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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
____________
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO
SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 FOR THE FISCAL YEAR ENDED JULY 31, 2000, OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934.
Commission File Number: 0-27898
IDT CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 22-3415036
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
520 Broad Street
Newark, New Jersey 07102
(Address of principal executive offices, including zip code)
(973) 438-1000
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock, par
value $.01 per share
(Title of class)
Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [_]
The aggregate market value of the voting stock held by non-affiliates of the
Registrant, based on the closing price of the Common Stock on October 27, 2000
of $30.813, as reported on the Nasdaq National Market, was approximately $683
million. Shares of Common Stock held by each officer and director and by each
person who owns 5% or more of the outstanding Common Stock (assuming conversion
of the Registrant's Class A Common Stock into Common Stock) have been excluded
from this computation, in that such persons may be deemed to be affiliates of
the Registrant. This determination of affiliate status is not necessarily a
conclusive determination for any other purpose.
As of October 27, 2000, the Registrant had outstanding 26,104,722 shares of
Common Stock, $.01 par value, and 9,970,233 shares of Class A Common Stock,
$.01 par value.
DOCUMENTS INCORPORATED BY REFERENCE
Certain information in the Registrant's definitive Proxy Statement for its
2000 Annual Meeting of Stockholders, which will be filed with the Securities and
Exchange Commission pursuant to Regulation 14A, not later than 120 days after
July 31, 2000 is incorporated by reference in Part III (Items 10, 11, 12 and 13)
of this Form 10-K.
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INDEX
IDT CORPORATION
ANNUAL REPORT ON FORM 10-K
Page No.
--------
PART I.................................................................................................. 1
Item 1. BUSINESS.................................................................................. 1
Item 2. PROPERTIES................................................................................ 1
Item 3. LEGAL PROCEEDINGS......................................................................... 31
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS....................................... 32
PART II................................................................................................. 33
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS..................... 33
Item 6. SELECTED FINANCIAL DATA................................................................... 34
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS..... 35
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS............................... 49
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA............................................... 49
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE...... 49
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT........................................ 50
Item 11. EXECUTIVE COMPENSATION.................................................................... 50
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT............................ 50
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS............................................ 50
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.......................... 51
SIGNATURES.............................................................................................. 54
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS.............................................................. F-1
PART I
Item 1. BUSINESS.
Summary
As used in this Annual Report, unless the context otherwise requires, the
terms "the Company," "IDT," "We," and "Our" refer to IDT Corporation, a Delaware
corporation, its predecessor, International Discount Telecommunications, Corp.,
a New York corporation ("IDT New York"), and their subsidiaries, collectively.
All information in this Annual Report gives effect to the 1995 reincorporation
of the Company in Delaware. The Company's fiscal year ends on July 31 of each
calendar year. Each reference to a Fiscal Year in this Annual Report refers to
the Fiscal Year ending in the calendar year indicated (e.g., Fiscal 2000 refers
to the Fiscal Year ended July 31, 2000).
IDT Corporation is a leading facilities-based emerging multinational
carrier that provides a broad range of telecommunications services to wholesale
and retail customers worldwide. In addition, our IDT Ventures division is
developing several innovative telecom and Internet-related businesses. Also,
through our wholly-owned IDT Investments subsidiary, we have equity interests in
other technology companies, including our former subsidiary, Net2Phone, Inc.
("Net2Phone") (NASDAQ: NTOP), which offers a variety of Internet telephony
products and services. We have grown considerably in recent years, generating
revenues of $335.4 million, $732.2 million and $1,093.9 million in Fiscal 1998,
Fiscal 1999 and Fiscal 2000, respectively.
IDT's telecommunications services include wholesale carrier services, and
retail services, including prepaid calling cards, domestic long distance
services and international retail services. IDT delivers its telecommunications
services over a high-quality network consisting of over 100 switches in the U.S.
and Europe and owned and leased capacity on 16 undersea fiber optic cables,
connecting our U.S. facilities with our international facilities and with the
facilities of our foreign partners in Europe, Latin America and Asia. We monitor
our network 24 hours a day, seven days a week through an automated network
operations center. In addition, we obtain transmission capacity from other
carriers. We deliver our international traffic worldwide pursuant to our
agreements with U.S.-based carriers, foreign carriers, and more than 20 of the
companies that are primarily responsible for providing telecommunications
services in particular countries (many of which are commonly referred to as
"Post, Telephone and Telegraphs," or "PTTs").
As of October 1, 2000, we had approximately 165 wholesale customers located
in the U.S. and Europe. In addition, IDT offers retail long distance services to
over 150,000 individual and business customers in the U.S. and worldwide.
Minutes of use for our telecommunications business have grown from 809.5 million
minutes in Fiscal 1998 to 2,777.8 million minutes in Fiscal 1999 to 4,252.0
million minutes in Fiscal 2000.
We plan to further expand our global telecommunications network
infrastructure, in order to allow us to route a greater percentage of our
international long distance traffic over owned lines. Routing calls over owned
lines, rather than leased lines, will help us to reduce our operating costs,
ensure the quality of our service and expand our customer base. However, we
follow a disciplined, incremental approach to expanding our network, adding new
facilities only when we determine that such investments are justified by traffic
volumes. Under this "smart build" approach, IDT enters new markets by leasing
fiber capacity. As traffic grows, we may install a switch to increase overall
capacity. As traffic increases further, we typically invest in bandwidth to
realize cost savings from routing calls over an owned network. If volume
continues to grow, we may deploy additional switching and/or fiber capacity. IDT
installed company-owned switches in Newark, New Jersey and in London, England in
Fiscal 2000. We plan to install and/or upgrade facilities in Newark and
Piscataway, New Jersey; London, England; Amsterdam and Rotterdam, Holland; and
Brussels, Belgium by the end of Fiscal 2001, and to continue to pursue operating
agreements with foreign carriers in order to terminate traffic directly at
favorable rates.
This Annual Report on Form 10-K contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, including statements that contain the words
"believes," "anticipates," "expects," "plans," "intends" and similar words and
phrases. Such forward-looking statements include, among other things, the
Company's plans to reorganize, implement its growth strategy, improve its
financial performance, expand its infrastructure, develop new products and
services, expand its sales force, expand its customer base and enter
international markets. Such forward-looking statements also include the
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Company's expectations concerning factors affecting the markets for its
products, such as changes in the U.S. and the international regulatory
environment and the demand for long-distance telecommunications, Internet access
and Internet telephony services. Actual results could differ from those
projected in any forward-looking statements.
Forward-looking statements are based on management's current views and
assumptions and involve known and unknown risks that could cause actual results,
performance or events to differ materially from those expressed or implied in
those statements. These risks include, but are not limited to, the following
risks:
. each of our business lines is highly sensitive to declining prices;
. competition in our core businesses could substantially reduce our
revenues and our profits;
. we may not be able to grow our operations in the future if we cannot
raise enough capital;
. our revenues and profits will not increase if we are unable to
continue to expand our telecommunications business;
. our expenses will increase substantially if we expand our network at a
rate that is faster or slower than the growth of our
telecommunications traffic;
. our operations would be impaired if we are unable to obtain the
products and services of the telecommunications companies that we are
dependent upon;
. termination of our carrier agreements with foreign partners or our
inability to enter into carrier agreements in the future could
materially and adversely affect our ability to compete in foreign
countries;
. our revenues and our growth will suffer if our retailers and sales
representatives fail to effectively market and distribute our products
and services;
. we may not be able to integrate our joint ventures, direct investments
and acquisitions successfully with our existing business;
. rapid technological change and frequent new product introductions in
our markets could render our products and services obsolete;
. our growth may be limited if we cannot effectively manage our
international operations;
. our business will not grow without increased use of the Internet;
. our revenues will be impaired if we experience difficulties in
collecting our receivables;
. we will not be profitable if we do not receive attractive rates from
other carriers for our long distance traffic;
. federal, state and international government regulation may reduce our
ability to provide services, or make our business less profitable and
we may become subject to increased costs of operations due to
uncertainty over the amount of payphone surcharges and Federal
Universal Service Fund obligations;
. we may become subject to increased price competition from other
carriers due to federal regulatory changes in determining
international settlement rates;
. European regulation of telecommunications services may not continue to
evolve towards streamlined regulation;
. telecommunications regulations of other countries may restrict our
operations;
. government regulation of Internet access may increase our costs of
operations and we may become subject to Internet access charges;
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. we may be subject to liability for information disseminated over our
Internet network;
. the infringement or duplication of our proprietary technology could
increase our competition and we could incur substantial costs in
defending or pursuing any claims relating to proprietary rights;
. network construction delays and system disruptions or failures could
prevent us from providing our services, cause us to lose customers and
adversely affect our business;
. our quarterly operating results are subject to variation, which could
cause us not to meet the expectations of securities analysts, and
should not be relied upon as an accurate indicator of our overall
performance;
. if we are unable to attract and retain qualified management and
technical personnel, we may not remain profitable; and
. IDT is controlled by its principal stockholder, which limits the
ability of other stockholders to affect the management of IDT.
The forward-looking statements are made as of the date of this Annual
Report on Form 10-K, and the Company assumes no obligation to update the
forward-looking statements, or to update the reasons why actual results could
differ from those projected in the forward-looking statements. Investors should
consult all of the information set forth herein and the other information set
forth from time to time in the Company's Reports filed with the Securities and
Exchange Commission pursuant to the Securities Act of 1933 and the Securities
Exchange Act of 1934, including the Company's reports on Forms 10-Q and 8-K.
History
The Company was founded in August 1990 and was originally incorporated in
New York as "International Discount Telecommunications Corp." Our company was
renamed IDT Corporation and reincorporated in Delaware in December 1995. Our
main offices are located at 520 Broad Street, Newark, New Jersey 07102; our
headquarters telephone number is (973) 438-1000. IDT's Internet address is
www.idt.net.
IDT entered the telecommunications business by introducing its
international call reorigination service in 1990 to capitalize on the
opportunity created by the large spread between U.S. and foreign-originated
international long distance telephone rates. Long distance calling costs in
certain highly regulated international markets are often prohibitive. Our call
reorigination service enables customers to access a U.S. dial tone from overseas
and place international calls that are reoriginated in the U.S. The customer
benefits from more favorable U.S. outbound long distance rates and superior
transmission quality. We used the expertise derived from, and the calling volume
generated by, our call reorigination business to enter the domestic long
distance business in late 1993 by reselling long distance services of other
carriers to our domestic customers. As a value-added service for our domestic
long distance customers, we began offering Internet access in early 1994,
eventually offering dial-up and dedicated Internet access to individuals and
businesses as stand-alone services. In 1995, we began reselling to other long
distance carriers access to the favorable telephone rates and special tariffs we
receive as a result of the calling volume generated by our call reorigination
customers. We began marketing prepaid calling cards in January 1997.
