cost of customer equipment and is stated at the lower of cost or market, with cost determined using the average cost method. We provide an inventory allowance for customer equipment that has been returned by customers but may not be able to be reissued to new customers or returned to the manufacturer for credit.

Income Taxes We recognize deferred tax assets and liabilities at enacted income tax rates for the temporary differences between the financial reporting bases and the tax bases of our assets and liabilities. Any effects of changes in income tax rates or tax laws are included in the provision for income taxes in the period of enactment. Our net deferred tax assets primarily consist of NOLs. We are required to record a valuation allowance against our net deferred tax assets to the extent we conclude 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 our net deferred tax assets (namely, the NOLs) prior to expiration.

In the fourth quarter of 2011, we concluded that it was more likely than not that taxable income in the future would be sufficient to utilize a significant portion of the future income tax benefit from our net deferred tax assets (namely, the NOLs) prior to expiration and we released $325,601 of the valuation allowance. We periodically review this conclusion, which requires significant management judgment. In the future, if available evidence changes our conclusions, we will make an adjustment to the related valuation allowance and income tax expense at that time.

Net Operating Loss Carry Forwards As of December 31, 2011, we had NOLs for United States federal and state tax purposes of $794,714 and $423,963, respectively, expiring at various times from years ending 2012 through 2030. In addition, we had NOLs for Canadian tax purposes of $37,564 expiring through 2027. We also had NOLs for United Kingdom tax purposes of $34,568 with no expiration date.

Our ability to use our tax attributes to offset tax on U.S. taxable income would be substantially limited if there were an "ownership change" as defined under Section 382 of the U.S. Internal Revenue Code. In general, an ownership change would occur if one or more "5-percent shareholders," as defined under Section 382, collectively increase their ownership in us by more than 50 percent over a rolling three-year period. The Section 382 limitation is applied annually so as to limit the use of our pre-change NOLs to an amount that generally equals the value of our stock immediately before the ownership change multiplied by a designated federal long-term tax-exempt rate. At December 31, 2011, there were no limitations on the use of our NOLs.

Net Operating Loss Rights Agreement On June 7, 2012, we entered into a Tax Benefits Preservation Plan ("Preservation Plan") designed to preserve stockholder value and tax assets. In connection with the adoption of the Preservation Plan, our board of directors declared a dividend of one 39-------------------------------------------------------------------------------- Table of Contents preferred share purchase right for each outstanding share of the Company's common stock. The preferred share purchase rights were distributed to stockholders of record as of June 18, 2012, as well as to holders of the Company's common stock issued after that date, but will only be activated if certain triggering events under the Preservation Plan occur.

Under the Preservation Plan, preferred share purchase rights will work to impose significant dilution upon any person or group which acquires beneficial ownership of 4.9% or more of the outstanding common stock, without the approval of our board of directors, from and after June 7, 2012. Stockholders that own 4.9% or more of the outstanding common stock as of the opening of business on June 7, 2012 will not trigger the preferred share purchase rights so long as they do not (i) acquire additional shares of common stock or (ii) fall under 4.9% ownership of common stock and then re-acquire shares that in the aggregate equal 4.9% or more of the common stock.

The Preservation Plan will expire no later than the close of business June 7, 2013, unless extended by our board of directors. Any extension would be subject to approval by our stockholders at the 2013 annual meeting.

Share-Based Compensation We account for share-based compensation in accordance with FASB ASC 718, "Compensation-Stock Compensation". Under the fair value recognition provisions of this pronouncement, share-based compensation cost is measured at the grant date based on the fair value of the award, reduced as appropriate based on estimated forfeitures, and is recognized as expense over the applicable vesting period of the stock award using the accelerated method.

Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements.

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