IDT entered the Internet telephony market in August 1996 with its
introduction of PC2Phone, the first commercial telephone service to connect
calls between personal computers and telephones over the Internet. We expanded
our Internet telephony offerings in September 1997 with the introduction of
Net2Phone Direct, a service that enables users to make international and
domestic calls over the Internet using standard telephones. In April 1998, we
launched Click2Talk, an Internet telephony product which allows customers to
make calls to the toll-free numbers of e-commerce companies anywhere in the
world using a PC. In August 1998, we introduced Click2CallMe, which allows
consumers visiting e-commerce companies to contact customer sales
representatives from the Web sites of such companies without charge.
On August 3, 1999, Net2Phone completed an initial public offering of
6,210,000 shares of its Common Stock, yielding $85.3 million in net proceeds. In
December 1999, we sold 2,200,000 Net2Phone shares, in connection with
Net2Phone's secondary offering. In August 2000, we completed the sale of
14,900,000 shares of Net2Phone to AT&T, receiving approximately $1.1 billion in
cash proceeds. We currently still hold approximately 10,000,000
3
shares of Class A Net2Phone common stock. As part of our transaction with AT&T,
we have granted AT&T the right of first refusal to purchase our remaining
Net2Phone shares. After August 11, 2000, we will no longer consolidate the
results of operation of Net2Phone.
Corporate Reorganization
In October 2000, we announced plans to reorganize the Company, creating
separate divisions designed to reflect our various businesses and their unique
strategies. Upon completing this reorganization, which is subject to regulatory
approval, receipt of counterparty consents and completion of various
administrative requirements, IDT Corporation will be a holding company,
consisting primarily of two main subsidiaries: IDT Telecom and IDT Ventures and
Investments. Each of these divisions will be described in greater detail below.
We believe that the reorganization may result in several benefits to IDT
and its shareholders. These advantages include:
. Giving IDT greater flexibility in managing and financing new and
existing business operations
. Enhancing our ability to create separate, publicly-traded companies
through potential initial public offerings (IPOs) of stock
. Giving IDT greater flexibility to expand in the future through
acquisitions of companies, which may be strategically advantageous to
our long-term growth
. Facilitating the formation of joint ventures or other strategic
alliances along business lines
. Furthering our objective of operating our telecom business on a more
self-sufficient, independent economic basis
. Facilitating improved delineation of administrative and other
responsibilities within our corporate structure
. Enhancing management focus, by permitting a designated group of
executive employees to concentrate their efforts on the concerns of
the consolidated enterprise as a whole while allowing management of
the principal subsidiaries to focus on business unit-specific
objectives
. Permitting us to further link executive compensation to the
performance of the different business units, thereby providing for
better management accountability
IDT Telecom
IDT's Telecom division provides competitively-priced wholesale and retail
telecommunications services to customers around the world. Services offered
include wholesale carrier services, prepaid calling cards, domestic long
distance services and international retail services. Our telecom division seeks
to take advantage of numerous market opportunities -- presented by an ever-
evolving worldwide telecommunications industry -- to profitably grow its
business.
The International Long Distance Market
International switched long distance services are provided through
switching and transmission facilities that automatically route calls to circuits
based upon a predetermined set of routing criteria. In the U.S., an
international long distance call typically originates on a local exchange
carrier's network and is switched to the caller's domestic long distance
carrier. The domestic long distance provider then carries the call to its own or
to another carrier's international gateway switch. From there it is carried to a
corresponding gateway switch operated in the country of destination by the
dominant carrier of that country and then is routed to the party being called
through that country's domestic telephone network.
International long distance providers can generally be categorized by the
extent of their ownership and use of switches and transmission facilities. The
largest U.S. carriers, AT&T, WorldCom, Inc. and Sprint Corporation primarily
utilize owned U.S. transmission facilities and tend to use other international
long distance providers to
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reach niche markets where they do not own a network, to take advantage of lower
prices, and to carry their overflow traffic. Since no single carrier has
transmission facilities that cover each of the more than 200 countries to which
major long distance providers offer service, a significantly larger group of
long distance providers has emerged, which own and operate their own switches
but either rely solely on resale agreements with other long distance carriers to
terminate traffic or use a combination of resale agreements and leased or owned
facilities in order to terminate their traffic.
Today, there are over 500 U.S. long distance companies, most of which are
small or medium-sized companies. In order to be successful, these small and
medium-sized companies typically offer their customers a full range of services,
including international long distance. However, most of these carriers do not
have the critical mass of customers to receive volume discounts on international
traffic from the larger facilities-based carriers such as AT&T, WorldCom and
Sprint. In addition, these companies have only a limited ability to invest in
international facilities. Alternative international carriers, such as us, have
capitalized on this demand for less expensive international transmission
facilities. These alternative international carriers are able to take advantage
of larger traffic volumes in order to obtain volume discounts on international
routes (resale traffic) and/or invest in facilities when the volume of
particular routes justifies such investments. As these emerging international
carriers have become established, they have also begun to carry overflow traffic
from the larger long distance providers that own overseas transmission
facilities.
Telecommunications Market Opportunities
The international communications industry is undergoing a period of rapid
technological and regulatory changes that have resulted in several market
opportunities for emerging telecommunications services providers, such as IDT.
Recent years have witnessed rapid growth in the usage of international
telecommunications services, the proliferation of carriers providing such
services, a shift towards deregulation in many of the world's major
telecommunications markets and the development of new technologies.
According to industry sources, in 1998, the international long distance
telecommunications industry accounted for approximately 93 billion minutes of
use, an increase of 12% from 83 billion minutes of use in 1997, and up from
approximately 34 billion minutes of use in 1990. Industry sources have estimated
that by 2002 this market may approach 160 billion in revenues, representing
compound annual growth rates from 1998 of approximately 15%.
We believe that growth in international long distance services is being
driven by:
. the globalization of the world's economies and the worldwide trend
toward deregulation of the telecommunications sector
. declining prices arising from increased competition generated by
privatization and deregulation
. increased worldwide telephone density in both traditional wireline and
wireless telephones
. the emergence of new technologies, which have resulted in higher
quality and lower costs
. a wider selection of products and services
. the growth in the transmission of data traffic
We anticipate that growth of voice and data traffic originated in markets
outside the U.S. will be higher than growth in voice and data traffic originated
within the U.S. due to recent deregulation in many foreign markets, relative
long-term economic growth rates and increasing access to telecommunications
facilities in emerging markets.
Deregulation and Competition
Consumer demand and competitive initiatives have acted as catalysts for
government deregulation, especially in developed countries. Significant
legislation and agreements have been adopted since the beginning of 1996 which
are expected to lead to increased liberalization of the majority of the world's
telecommunication markets, including:
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. the U.S. Telecommunications Act, signed in February 1996, which
establishes parameters for the implementation of full competition in
the U.S. domestic local and long distance markets;
. the European Union's Services Directive, adopted in 1990, which
abolishes exclusive rights for the provision of voice telephony
services throughout the European Union and the public switched
telephone networks of every member country of the European Union by
January 1, 1998, subject to extension by certain European Union member
countries; and
. the WTO Agreement, signed in February 1997, which creates a framework
under which 69 countries have committed to liberalize their
telecommunications laws in order to permit increased competition and,
in most cases, foreign ownership in their telecommunications markets,
beginning in 1998.
We believe that these initiatives, as well as other proposed legislation
and agreements, will provide increased opportunities for emerging competitive
carriers such as IDT to provide telecommunications services in targeted markets.
Deregulation has encouraged competition, which in turn has prompted
carriers to offer a wider selection of services and reduce prices. The
industry's projections for substantially increased international minutes of use
and revenue over both the near term and long term are based in part on the
belief that reduced pricing as a result of deregulation and competition will
result in a substantial increase in the demand for telecommunications services
in most markets. In fact, this price elasticity of demand has already been
witnessed on a large scale worldwide.
The competitive opportunities have affected the deregulated, deregulating
and regulated markets in different ways. In a fully deregulated country, such as
the U.S. or the U.K., carriers can establish switching facilities, own or lease
fiber optic cable, enter into operating agreements with foreign carriers and,
accordingly, provide direct access service. However, new carrier entrants to a
deregulated market are usually not in a position to build their own
infrastructure. They generally prefer not to purchase services from incumbent
carriers and current competitors, whose incentives are to make the entrants'
access as restrictive and expensive as possible. These circumstances create a
demand for a carrier's carrier -- a firm that is capable of constructing its own
long distance network with a primary focus on serving other companies who market
their services directly to consumers. A carrier's carrier builds an
international telecommunications network to serve entrants in the retail market
and often offers rates that are much lower than the incumbent carrier offers to
entrants.
In markets that have not been deregulated, or are slow in implementing
deregulation, there are typically two or three competing carriers, including the
national monopoly. In such markets, a carrier's carrier will sell minutes to,
and buy minutes from, the competitive carriers, who seek minutes volume as well
as lower costs in order to enable them to compete. In addition, the carrier's
carrier will also continue to offer similar services to the national monopoly.
In markets that are fully regulated, such as various countries in the
Middle East, Asia and Africa, the regulated telephone monopoly or incumbent
carrier sets prices based on the accounting rate system, a framework for
originating, carrying and terminating calls that has been in place since just
after World War II. Within each country, the regulatory authority negotiates
rates with a foreign PTT. These accounting rates tend to be artificially
inflated, with no relation to the actual costs of carrying traffic. However,
even monopolists providing services in closed markets find that operating their
own network is unduly expensive, and given the low prices available relative to
those offered in their bilateral agreements, the most cost effective solution in
many situations is to employ a carrier's carrier. Unlike the monopolist, the
carrier's carrier can fill its network with calls originating in many countries
without being bound by accounting rates.
Teledensity
A major trend in the worldwide telecommunications industry in recent years
has been increased teledensity, or the measure of telephone lines per units of
population. Teledensity rates vary widely across different regions and
countries, with a relatively strong relationship between a country's per capita
income and its teledensity, as richer countries tend to have higher teledensity
rates than do their poorer counterparts. The following table highlights the
"teledensity gap" which exists between the world's more developed and less
developed countries and regions.
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---------------------------------------------
Country or Region Teledensity
---------------------------------------------
Africa 2.4%
---------------------------------------------
Americas (including U.S.) 32.8%
---------------------------------------------
Asia 8.0%
---------------------------------------------
Europe 38.1%
---------------------------------------------
Oceania 41.1%
---------------------------------------------
United States 66.1%
---------------------------------------------
World 14.9%
---------------------------------------------
However, it appears as though the "teledensity gap" may be narrowing. Many
governments of developing nations have begun to view increased teledensity as a
potential driver for economic growth, and have been focusing on improving
telephone line penetration in their countries. As a result, teledensity rates
around the world have been rising, and are expected to continue to increase over
the foreseeable future. As more people around the world gain access to
telephones, international long distance minutes will increase.
IDT believes that it is particularly well-positioned to benefit from the
anticipated improvements in teledensity rates in areas such as Africa, Asia and
Latin America. Our wholesale business focuses on these relatively high revenue-
per-minute telecommunications markets. In addition, our prepaid calling cards
are marketed primarily to the ethnic, immigrant communities in the U.S., Europe
and Latin America. Therefore, a significant proportion of our international
debit card minutes go to regions such as Africa, Asia and Latin America, as our
customers call their friends and families in their native countries. We estimate
that over 50% of our international wholesale and debit card minutes go to these
regions. As teledensity rates in these areas continue to increase, we believe
that demand for calling time to these countries will also rise, fueling further
growth in our prepaid calling card business.
New Technologies
New technologies, including the development of next-generation fiber optic
cable and improvements in digital compression, have improved quality and
increased transmission capacities and speed, with transmission costs decreasing
as a result. In addition, the growth of the Internet as a communications medium,
and advances in packet switching technology and Internet telephony, are expected
to have an increasing impact on the international telecommunications market.
Advances in technology have created a variety of ways for
telecommunications carriers to provide customer access to their networks and
services. These include customer-paid local access, international and domestic
toll-free access, direct digital access through dedicated lines, equal access
through automated routing from the public switched telephone network and
Internet telephony. The type of access offered depends on the proximity of
switching facilities to the customer, the needs of the customer and the
regulatory environment in which the carrier competes. Overall, these advances
have resulted in a trend towards bypassing traditional international long
distance agreements between national monopolies and the proliferation of voice
and data service providers.
Furthermore, technological advancements have allowed the use of "packet
switching" technology for the transmission of voice telecommunications traffic,
enabling a substantial increase in network efficiency, as well as the use of the
Internet for voice communications. Traditional international long distance calls
use a technology called "circuit switching," which carries the calls over
international voice telephone networks. Circuit switching requires a dedicated
connection between the caller and the recipient which must stay open for the
duration of the call. On the other hand, packet switching technology breaks
voice and fax calls into separate data packets, sends them over the Internet,
then reassembles them in their original form for delivery to the recipient. This
technology allows data packets representing multiple conversations to be carried
over the same line, and is therefore inherently more efficient than is circuit
switching technology. In addition, the use of the Internet as a voice
communications medium provides significant reductions in the cost of
transmitting traffic, while bypassing the cumbersome and expensive settlement
process traditional in international voice communications. The development of
voice applications for the Internet is part of a larger trend of convergence of
standard voice and data networks. Internet telephony services are expected to be
one of the fastest growth segments in the telecommunications industry.
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Increasing Importance of Data Services
As the world continues to transition to information-based economies, and
the telecommunications and Internet industries continue to converge, the
transmission of data will take on a more important role in the business of
telecommunications carriers such as IDT. Although we believe that transmission
of "voice minutes" will continue to increase, we anticipate that more of our
business in the future will involve the transmission of "data minutes."
Currently, data is the major driver behind the industry's projections of future
demand, and the basis for the enormous amount of bandwidth that is being
installed around the globe. Industry sources have estimated that due to
increased demand for data services, the global volume of data traffic is
increasing by more than 100% per year. This explosion in demand for data
services is being fueled by several factors, including:
. Increasing use of the Internet and corporate Intranets
. Continued personal computer penetration
. The emergence, and rapid acceptance, of e-commerce as a substitute for
more traditional transactions
. Growing demand for other Internet-related services, such as web
hosting
As with the voice minutes market, we believe that the growth in the data
services market will be greater overseas than in the U.S., owing to the
significantly lower relative levels of Internet use, PC penetration and
corporate Intranet and web hosting activities outside the U.S. This indicates
greater potential upside in these international markets.
The growth in data transmission presents us with opportunities to both
expand our business with our existing customers, and to reach a new customer
base. We will be able to add a data element to the services we currently provide
our existing telecommunications customers, offering services such as Internet
telephony, remote Internet access, web-hosting, and co-location and data center
services. We will also be able to offer services to a broad, new customer base
for IDT, including Internet Service Providers (ISPs) and Application Service
Providers, as we carry their data minutes over our network.
The IDT Approach
IDT's background as a leading alternative provider of wholesale and retail
international telecommunications services, combined with its experience as a
domestic Internet service provider and its leadership role in the field of
Internet telephony, position it to capitalize on the various opportunities
presented by today's telecommunications industry. Our objective is to enhance
our current position as a leading facilities-based provider of high-quality,
low-cost telecommunications services to wholesale and retail customers in both
the U.S. and abroad. The following goals represent key elements of our strategy:
Focus on International Telecommunications. We believe that the
international long distance market provides attractive opportunities due to its
higher revenue and gross profit per minute, and higher projected growth rate
compared to the domestic long distance market. We target international markets
with high volumes of traffic, relatively high per-minute rates and favorable
prospects for deregulation and privatization. We believe that the ongoing trend
toward deregulation and privatization will create new opportunities for us to
increase our revenues and to reduce our termination costs, while maintaining
balanced growth in wholesale and retail traffic.
Expand Switching and Transmission Facilities. We are continuing to expand
and enhance our network facilities by investing in switching and transmission
facilities where traffic volumes justify such investments. During Fiscal 2001 we
intend to invest in:
. undersea cables connecting the U.S., Europe, South America and Asia
. terrestrial fiber capacity within the U.S. and Europe
. gateway switches and facilities in the U.S., the U.K., the Netherlands
and other European countries
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. additional network compression equipment.
We believe that these investments will allow us to broaden the scope of our
telecommunications activities and to reduce the cost of our services, while
maintaining our high service quality.
Expand Service Offerings and Marketing Activities. We intend to continue to
develop value-added services and to market them on a wholesale and retail basis
in order to increase margins, optimize network utilization and improve customer
loyalty. IDT has historically used technology to capitalize on regulatory
opportunities and market niches by offering innovative value-added services such
as call reorigination, international prepaid calling cards and Internet
telephony. Our wholesale business will attempt to offer a more complete suite of
value-added carrier services to both its existing customer base and to new
customers. Within our retail division, we will continue to seek profitable
niches within the telecommunications markets, adding higher-margin retail
businesses, such as residential long distance and wireless products and
services, to our existing sales mix.
Pursue Strategic Alliances and International Agreements. We intend to
capitalize on our strategic alliances and other relationships with U.S. and
foreign companies in order to expand our customer base. We have traditionally
been able to capitalize on our significant traffic volume and technological
expertise to negotiate favorable termination agreements with international
carriers. We intend to continue to seek new termination relationships with
established and emerging carriers to reduce our termination costs for
traditional international voice telephony, and in some cases to use our
relationship with Net2Phone for additional low cost termination. To date, we
have entered into approximately 65 agreements with carriers that provide for the
favorably priced termination of its calls worldwide.
As part of the transaction in which we sold 14.9 million of our Net2Phone
shares to AT&T, we have announced that we would pursue operating agreements with
AT&T and/or its international affiliates.
Telecommunications Services
IDT provides its wholesale and retail customers with integrated and
competitively priced international and domestic telecommunications services. Our
four primary telecommunications services are: wholesale carrier services,
prepaid calling cards, domestic long distance services in the U.S., and
international retail services. We generated revenues from our telecommunications
business of approximately $1,023.0 million during Fiscal 2000, up from $684.6
million during Fiscal 1999. Telecommunications revenues represented 93.5% of
IDT's total consolidated revenues in both Fiscal 2000 and Fiscal 1999.
Wholesale Carrier Services
We sell our wholesale carrier services to other U.S. and international
carriers, utilizing flexible and least-cost traffic routing and based on our
expertise in navigating the complex accounting rate system. In this way, we act
as a "carrier's carrier," providing the numerous entrants in the retail market
with rates that are much lower than those previously offered by the more
established carriers. We are able to offer competitive rates to our carrier
customers as a result of our extensive relationships in the long distance
telecommunications industry, our ability to generate a high volume of long
distance call traffic and the advantageous rates negotiated with foreign PTTs
and competitive carriers. As of October 1, 2000, we had approximately 165
wholesale customers located in the U.S. and Europe, with wholesale carrier sales
representing 47.6% of IDT's total consolidated revenues in Fiscal 2000.
The wholesale carrier business is currently undergoing a transformation, as
intense competition has led to significant price declines and margin pressure.
In this environment, several less efficient operators, who generally do not
possess the critical mass necessary to succeed, are finding it increasingly
difficult to compete. We anticipate that this trend will continue in the coming
years, as some competitors leave the industry, and the more financially sound
players, including IDT, gain market share at the expense of the weaker
competitors. In the short-term however, we anticipate that we will continue to
be faced with a challenging operating environment for wholesale carrier
services, characterized by continued margin pressure.
9
Competitive Advantages
We believe that we have several competitive advantages in the wholesale
carrier business, including the following:
. Strong existing relationships with national monopolies and other leading
carriers, which, we believe, allow us to negotiate advantageous rates.
. Our prepaid card business, which generates a high volume of long distance
call traffic. Because we can bring new minutes to the national monopoly,
rather than simply taking minutes from another carrier with whom it might
already have an agreement, we are favored by national monopolies.
. Superior switching, routing and customer service technology. Our backbone
network has demonstrated its superior quality in several tests. Our back
office technology allows us to generate real-time information, allowing for
better cost analysis and customer service and facilitating strict quality
controls.
. Our ability to offer "value-added carrier services," such as giving
carriers remote access to our debit card platform. This enables us to offer
additional "turnkey" capabilities to carrier customers and positions us as
a "total outsourcing provider" of carrier services, something that our pure
wholesale competitors cannot offer.
. Our status as an independent wholesale carrier that does not compete for
the core retail customers sought by our carrier customers.
. Our ability to rapidly react to changing price environments, which has
allowed us to take advantage of attractive rates more quickly than have our
competitors.
. Our early-entrant status in several regulated markets, which, we believe,
will provide an advantage when these markets deregulate.
. Our careful attention to cost control, efficiency and the maintenance of
lower general overhead expenses.
Wholesale Carrier Strategies
We have strategies tailored to different markets: regulated markets,
deregulated markets and markets that are currently deregulating.
In deregulated countries, we offer new market entrants, who are generally not
in the position to build their own infrastructure, carrier services at rates
that are typically lower than the incumbent carrier is offering. In such
countries, we also establish and expand our arbitrage operations by taking
advantage of the competitive environment to buy minutes at a lower rate and then
sell them at a higher rate. In markets that are fully regulated, our strategy is
to establish a relationship with the national monopoly and enter into agreements
to carry and terminate its minutes. We can typically offer the national
monopolies lower prices than those offered in their existing bilateral
agreements. In markets that are undergoing the deregulation process, there are
typically two or three competing carriers, including the national monopoly. In
these markets, our strategy involves selling minutes to, and buying minutes
from, the competitive carriers, who seek minutes volume as well as lower costs
in order to compete. We also continue to offer similar services to the national
monopoly.
These different strategies, for the three types of markets, are part of our
overall strategy for the deregulating world. As a country moves from regulated
to fully deregulated status, our strategy for that country shifts to take
advantage of the opportunities presented at any given time. By first entering a
market when it is regulated and establishing relationships with the national
monopoly, we obtain early entrant status, which prepares us to compete more
effectively as the market deregulates. By the time the market opens for
competition, we have acquired a thorough knowledge of the market (in terms of
potential minutes generated, most frequently called routes, culture, etc.),
which we believe is a competitive advantage for both our wholesale carrier and
retail operations.
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Retail Telecommunications
Prepaid Calling Cards
We sell prepaid debit and rechargeable calling cards providing access to more
than 230 countries and territories. Our rates are up to 50% lower than the rates
for international calls that are charged by the major facilities-based carriers.
We market debit cards primarily to ethnic communities in the U.S. that generate
high levels of international traffic to specific countries where we have
favorable termination agreements. Recent immigrants and members of the ethnic
communities tend to be heavy users of international long distance, given their
desire to keep in touch with family members and friends back home. Our business
is particularly strong in the Northeast U.S., aided by our extensive
distribution network and attractive rates to areas such as Colombia, Mexico and
the Dominican Republic. We have also been rapidly expanding our operations in
California, Florida, Illinois, Texas and other parts of the U.S. Outside the
U.S., we market cards in the U.K., France, Germany, Italy, Spain and the
Netherlands, seeking to capitalize on the opportunity presented by the recent
surge in immigration from under-developed countries around the globe to Europe's
developed nations. We have also recently begun to sell cards in Latin America.
We sold over 50,000,000 prepaid calling cards during Fiscal 2000. During Fiscal
2000, sales of prepaid calling cards accounted for 43.6% of IDT's total
consolidated revenues.
We offer both IDT-branded and non- IDT-branded prepaid calling cards, with
favorable rates to specific areas of the world. The cards are sold in several
different dollar denominations, most commonly $5, $10 and $20. The table below
lists the major IDT phone cards we sell:
Asimon Florida Exclusive New York Alliance
Blackstone America Florida Friend New York Exclusive
California Exclusive Georgia Exclusive Pennsylvania Exclusive
Carribean Friend Illinois Exclusive Pepe Colombianita
Carolina Exclusive Kababayan Pepe Megatel
Centro Americard Long Island Exclusive Puerto Rico Exclusive
China Card M&M Card Rhode Island Exclusive
Circle Line Mass Exclusive South Seas
Colombianita Card Massachusetts Talk Tele Talk
Connecticut Exclusive Mega Mexico Card Texas Exclusive
Cumbia 800 Megatel Card Union Phone Card
Dominicall Card Megatel Vending Union Phone Vending
Eastern Europe Metropolis Vending Exclusive
Easy Pass IDT Merengue Card Virtual Internet Card
Easytalk LA Michigan Exclusive Walter Mercado Phone
Easy Talk NJ New Jersey Alliance Washington Alliance
Flat Rate Nickel 2001 New Jersey Exclusive Washington Exclusive
Our rechargeable cards, distributed primarily through in-flight magazines,
permit users to place calls from over 40 countries through international toll-
free services.
Our retail customers can use our calling cards at a touch tone telephone by
dialing an access number, followed by a personal identification number (a
"PIN") assigned to each prepaid calling card and the telephone number the
customer seeks to reach. Our switch completes the call, and our debit card
platform reduces the outstanding balance of the card during the call. We offer
prepaid calling cards that can be used to access our network by dialing a toll-
free number or, in specific metropolitan markets, local area calling cards that
only require a local call. We believe that many of our customers typically use
our calling cards as their primary means of making long distance calls due to
attractive rates, reliable service, the ease of monitoring and budgeting their
long distance spending and the appealing variety of calling cards we offer to
different market segments.
IDT expanded its domestic debit card platform through its acquisition of
InterExchange and its subsidiaries (collectively, "InterExchange"), completed
in May 1998. Through InterExchange, we operate one of the nation's largest
international debit card platforms. The platform provides us with a broad range
of services used to conduct our calling card operations, including billing,
routing of calls, and determining the amount of credit available on each
outstanding calling card.
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As part of our rapid expansion in the prepaid calling card market, we have
started marketing private label phone cards. Private label cards serve as
lucrative promotional items and can also be used to help generate brand name
awareness. We have launched several co-branded cards in partnership with
consumer product companies, including the Coca-Cola Company in the Dominican
Republic.
Competitive Advantages
We believe that we possess the following advantages over our competition in
the prepaid calling card industry:
. Our status as a carrier's carrier allows us to offer calling time over more
routes to the countries that are in demand in the retail marketplace, at
attractive prices.
. Our debit platform, which we believe to be the most advanced in the
industry, enables us to process a large number of cards simultaneously and
to provide multi-lingual and multi-currency cards.
. Our expertise, market savvy and distribution channel, which covers over
100,000 retail outlets.
. Our understanding of, and commitment to, the ethnic prepaid calling card
market.
. We are able to provide low rates and at the same time maintain our margins
by taking a disciplined approach to advertising and because we enjoy low
overhead and low headcount. We believe that as our carrier business builds
out its network, our prepaid business' cost per minute will decline,
helping margins.
Domestic Long Distance Services
IDT markets certain long distance services directly to retail customers in the
U.S. Introduced in February 2000, our calling plan features a flat rate of five
cents per minute for all state-to-state calls within the continental United
States, 24 hours a day, seven days a week. We also offer a free IDT Calling
Card, with no monthly fees or per-call surcharges, featuring a domestic rate of
ten cents per minute. Our rates for international calls are also extremely
competitive, well below those charged by the major facilities-based carriers. In
April 2000, we began to more aggressively market our domestic long distance
services, by expanding the existing TV ad campaign to additional markets and
introducing new marketing channels, including print advertisements, direct mail,
online advertising and partnerships.
As of October 1, 2000, we had over 150,000 domestic long distance customers.
Domestic long distance services accounted for 1.3% of our total consolidated
revenues in Fiscal 2000. As we continue to make significant expenditures to
market this service, resulting in customer growth, we anticipate that domestic
long distance services will begin to account for an increasing proportion of our
total revenues in future periods.
International Retail Services
We offer international retail services to customers outside of the U.S.,
primarily through call reorigination. We also provide our call reorigination
customers with access to enhanced U.S. telecommunications service options at
U.S. long distance rates. These options include: voicemail, itemized billing,
speed dial codes that allow customers convenient access to the call
reorigination service, personalized voice prompts that allow customers to be
called back at extensions where the party being dialed must be requested by
name, remote programmable service that allows customers the flexibility of
selecting the number called back instead of receiving the call at a
preprogrammed number, access to U.S. toll-free 888 and 800 numbers, and
simplified billing that combines the cost of the call back to the customer and
the cost of the customer's outbound call from the U.S. in one bill for
convenient and orderly presentation. We market our call reorigination service to
businesses and individuals. International retail services accounted for 1.0% of
IDT's total consolidated revenues in Fiscal 2000.
Internet Services
In 1994, IDT began offering Internet access to individuals and businesses. We
currently offer a variety of both dial-up and direct-connect dedicated Internet
services. IDT's Internet access network, which consists of multiple leased
lines, offers approximately 200 points-of-access through approximately 35
points-of-presence (POPs) owned
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by IDT. In addition, we offer approximately 2,300 points-of-access through POPs
owned by local and regional ISPs, called Alliance Partners, through which
subscribers may access the Internet. As of October 1, 2000, IDT offered local
dial-up access to approximately over 20,000 retail customers, provided dedicated
access to nearly 350 medium and large-sized businesses, offered Web hosting
services to approximately 2,000 customers and provided Digital Subscriber Line
(DSL) services to 800 customers. Internet services accounted for 1.2% of IDT's
total consolidated revenues in Fiscal 2000.
In recent years, our Internet business has pursued a targeted niche strategy,
seeking to offer products and services to markets where we would not be required
to incur the significant customer acquisition costs generally associated with
"mass market" Internet service providers. Consequently, our Internet strategy
shifted several times through Fiscal Years 1999 and 2000, as we attempted to
profitably exploit market opportunities in the Internet industry. Most recently,
we offered free Internet access and other services through our Free-At-Last.com
subsidiary. However, in October 2000, we announced that we were transitioning
our FreeAtLast.com Internet service from a free service to a subscription plan.
In addition, as part of our joint venture agreements with Terra Networks, and
the subsequent exchange of our interests in these ventures for Terra Networks
stock, we have given most of our dial-up customers to Terra Networks. We are
currently considering several options for our Internet business, and we expect
to continue to scale back our operations in this area.
Sales, Marketing and Distribution
We primarily market our international telecommunications services through our
direct wholesale carrier services sales staff. The staff primarily relies on,
and benefits from (i) IDT's extensive relationships and increasing international
exposure and recognition throughout the long distance industry for marketing its
carrier services; (ii) our substantial traffic volumes, which enable us to
negotiate for lower rates; and (iii) favorable terminating rates negotiated with
PTTs and foreign carriers.
We primarily market our international call reorigination services through our
overseas network of independent sales representatives. The foreign sales
representatives, who are supervised by our U.S.-based sales managers, provide us
with access to local business and residential customers and new opportunities in
the local markets they serve. We pay our foreign sales representatives on a
commission basis. As of October 2000, we were represented by over 300 foreign
sales representatives worldwide. We have also commenced direct sales efforts,
primarily through overseas advertising in international print media to penetrate
particular market segments that we do not currently serve.
We currently market our prepaid debit cards to retail outlets throughout the
U.S. through Union Telecard Alliance, LLC ("Union"), a joint venture company
of which we own 51% of the outstanding equity interests. Union is one of the
largest distributors of prepaid calling cards in the nation, utilizing a network
of over 600 sub-distributors who sell through over 100,000 retail outlets
throughout the United States. In July 1999, we entered into an agreement with
All Americas Cable & Radio ("AACR"), a long distance carrier based in the
Dominican Republic, in which we will distribute prepaid calling cards in the
Dominican Republic on behalf of AACR. As part of our plan to expand our
territory beyond the U.S., we have begun to establish a distribution network in
the Dominican Republic to replicate our calling card distribution network in the
United States. In May 2000, Union began distributing prepaid cards in Puerto
Rico, and plans to begin distributing cards in parts of Central America during
Fiscal 2001.
Union has entered into agreements with sub-distributors, located in Illinois,
Florida, New York, Ohio and Texas, whereby the sub-distributors have agreed to
market the our prepaid calling cards in exchange for preferential pricing,
exclusive cards, extensions of credit, incentive bonuses and technical support
from us, which is intended to assist each respective sub-distributor in the
growth and development of its business. Our exclusive calling cards will be
marketed by the corresponding partnership in a given state.
In addition to selling IDT's prepaid calling cards, Union sells prepaid
calling cards of other companies. This allows Union to operate as a "one-stop
shop" for the widest possible range of prepaid phone cards, enabling Union to
enhance its sales to the retail outlets it currently serves.
IDT also sells rechargeable calling cards, which are distributed primarily
through in-flight magazines.
13
We have significantly increased our marketing expenditures for our domestic
long distance services, in conjunction with the announcement of our new flat-
rate, five-cents-a-minute calling plan. The advertising campaign for these
services is mostly driven by direct television advertising in targeted markets,
and is supplemented with a direct mail program. Our goal is to continue spending
on marketing and advertising to build our domestic long distance customer base,
with a primary focus on keeping cost-per-customer acquired at or below our
targeted levels.
Billing and Customer Support
IDT believes that reliable, sophisticated and flexible billing and information
systems are essential to its ability to remain competitive in the global
telecommunications market. Accordingly, we have invested substantial resources
to develop and implement our proprietary management information systems.
Our billing system enables us to:
. accurately analyze our network traffic, revenues and margins by customer
and by route on an intra-day basis;
. validate carrier settlements; and
. monitor least cost routing of customer traffic.
The entire process is fully automated and increases efficiencies by reducing
the need for monitoring by our employees. We believe that the accuracy and
efficiency of our management information systems provide us with a significant
strategic advantage over other emerging carriers.
We believe that our ability to provide adequate customer support services is a
crucial component of our ability to retain customers. We have successfully
focused on improving such service through a number of measures, including the
addition of support personnel and the monitoring of customer waiting time. The
customer support staff provides 24-hour technical assistance in addition to
general service assistance. Customer support personnel communicate with
subscribers via telephone, e-mail and fax. We require that each customer support
staff member field a minimum number of calls and e-mails each day. We also
employ liaisons between the customer support and technical staffs to ensure
maximum responsiveness to changing customer demands.
Network Infrastructure
We maintain an international telecommunications switching infrastructure and
U.S. domestic network, consisting of owned and leased lines that enable us to
provide an array of telecommunications, Internet access and Internet telephony
services to our customers worldwide. IDT's network is monitored 24 hours a day,
seven days a week, and 365 days a year by its network operations center. The
entire network is centrally managed from IDT's control center through the use of
a standardized communications protocol. In addition, we use two proprietary
monitoring systems to manage modem pools.
Telecommunications Network
Private Line Network
We operate a growing telephone network consisting of U.S. domestic dedicated
leased fiber optic and copper lines, and IDT-owned switch equipment in the U.S.
which are interconnected to major PTTs, emerging carriers and domestic
interexchange carriers, local exchange carriers and competitive local exchange
carriers. Our major switching facilities are located in Piscataway, N.J.;
Newark, N.J.; New York, N.Y.; London, England and Rotterdam, Holland. These
varied locations serve to provide the network with redundancy and diversity. All
of these locations are linked with the dominant local exchange carrier as well
as at least one of the competitive local exchange carriers, allowing us to
interconnect with all major interexchange carriers to switch traffic via our
leased private-line DS3 network. Furthermore, all of our locations are
interconnected via leased lines to enhance network reliability and redundancy as
each location interconnects with the various carriers.
14
In September 1998, we entered into a $32 million, 20 year Indefeasible Right
of Use (IRU) agreement with Frontier Communications (now a unit of Global
Crossing Ltd.) to obtain dedicated DS-1, DS-3, OC-3 and OC-12 circuit capacity
in the U.S. over Frontier's network, connecting more than 120 metropolitan areas
around the nation. These network facilities have enabled us to expand the range
and reliability of our data and voice transmission service, while reducing
network costs. IDT is able to offer nationwide dial-up long distance and dial-
around (10xxx) services, reduce 800-origination costs and provide for
origination and termination of carrier traffic in all major U.S. cities.
In October 1999, we entered into an agreement with Frontier whereby we
enhanced our ability to provide presubscribed long distance (1+) and dedicated
and toll-free services throughout the United States as well as casual calling
(10xxx) in selected areas of the country. The additional capacity has
significantly enhanced our ability to provide long distance dial up services.
In addition, we own and lease switched services to connect our U.S. and U.K.
facilities. These services are used to originate traffic from IDT's customer
base in the U.K. and to terminate existing carrier and call reorigination
traffic to the U.K. We have about 65 operating and terminating agreements that
provide for the termination of traffic worldwide, including agreements with
companies based in Spain, the Dominican Republic, Italy, Bangladesh, Cyprus and
Chile. We also plan to obtain leased lines to these destinations, which will
result in reduced costs for termination to these countries. We have also
targeted countries such as the Netherlands, Germany and France for network
expansion due to the large number of minutes we presently terminate and the size
of our installed base of telecommunications customers in these countries.
International Telecommunications Acquisitions & Agreements
In January 1999, we signed agreements with France Telecom, Deutsche Telkom,
Swisscom N.A. and Telefonica de Espana, four major telecommunications companies
based in Europe, to establish a direct fiber-optic connection between the
companies for international long distance service. The agreement establishes
direct channels between the companies' international switching points and our
facilities in the United States and United Kingdom. We have already established
a presence in the United Kingdom with its facilities-based switch, and have
purchased more than 12,000 kilometers of undersea cable connecting the United
States, Canada and the United Kingdom.
In February 1999, we acquired Orion Telekom B.V., now known as IDT Netherlands
B.V., a Netherlands based provider of telecommunications services. Through this
acquisition, we procured an Interconnect/Access agreement with Royal KPN NV
("KPN") the leading phone company in the Netherlands, and associated physical
interconnections, an installed Alcatel S12 switch, an operating license in
Holland and a facility in Rotterdam. Our voice licensing in the Netherlands
coupled with the interconnection available through KPN has enabled us to offer
wholesale and retail carrier services in the Dutch market.
Switching Platforms
We utilize two major switching platforms. We use our Lucent switches for our
application-based products such as call reorigination, direct dial, call
through, prepaid calling cards, and value-added services such as voice prompts,
speed dialing, voice mail and conferencing. The Lucent switches (such as the
LNX) are flexible and programmable, and are designed to implement network-based
intelligence quickly and efficiently. We currently own and/or lease 113 Lucent
switches. The other platform is the Nortel DMS250-300/GSP, which serves as an
international gateway and generic carrier switch. We currently own four Nortel
switches. A third platform, the Alcatel, is used at our switching facility in
the Netherlands. We plan to upgrade our switching platforms in New Jersey,
London and Amsterdam during Fiscal 2001. All of our switches are modular,
scaleable and equipped to signal in such protocols as ISDN or SS7 so as to be
compatible with either domestic or foreign networks.
Software
Our Lucent switches incorporate Company-developed software which efficiently
performs all the applications we require to provide value-added services, as
well as billing and traffic analysis. The software enables the Lucent switches
to route all calls via our least-cost routing platform. Least-cost routing is a
process by which we optimize the routing of calls over the least-cost route on
our switches for over 230 countries. In the event that traffic cannot be handled
over the least-cost route due to capacity or network limitations, the least-cost
routing system is designed to
15
transmit the traffic over the next least-cost route. The least-cost routing
system analyzes several variables that may affect the cost of a long distance
call, including different suppliers, different time zones and multiple choices
of terminating carrier in each country. In some instances, instead of routing a
call directly between two overseas points, the least-cost routing system may
backhaul a carrier's minutes using resold switched services to another of our
U.S.-based switches in order to terminate the traffic in a third country while
taking advantage of our competitive international long distance rates. The
least-cost routing system is continually reviewed in light of rates available
from different suppliers to different countries to determine whether we should
add new suppliers to its switch to further reduce the cost of routing traffic to
a specific country and to maintain redundancy, diversity and quality within the
switching network. By utilizing a least-cost routing system, we are able to
minimize our costs, and offer lower rates to our customers. This is of
significant importance when serving a market which has become increasingly
price-sensitive.
Internet Network
We operate a national Internet network comprised of a leased DS3 45 megabits
per second backbone of high speed fiber optic lines connecting eight major
cities across the U.S., and leased dedicated T1 fiber optic lines connecting
smaller cities to the network. The network backbone uses state-of-the-art
routing platforms including Cisco Series 7000 routers and Nortel ERS Magellan
switches. The DS3 backbone connects traffic at four major Internet "meet"
points where we maintain switching and routing equipment and has peering
arrangements to exchange Internet traffic with over 50 other Internet backbone
providers. To minimize the potential detrimental effects of single points of
failure, we deploy a minimum of two dedicated leased data lines to each backbone
node and remotely positions secondary servers for all configuration and
authentication hosts. Multiple data segments are used in high traffic areas to
minimize packet loss and to reduce the frequency of congestion in the network.
Also, major IDT backbone nodes employ routing switches for directing network
traffic. To further enhance network performance, we employ an "Open Shortest
Path First" protocol, which allows data traffic to be routed most efficiently.
We seek to retain flexibility and to maximize our opportunities by utilizing a
continuously changing mix of routing alternatives. This diversified approach is
intended to enable us to take advantage of the rapidly evolving Internet market
in order to provide low-cost service to our customers.
We utilize the local dial-up switching infrastructure of several Alliance
Partners across the country to supplement our owned and operated local dial-up
infrastructure. The Alliance Partners, which are independently-owned Internet
service providers, employ routing and modem equipment which meet our standards
for providing dial-up access services. We offer the Alliance Partners a monthly
fee for each customer account routed through their local access networks. We
also provide billing, advertising, marketing and customer acquisition services,
in exchange for which the Alliance Partners provide local Internet access. The
agreements with Alliance Partners generally have one year terms and do not
prohibit us from constructing our own local installed POP where warranted.
Research and Development
We employ a technical staff that is devoted to the improvement and enhancement
of our existing telecommunications and Internet products and services, including
switching technologies and the development of new technologies and products. We
believe that the ability to adjust and improve existing technology and to
develop new technologies in response to, and in anticipation of, customers'
changing demands is necessary to compete in the rapidly changing
telecommunications and Internet industries. There can be no assurance that we
will be able to successfully develop new technologies or effectively respond to
technological changes or new industry standards or developments on a timely
basis, if at all. For the years ended July 31, 1998, 1999 and 2000, research and
development costs totaled approximately $481,000, $757,000 and $4,692,000,
respectively.
In connection with IDT's acquisition of InterExchange in May 1998, we acquired
InterExchange's in-process research and development relating to alternative
switching and compression technologies. IDT has chosen to discontinue the
acquired research and development projects in favor of utilizing advanced vendor
technologies.
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Competition
The markets in which we operate are extremely competitive and can be
significantly influenced by the marketing and pricing decisions of the larger
industry participants. The barriers to entry are not insurmountable in any of
the markets in which we compete. We expect competition in these markets to
intensify in the future.
The market for prepaid calling cards has become highly competitive. In the
prepaid calling card market, we compete with other providers of prepaid calling
cards and with providers of telecommunications services in general. Many of the
largest telecommunications providers, including AT&T, WorldCom and Sprint
currently market prepaid calling cards, which in certain cases, compete with the
prepaid calling cards we sell. These companies are substantially larger and have
greater financial, technical, engineering, personnel and marketing resources,
longer operating histories, greater name recognition and larger customer bases
than does the Company. We also compete with smaller, emerging carriers in the
prepaid calling card market, including RSL Communications, Ltd., Viatel, Inc.,
Primus Telecommunications and PT-1 Communications. In marketing prepaid calling
cards to customers outside the U.S. market, we compete with the large PTTs, such
as British Telecommunications (BT) in the U.K. We believe that additional
competitors are likely to enter the prepaid calling card market (including
Internet-based service providers and other telecommunications companies) during
the next several years.
With respect to its other telecommunication services, we compete with:
. interexchange carriers and other long distance resellers and providers,
including large carriers such as AT&T, WorldCom, Inc. and Sprint
. foreign PTTs
. other providers of international long distance services such as Pacific
Gateway Exchange, Primus Telecommunications, RSL Communications Ltd.,
Viatel, Inc., and World Access, Inc.
. alliances between large multinational carriers that provide wholesale
carrier services
. new entrants to the domestic long distance market such as the regional bell
operating companies in the U.S., who have announced plans to enter the U.S.
interstate long distance market pursuant to recent legislation
conditionally authorizing such entry
. small long distance resellers.
Moreover, some of our competitors have announced business plans similar to
ours regarding the expansion of telecommunications networks into Europe and
Latin America. Many of our competitors are significantly larger and have
substantially greater market presence, as well as greater financial, technical,
operational, marketing and other resources and experience than the Company.
We compete for customers in the telecommunications markets primarily based on
price and, to a lesser extent, the type and quality of service offered.
Increased competition could force us to reduce our prices and profit margins if
our competitors are able to procure rates or enter into service agreements that
are comparable to or better than those we obtain, or are able to offer other
incentives to existing and potential customers. Similarly, we have no control
over the prices set by our competitors in the long distance resale carrier-to-
carrier market.
IDT Ventures
Our IDT Ventures division was formed to develop several new innovative
telecommunications and Internet-related businesses, with a focus on identifying
and exploiting niche market opportunities, specifically in markets where we can
leverage one or more of our existing strengths.
The IDT Approach
The goal of IDT Ventures is to remain on the cutting-edge of technology and
business development. The formation of venture businesses is both analytical and
visionary in nature. Our high-level executive development
17
team draws on its substantial experience in the high-technology and
telecommunications fields to identify existing yet overlooked opportunities,
while at the same time anticipating and evaluating future demand for certain new
technologies, products and services. Once a promising venture is identified, and
the project proceeds from concept to development, our development team allocates
the financial and human resources necessary to move the project through the
development stage. In order to ensure proper management focus on each potential
new business, we provide each venture with a dedicated management team, seeking
individuals whose skill-sets and experience most closely match those needed for
each particular venture.
Although these new ventures will benefit at the outset from IDT's financial
strength, which will allow us to fund these businesses in their early stages, we
will require these businesses to demonstrate their ability to become profitable
and obtain independent financing at a relatively early stage. In general, the
long-term plan for these ventures businesses, once they have reached critical
mass, is to separate them as independent financial entities, as in the case of
our former subsidiary, Net2Phone. In this way, IDT Ventures hopes to build
businesses which can eventually become stand-alone companies. Currently, the
Ventures division consists primarily of TV.TV and IDT Wireless.
TV.TV
In September 2000, we announced the formal creation of TV.TV, a new venture
designed to deliver high quality online video content, as well as television and
entertainment services to the emerging broadband market. TV.TV (also known as
"Genie" while in its development stage) will provide free television on demand
supported by targeted advertising, pay-per-view events, subscription services
and e-commerce revenues.
TV.TV is constructing its own private broadband network, to enable it to
deliver content at quality that exceeds that available through the public
Internet. TV.TV will co-locate its servers at cable head-ends and DSL
aggregation points, connecting broadband users to its network. TV.TV's platform
is neutral, as it can be accessed through cable modems, DSL, digital cable set
top boxes, or even wireless services.
TV.TV is currently developing proprietary technology for a range of advanced
security solutions, including encryption, digital fingerprinting and
watermarking that protect content against piracy and unlicensed use or
duplication. By converting film and other programming content into an encrypted,
digital format that can be streamed on the Web, the TV.TV platform offers a
secure, turnkey solution for moving entertainment properties onto the Internet,
where they can be accessed by a diverse, geographically dispersed and growing
online audience.
TV.TV is due to be operational in multiple pilot markets by the end of
calendar 2000. The service will be launched in a market-by-market rollout,
beginning with New York City, San Jose, CA and Billings, MT, to customers with a
high-speed, broadband connection to the Internet.
IDT Wireless
In response to the numerous opportunities offered by the rapidly growing
wireless industry, IDT formed its IDT Wireless division in March 2000 to develop
and offer competitively priced paging and cellular products. These products will
feature IDT's "calling-party-pays" technology, which eliminates the fees that
subscribers are currently forced to pay for incoming pages and calls in the U.S.
In June 2000, IDT launched its FREEWAY pagers, featuring the calling-party-
pays technology. With Freeway Pagers, users pay a one-time purchase price for
the pager, with no need to pay again for service. FREEWAY pagers are available
through the same extensive retail distribution network that currently sells IDT
Prepaid Calling Cards, as well as many national and regional retail chain
stores. The FREEWAY numeric pager has a suggested retail price of $49.95, while
the FREEWAY text model has a suggested retail price of $79.95. With the FREEWAY
numeric pager, the calling party is charged 35 cents for each page. The FREEWAY
text messaging pager lets a calling party send a text message of up to 120
characters for a 50 cents charge.
Also in June 2000, we announced the launch of our branded wireless program,
including prepaid wireless mobile phone service, with enhanced features, such as
Voicemail, Caller ID and Call Waiting. IDT's network services are provided on
the Sprint PCS(K) Nationwide wireless Network. Under IDT's Private Label
Services arrangement with Sprint PCS, IDT customers have access to PCS service
anywhere on the Sprint PCS Nationwide
18
Network, serving more than 300 major metropolitan areas. Customers can purchase
wireless minutes, as needed, in amounts ranging from $25 to $200. IDT's prepaid
wireless service is initially being offered in retail outlets in the New York
Metropolitan area, with distribution to be phased in nationwide.
In addition, IDT plans to license its technology to other cellular providers,
creating an additional business and source of revenue from its "calling party
pays" technology.
Brix Communications
In September 1999, IDT formed Brix Communications to provide diversified
telecommunications and Internet services to tenants of commercial buildings and
residential multifamily properties. Brix offers high speed voice and data
services, including local and long distance telephone service (dedicated and
1+), cable television service (cable and/or fiber optic), on line service with
direct Internet access and Internet access services (DSL, dedicated and dial up)
and various other Internet services. Brix's strategy involves entering into a
partnership with a property owner, under which Brix provides the building-wide
infrastructure upgrade at no cost to the landlord, in return for allowing Brix
to offer its Internet, telecommunications and video services to tenants. We are
currently exploring our options for the Brix Communications subsidiary,
including, but not limited to, the possible sale of Brix Communications to
another company.
IDT Investments
IDT Investments represents IDT's equity investments in other
telecommunications or Internet-related companies. This division seeks to
leverage our extensive industry knowledge and relationships to identify
promising investment opportunities. Because of IDT's experience in, and
knowledge of, the worldwide telecommunications and Internet industries, we
believe that we are well qualified to assess the value of the investments with
which we are frequently presented. Like our IDT Ventures unit, IDT Investment's
goal is to identify opportunities in the telecommunications and Internet fields
which can be exploited through the use of superior technology. Unlike IDT
Ventures, however, IDT Investments seeks to accomplish this goal through its
minority investments in other entities. We anticipate that our investments will
often involve companies with whom we have existing business relationships,
although the scope of our investment program will not necessarily be limited to
those entities. Our primary investments include our holdings in Net2Phone, our
former subsidiary; Terra Networks, and 2AM Inc.
Net2Phone
IDT now owns approximately 10,000,000 shares the Class A Common Stock of
Net2Phone (NASDAQ: NTOP). Originally formed by IDT in 1996, Net2Phone is the
world's leading provider of Internet telephony products and services. Net2Phone
routes millions of minutes over the Internet every month. According to
International Data Corporation, Net2Phone is the industry leader in IP (Internet
Protocol) telephony minutes routed, with nearly 40% market share.
Net2Phone offers a variety of products and services, including:
. Net2Phone: Software for PC-to-phone service, which now includes free PC-to-
PC calling, PC-to-fax service and free voice E-mail.
. Net2Phone Direct: Low cost phone-to-phone and fax-to-fax service over
Net2Phone's IP telephony network. Net2Phone also offers the Net2Phone
Direct Prepaid Calling Card, allowing users to place phone calls via the
Internet to another phone.
. Voice Enabled E-Commerce Solutions, such as Click2Talk, Click2Callme and
Click Together.
. Yap (Your Alternative Phone): Net2Phone's retail line of hardware solutions
designed to enable users to easily make Internet phone calls.
When IDT launched Net2Phone in 1996, it became the first commercial telephone
service to bridge calls between multimedia PCs and telephones via the Internet,
and to charge for this service on a per-minute basis. Upon installation of the
Net2Phone software, which is provided by Net2Phone primarily through the
Internet without
19
charge, a Net2Phone user receives an account number, and chooses a personal
identification number as an added security feature. Once the Net2Phone software
is installed, a user may place toll-free "800" or "888" calls from anywhere
in the world without incurring any charges for such calls. Upon a user's
prepayment for Net2Phone minutes, the user may begin using Net2Phone to place
telephone calls worldwide.
A user places a Net2Phone call after establishing a connection to the
Internet. The call is routed over the Internet, at no charge to the customer, to
our telecommunications switches in the U.S. The call is then routed in the same
manner as other voice telephony calls, using our least-cost routing platform in
order to increase the savings realized by international callers. Net2Phone's
voice quality has been enhanced through the use of technology licensed from
Lucent Technologies, Inc., and the software relating to Net2Phone is available
in seven different languages. For calls originating overseas, the cost of
placing and terminating the call with Net2Phone is substantially below the rates
generally charged by traditional foreign carriers to place and terminate
standard international telephone calls.
In September 2000, Net2Phone announced the formation of a new company, Adir
Technologies, designed to develop and market network management software for
Voice over IP (VoIP) and other packet-based multimedia networks. Net2Phone also
announced that Cisco Systems (NASDAQ: CSCO) has purchased a minority equity
interest in Adir Technologies. Cisco will jointly market Adir's network
management platform to its VoIP customers. IDT has invested $7.0 million in Adir
Technologies, in return for a minority equity interest.
In August 1999, Net2Phone completed an initial public offering of 6,210,000
shares of its Common Stock. Prior to the Initial Public Offering, Net2Phone was
a 90%-owned direct subsidiary of IDT. After the Initial Public Offering, IDT
owned 56.2% of the capital stock of Net2Phone. IDT owns Class A stock that has
twice the voting power of Net2Phone's common stock. Therefore, after the Initial
Public Offering, we controlled 64.0% of Net2Phone's vote.
In connection with Net2Phone's Initial Public offering, we entered into
several agreements with Net2Phone, including an assignment agreement, a
separation agreement, an IDT services agreement, a Net2Phone services agreement,
a tax sharing and indemnification agreement, a joint marketing agreement and an
Internet/telecommunications agreement.
In December 1999, Net2Phone sold an additional 6,300,000 shares of common
stock (the "Secondary Offering"). Of the 6,300,000 shares sold in the
Secondary Offering, 2,200,000 shares were sold by IDT. After the Secondary
Offering, we had a 48.3% ownership interest and a 57.3% voting interest in
Net2Phone.
In August 2000, we sold 14,900,000 of our Net2Phone shares to AT&T Corp., for
a purchase price of $75.00 per share, for total cash consideration of
approximately $1.1 billion. In addition, AT&T purchased an additional 4,000,000
newly-issued Net2Phone shares, also at a price of $75.00 per share, paying
proceeds of approximately $300 million to Net2Phone. After completing these
transactions, AT&T held 31.8% of Net2Phone's outstanding stock, and a 38.8%
voting interest. IDT held 16.8% of Net2Phone's outstanding stock, and a 20.5%
voting interest.
Terra Networks
As of October 30, 2000, IDT owned 2,070,000 shares of Terra Networks, the
Internet subsidiary of Telefonica, S.A. of Spain. Terra provides Internet access
and local language interactive content and services to the Spanish and
Portuguese-speaking world, including the Hispanic communities in the United
States.
In October 1999, IDT entered into a joint venture agreement with Terra
Networks pursuant to which the parties formed two limited liability companies to
provide Internet services and products for customers in the United States,
mainly targeting and focusing on the Hispanic population in the United States.
One company, Terra Networks Access Services, was formed to provide Internet
access to customers in the target market, while the other company, Terra
Networks Interactive Services, was formed to develop and manage an Internet
portal that will provide content-based Internet services, electronic commerce
offerings and other Internet services to customers in the target market. At the
time of the agreement, IDT owned 49% of Terra Networks Access Services and 10%
of Terra Networks Interactive Services. In addition, IDT participated in Terra
Networks' U.S. initial public offering (IPO) in November, 1999, purchasing
1,156,682 Terra Networks shares for approximately $15.5 million.
20
In May 2000, IDT announced that it was exchanging its ownership interests in
Terra Networks Access Services and Terra Networks Interactive Services for
3,750,000 additional Terra shares. Upon the completion of the transaction, Terra
Networks held 100% ownership of both Terra Networks Access Services and Terra
Networks Interactive Services. IDT was also released from the "lock-up"
provision restricting it from disposing of its Terra Networks shares. Under the
terms of the new agreement, IDT was granted authorization to dispose of its
Terra stock, at a maximum rate of 75,000 Terra shares per day, not to exceed
500,000 per month. Through October 1, 2000, we have sold 2,836,682 Terra shares,
generating proceeds of approximately $111.6 million.
2AM Inc.
IDT holds a 25% equity interest in privately-held 2AM, Inc. 2AM has three core
business divisions: 2AM Game Club, TVAD2NET and 2AM Development Ltd. 2AM Game
Club has created an international Internet community competing in multi-player
games with accompanying chat. These games, each of which can involve a large
number of players, permit 2AM to display advertising banners, for which it
receives revenue. TVAD2NET has developed software that permits, in a process
that does not disturb the user, full motion video advertisements to be slowly
sent over a low bandwidth connection onto a computer's hard drive. Because this
technology does not slow down the applications running on the computer, the user
experiences the advertisements as only a 15 to 30 second video commercial
interruption. 2AM Development Ltd. is developing various technologies, including
technology that allows individuals to be linked as they surf the Internet
together.
Regulatory Environment
Deregulation in the U.S. and International Telecommunications Markets
Deregulation accelerated in the U.S. in 1984 with the divestiture by American
Telephone & Telegraph, Inc. ("AT&T") of the regional bell operating companies.
This gave rise to an influx of competitive telecommunications companies. Today,
there are over 500 U.S. long distance companies. Deregulation in the U.K. began
in 1981, when Mercury, a subsidiary of Cable & Wireless plc, was granted a
license to operate a facilities-based network and compete with British
Telecommunications plc ("BT"). Deregulation spread to other European countries
with the adoption of the "Directive on Competition in the Markets for
Telecommunication Services" in 1990. A series of subsequent European Union
directives, reports and actions have resulted in significant but not complete
deregulation of the telecommunications industries in most European Union member
states. Further deregulation of the European Union telecommunications market is
scheduled to occur in 2000 upon the implementation of the European Union's
"Amending Directive to the Interconnection Directive," which mandates the
introduction of equal access and carrier pre-selection by 2000. See
"Regulation--European Regulation of Telecommunications Services." A similar
movement toward deregulation has already taken place in Australia and New
Zealand, and is also taking place in Japan, Mexico, Hong Kong and other markets.
Other governments have begun to allow competition for value-added and other
selected telecommunications services and features, including data and facsimile
services and certain restricted voice services. Deregulation and privatization
have also allowed new long distance providers to emerge in other foreign
markets. In many countries, however, the rate of change and emergence of
competition remain slow, and the timing and extent of future deregulation is
uncertain.
Deregulation has encouraged competition, which in turn has prompted carriers
to offer a wider selection of products and services at lower prices. We believe
that the lower prices for telecommunications services that have resulted from
increased competition have been more than offset by decreases in the costs of
providing such services and increases in telecommunications usage. For example,
based on FCC data for the period 1989 through 1995, per-minute settlement
payments by U.S.-based carriers to foreign PTTs fell 31.4%, from $0.70 per
minute to $0.48 per minute. Over this same period, however, per-minute
international billed revenues fell only 13.7%, from $1.02 in 1989 to $0.88 in
1995. We believe that as settlement rates and capacity costs continue to
decline, international long distance will continue to provide opportunities to
generate relatively high revenues and per-minute gross profits.
21
Government Regulation of the Telecommunications Industry
Telecommunications
As a multinational telecommunications company, the Company is subject to
varying degrees of regulation in each of the jurisdictions in which it operates.
As a non-dominant carrier lacking substantial power to influence market prices
in the U.S., the Company's provision of international and domestic long distance
telecommunications services in the U.S. is generally subject to less regulation
than a carrier that has such power. Despite recent trends toward deregulation,
some of the countries in which the Company intends to provide telecommunications
services do not currently permit the Company to provide public switched voice
telecommunications services. In those countries in which the Company operates
that are not yet open to public switched voice service competition, the Company
provides services to closed user groups and a variety of value-added services,
as permitted by each country's laws.
In February 1997, the United States and 68 other countries signed the World
Trade Organization Agreement on Basic Telecommunications Services ("WTO
Agreement") to facilitate competition in basic telecommunications services.
Pursuant to the WTO Agreement, signatories committed to varying degrees and
within varying time frames to provide competitive telecommunications providers
access to their domestic and international markets, reduce or eliminate foreign
ownership restrictions, and establish regulatory regimes that foster
telecommunications competition. The WTO Agreement became effective on February
5, 1998. Although the Company believes that the WTO Agreement could provide us
with significant opportunities to compete in markets that were not previously
accessible, it could also provide opportunities for our competitors. There can
be no assurance that the pro-competitive effects of the WTO Agreement will not
have a material adverse effect on the Company's business, financial condition,
and results of operation or that members of the WTO will implement the terms of
the WTO Agreement.
Regulation of U.S. Domestic Telecommunications Services. In the U.S.,
provision of the Company's services is subject to the provisions of the
Communications Act of 1934, as amended by the Telecommunications Act of 1996
(the "Act"), regulations promulgated thereunder, as well as the applicable
laws and regulations of the various states administered by the relevant state
authorities. The recent trend in the U.S., for both federal and state regulation
of telecommunications service providers, has been in the direction of reducing
regulation. Nonetheless, the FCC and relevant state authorities continue to
regulate ownership of transmission facilities, provision of services and the
terms and conditions under which the Company's services are provided. Non-
dominant carriers, such as the Company, are required by federal and state law
and regulations to file tariffs listing the rates, terms and conditions for the
services they provide. In October 1996, the FCC adopted an order (the
"Detariffing Order") which eliminated the requirement that non-dominant
interstate carriers such as the Company maintain tariffs on file with the FCC
for domestic interstate services. The Detariffing Order was upheld on appeal by
the U.S. Court of Appeals for the D.C. Circuit and will require the Company to
withdraw its FCC interstate interexchange service tariff by January 31, 2001.
After that time, the Company will be required to maintain its services and rates
on the Company's website. The detariffing of services poses additional risk for
the Company because it will no longer have the benefit of the "filed rate
doctrine" which enables the Company to bind its customers to the terms and
conditions of the tariff without having each customer sign a written contract
and enables the Company to change rates and services on one day's notice. The
Company may be subjected to increased risk of claims from customers involving
terms of service and rates that could impact the Company's financial operations.
On May 8, 1997, the FCC issued an order to implement the provisions of the Act
relating to the preservation and advancement of universal telephone service (the
"Universal Service Order"). The Universal Service Order requires all
telecommunications carriers providing interstate telecommunications services to
contribute to universal support by contributing to (i) a fund for schools and
libraries, (ii) a fund for rural health care and (iii) a fund for the
development of regions characterized by high telecommunications costs and low
income levels (collectively, the "Universal Service Funds"). These
contributions became due beginning in 1998 for all providers of interstate
telecommunications services. Such contributions are assessed based on certain
defined interstate and international end user telecommunications revenues.
Contribution factors vary quarterly, and carriers, including the Company, are
billed each month. In addition, many state regulatory agencies have instituted
proceedings to revise state universal support mechanisms to make them consistent
with the requirements of the Act. As a result, the Company will be subject to
state, as well as federal, universal service fund contribution requirements,
which will vary from state to state.
22
In July 1999, the United States Court of Appeals for the Fifth Circuit
released its decision reviewing the FCC's Universal Service Order. This decision
will have a significant impact on carrier's obligations to make payments to the
FCC's Universal Service Funds. The Court found that the FCC cannot include
intrastate revenues in the calculation of universal service contributions. Local
exchange carriers' revenues are largely intrastate and their interstate revenues
are primarily from other carriers and not subject to universal service
assessment. Therefore, the contributions required to be made by these carriers
will be sharply reduced, placing an even greater burden on interexchange
carriers, including the Company, to fund the universal service program. The
Court also reversed the FCC's decision to include the international revenues of
interstate carriers in the universal service contribution base.
In implementing the Court's decision, the FCC has amended its universal
service fund rules and removed intrastate-end user telecommunications revenues
from the assessment base for the schools and libraries and rural health care
support mechanisms. The FCC will assess contributions to the universal service
program using a single contribution factor based on interstate and international
end-user telecommunications revenues. The proposed contribution factor for the
fourth quarter of 2000 is 5.6688% of interstate and international end-user
telecommunications revenues. This increase in the universal service contribution
factor may significantly increase the Company's contribution to the FCC's
Universal Service Fund.
Pursuant to the Universal Service Order, all carriers are required to submit a
Universal Service Fund worksheet in March and September of each year. In
addition, carriers are required to annually file a single telecommunications
reporting worksheet for the FCC's Universal Service Fund, Telecommunications
Relay Services, Local Number Portability, and North American Numbering Plan
programs. The amounts remitted to the Universal Service Fund may be billed to
the Company's customers. If the Company does not bill these amounts to its
customers, its profit margins may be less than if it had elected to do so.
However, if the Company elects to bill these amounts to its customers, customers
may reduce their use of the Company's services, or elect to use the services
provided by the Company's competitors, which may have a material adverse effect
upon the Company's business, financial condition, or results of operations.
The FCC has approved Verizon's (formerly Bell Atlantic-New York) Section 271
application for authority to provide interLATA interexchange service to
customers in New York and Southwestern Bell Telephone Company's ("SWBT")
Section 271 application to provide interLATA interexchange service to customers
in Texas. Because the FCC has approved these Section 271 applications,
interexchange carriers, such as the Company, will be subjected to increased
competition from these companies in the New York and Texas markets for
interexchange services. As a result, the Company may face increased pressure to
reduce its rates for interexchange services which may have an adverse impact on
the Company's revenues. Verizon recently filed a Section 271 application to
provide interLATA interexchange services in Massachusetts and Verizon, SWBT, US
West, and Bell South have announced that they intend to file Section 271
applications in additional states, which if granted, would further increase
competition in the provision of interexchange services and result in downward
price pressures for such services in these states.
The Company's costs of providing long distance services will be affected by
changes in access charge rates imposed by regional bell operating companies on
long distance carriers for origination and termination of calls over the local
facilities. The FCC has made major changes in the interstate access charge
structure. On May 31, 2000, the FCC issued an Order adopting the access charge
reform measures based on a proposal from an industry coalition referred to as
CALLS that included some major interexchange carriers, most regional bell
operating companies, and GTE. This proposal lowers collective interstate access
charges by local exchange carriers subject to price cap regulation by $3.2
billion and ends certain charges paid by interexchange carriers. As part of the
proposal, AT&T and Sprint agreed to pass through access charge savings to
customers. The FCC Order is currently the subject of motions for reconsideration
as well as an appeal to the D.C. Circuit Court of Appeals. If upheld, access
charges will decrease for interexchange carriers and Company may face increased
competition to lower its prices for long distance services.
In addition to regulation by the FCC, the majority of the states require the
Company to register or apply for certification prior to initiating intrastate
interexchange telecommunications services. To date, the Company, together with
its subsidiaries, is authorized through certification, registration or on a
deregulated basis to provide intrastate interexchange telecommunications
services in 48 states. State issued certificates of authority to provide
intrastate interexchange telecommunications services can generally be
conditioned, modified, canceled, terminated or revoked by state regulatory
authorities for failure to comply with state law and/or the rules, regulations
and policies of the state regulatory authorities. Fines and other penalties also
may be imposed for such violations.
23
U.S. Regulation of International Telecommunications Services. In the United
States, to the extent that the Company offers services as a carrier, the Company
is required to obtain authority under Section 214 of the Act, in order to
provide international telecommunications service that originates or terminates
in the United States. U.S. international carriers also are required to file and
maintain international tariffs with the FCC specifying the rates, terms and
conditions of their services. The Company has obtained the required Section 214
authorization from the FCC to provide U.S. international service and has filed
an international tariff. In addition, as a condition of the Company's Section
214 authorization, the Company is subject to various reporting and filing
requirements. However, the FCC recently issued a Notice of Proposed Rulemaking
proposing to detariff international services and to further streamline contract
filing requirements. Failure to comply with the FCC's rules could result in
fines, penalties, forfeitures or revocation of the Company's FCC authorization,
each of which could have a material adverse effect on our business, financial
condition, and results of operation.
The Company must conduct its U.S. international business in compliance with
the FCC's International Settlements Policy, the rules that establish the
parameters by which U.S.-based carriers and their foreign correspondents settle
the cost of terminating each other's traffic over their respective networks.
Under the FCC's International Settlements Policy, absent approval from the FCC,
international telecommunications service agreements with dominant foreign
carriers must be non-discriminatory, provide for settlement rates equal to one-
half of the accounting rate, and require proportionate share of return traffic.
In recent rule reforms, the FCC expressly exempted from the International
Settlements Policy rules, U.S. carrier arrangements with non-dominant foreign
carriers as well as arrangements with any foreign carrier (dominant or non-
dominant) on certain competitive routes where at least 50% of U.S.-billed
traffic is terminated at settlement rates at least 25% below the FCC's
applicable benchmark settlement rates. These routes currently include: Canada,
Denmark, France, Germany, Hong Kong, Ireland, Italy, the Netherlands, Norway,
Sweden and the United Kingdom. For arrangements that will continue to be subject
to the International Settlements Policy, the FCC imposes mandatory settlement
rate benchmarks. These benchmarks are intended to reduce the rates that U.S.
carriers pay foreign carriers to terminate traffic in their home countries. The
FCC also prohibits a U.S. carrier affiliated with a foreign carrier from
providing facilities-based switched or private line services to the foreign
carrier's home market unless and until the foreign carrier has implemented a
settlement rate at or below the relevant benchmark. Certain confidential filing
requirements still apply to dominant carrier arrangements.
The FCC's new rules declined to expand the scope of the International Simple
Resale ("ISR") policy, which permits U.S. carriers to provide international
switched services over private lines interconnected to the public switched
telecommunications network on the current FCC-authorized routes. The FCC will
continue to maintain the distinction between routes it approves for ISR and
routes on which it removes the International Settlements Policy. Even though the
FCC dramatically scaled back the application of the International Settlements
Policy, the FCC's ISR policy still requires FCC approval to provide ISR services
in an arrangement with a foreign dominant carrier on non-competitive routes.
To the extent that the International Settlements Policy still applies, the FCC
could find that the Company does not meet certain International Settlements
Policy requirements with respect to certain of our foreign carrier agreements.
Although the FCC generally has not issued penalties in this area, it has issued
a Notice of Apparent Liability to a U.S. company for violations of the
International Settlements Policy and it could, among other things, issue a cease
and desist order, impose fines or allow the collection of damages if it finds
that we are not in compliance with the International Settlements Policy. Any of
these events could have a material adverse effect on the Company's business,
financial condition, or results of operation.
The Company offers its callback services pursuant to its Section 214
Authorization. The FCC has determined that callback services that use
uncompleted call signaling do not violate U.S. or international law, but that
U.S. companies providing such services must comply with the laws of the
countries in which they operate as a condition of such companies' Section 214
Authorizations. The FCC reserves the right to condition, modify or revoke any
Section 214 Authorizations and impose fines for violations of the Act or the
FCC's regulations, rules or policies promulgated thereunder, or for violations
of the clear and explicit telecommunications laws of other countries that are
unable to enforce their laws against callback services using uncompleted call
signaling. FCC policy provides that foreign governments that satisfy certain
conditions may request FCC assistance in enforcing their laws against callback
providers based in the U.S. that are violating the laws of these jurisdictions.
Thirty countries have formally notified the FCC that callback services violate
their laws. The FCC has held that it would consider enforcement
24
action against companies based in the U.S. engaged in callback services by means
of uncompleted call signaling in countries where this activity is expressly
prohibited. In fact, the FCC granted a complaint by the Philippines Long
Distance Telephone Company and required U.S. carriers to stop providing callback
services to customers in the Philippines. A petition filed by the
Telecommunications Resellers Association in 1998 requesting that the FCC cease
enforcing foreign laws against callback services is still pending. There can be
no assurance that the FCC will not take further action in the future.
Enforcement action could include an order to cease providing callback services
in such country, the imposition of one or more restrictions on the Company,
monetary fines or, in extreme circumstances, the revocation of the Company's
Section 214 Authorization, and could have a material adverse effect on the
Company's business, financial condition and results of operations.
To date, the FCC has made no pronouncement as to whether refiling arrangements
are inconsistent with the regulations of the U.S. or the International
Telecommunication Union (the "ITU"), and a 1995 petition to the FCC for
declaratory ruling regarding Sprint's Fonaccess service was withdrawn. Although
it is possible that the FCC will determine that refiling violates U.S. and/or
international law and that such a finding could have a material adverse effect
on the Company's business, operating results and financial condition, the FCC is
not currently considering such issues in any active proceeding.
Regulatory requirements pertinent to the Company's operations will continue to
evolve as a result of the WTO Agreement, federal legislation, court decisions,
and new and revised policies of the FCC. In particular, the FCC continues to
refine its international service rules to promote competition, reflect and
encourage liberalization in foreign countries and reduce international
accounting rates toward cost.
European Regulation of Telecommunications Services. In Europe, the regulation
of the telecommunications industry is governed at a supranational level by the
European Union and to a large extent by the national law of the individual
European Union Member States. The European Union's institutions, such as the
European Commission, are responsible for creating pan-European policies. Through
its legislation, the European Union has developed a regulatory framework aimed
at creating an open, competitive telecommunications market. The European Union
was established by the Treaty of Rome and subsequent conventions and the
European Commission and the Council of Ministers of the European Union are
authorized by such treaties to issue European Union "directives." European
Union Member States are required to implement these directives through national
legislation. If a Member State fails to adopt such directives, the European
Commission may take action, including referral to the European Court of Justice,
to enforce the directives. In practice, Member States have sig