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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Year Ended December 31, 1998
Commission File No. 0-26728
TEL-SAVE.COM, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 23-2827736
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
6805 ROUTE 202
NEW HOPE, PENNSYLVANIA 18938
(215) 862-1500
(Address, including zip code, and telephone
number, including area code, of registrant's
principal executive offices)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
Title of each class: Name of each exchange on which registered:
None Not applicable
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, PAR VALUE $.01 PER SHARE
Indicate by check mark whether the Registrant (1) has filed all documents and
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 the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment of this Form 10-K. [X]
The aggregate market value of voting stock held by non-affiliates of the
registrant as of March 26, 1999 was approximately $556,725,623 based on the
average of the high and low prices of the Common Stock on March 26, 1999 of
$10.1875 per share as reported on the Nasdaq National Market.
As of March 26, 1999, the Registrant had issued and outstanding 60,100,182
shares of its Common Stock, par value $.01 per share.
2
TEL-SAVE.COM, INC.
INDEX TO FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 1998
PART I
1. BUSINESS.....................................................................................................
2. PROPERTIES...................................................................................................
3. LEGAL PROCEEDINGS............................................................................................
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS..........................................................
PART II
5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS......................................................................................................
6. SELECTED CONSOLIDATED FINANCIAL DATA.........................................................................
7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS....................................................................................
8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA..................................................................
9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS AND FINANCIAL
RELATED TRANSACTIONS.........................................................................................
PART III
10. DIRECTORS AND EXECUTIVE OFICERS OF THE REGISTRANT............................................................
11. EXECUTIVE COMPENSATION.......................................................................................
12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT...............................................
13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS...............................................................
PART IV
14. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS...............................................................
3
PART I
ITEM 1. BUSINESS
OVERVIEW
Tel-Save.com, Inc. (together with its subsidiaries, the "Company" or
"Tel-Save.com") provides telecommunications services to business and residential
customers throughout the United States, primarily through its e-commerce
platform. The Company believes that it currently has the largest share of the
e-commerce market for long distance telephone services. The Company's e-commerce
platform is built around the Company's advanced online and web-enabled customer
care, billing and information systems. The Company has announced that it will
seek in the future to utilize its e-commerce business platform to market and
sell new products and services, including the sale of advertising.
The Company's telecommunication service offerings include long distance
outbound service, inbound toll-free service and dedicated private line services
for data. The Company markets its telecommunications services through its
exclusive telecommunications marketing agreement with AOL and on the internet
through its web site located at www.tel-save.com. The Company also sells its
services on a wholesale basis.
Tel-Save.com operates a network that carries a majority of its
customers' calls. The Company's network includes Company-owned Lucent 5ESS-2000
switches located in selected areas throughout the United States. These switches
are widely considered among the highest quality and most reliable
telecommunications switches available in the market today. The network is
further supported by agreements with major interexchange carriers that provide
interconnections among the Company's switches and local carriers' switches,
origination and termination of calls, overflow capacity, international long
distance services and other services that the Company provides to its customers.
The Company has also developed and integrated into its network sophisticated
information and billing systems that allow the Company to manage its network
efficiently and to provide its customers with high quality customer care and
billing systems.
In early 1997, the Company acquired from AOL rights to market and sell
the Company's telecommunications services to AOL subscribers. The agreement with
AOL has become an important part of the Company's current business strategy. A
majority of the Company's customers come from AOL's rapidly growing subscriber
base. As a result of the AOL agreement, the Company believes that it has one of
the largest bases of online customers making repetitive purchases of products or
services through online billing and automatic credit card payments.
Under the AOL marketing agreement, the Company maintains sites on the
AOL online network to provide for customer sign-up and to provide customers and
potential customers with information about the Company's products and services
as well as billing information and customer service. The Company provides these
services and features using the Company's web-enabled technologies that allow
the Company to offer e-commerce customers:
o Detailed rate schedules and product and service related information.
o Fast and easy online sign-up for the Company's telecommunications
services.
o Credit card billing, avoiding costly and cumbersome paper billing.
o Real-time billing services and online information, providing customers
with up-to-date billing information 24 hours a day, 7 days a week.
Since the beginning of its relationship with AOL, the Company has
negotiated a number of amendments to its agreements with AOL based on the
experience gained by the Company in the marketing and sale of services to AOL
subscribers. Substantial amendments negotiated with AOL during the fourth
quarter of 1998 were completed on January 5, 1999. These amendments accomplished
the following changes to the Company's relationship with AOL:
o Eliminated the Company's obligation to make profit-sharing and bounty
payments to AOL and introduced fixed quarterly payments during the
exclusivity period of the agreement.
o Altered the terms of the online and offline marketing arrangements
between the Company and AOL. The Company maintains valuable marketing
rights which continue under the agreement through June 2003.
o Extended the term of the AOL agreement, including the long distance and
wireless exclusivity periods, up until June 2003 while eliminating any
exclusive rights for marketing local telecommunications services,
subject to payment of certain amounts to the Company. AOL can allow
others to market long distance telephone and wireless services to the
AOL membership after June 2000 by foregoing the fixed quarterly
payments described above.
o Eliminated AOL's rights to receive further common stock warrants. AOL
reported beneficial ownership (including the warrants) of approximately
11% of the Company's Outstanding common stock.
o Established the rights of the Company to offer additional services and
products to AOL subscribers.
5
In connection with the amendments to the AOL agreements, AOL made a
significant equity investment in Tel-Save.com, acquiring 4,121,372 shares of
common stock for $55 million in cash and the surrender of rights to acquire up
to 5,076,016 shares of common stock pursuant to various warrants held by AOL.
AOL retained existing warrants to acquire up to an additional 2,721,984 shares
of the Company's common stock. For a discussion of certain rights of AOL to
require the Company to reimburse AOL for certain losses on the sale of shares by
AOL, see "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Liquidity and Capital Resources".
Tel-Save, Inc., the Company's predecessor and now its principal
operating subsidiary, was incorporated in Pennsylvania in May 1989. The Company
was incorporated in June 1995. The address of the Company's principal current
executive offices is 6805 Route 202, New Hope, Pennsylvania 18938, and its
telephone number is (215) 862-1500. The Company's web site is located at
www.tel-save.com. The Company recently entered into a lease for a 3,700 square
foot facility in Reston, Virginia, which will serve as the Company's future
headquarters for the majority of its executive officers and marketing personnel.
Unless the context otherwise requires, references to the "Company" or to
"Tel-Save.com" refer to Tel-Save.com, Inc. and its subsidiaries.
SALES AND MARKETING
The Company conducts its sales and marketing efforts both online,
through AOL and the Company's own web site located at www.tel-save.com, as well
as through traditional channels, such as direct mail, telemarketing and
independent resellers or partition arrangements.
In 1998, the Company's sales and marketing efforts focused almost
exclusively on recruiting AOL subscribers as customers of its telecommunications
services and establishing a substantial base of online customers. The Company's
marketing efforts were carried out through online marketing initiatives over the
AOL network and through a variety of direct marketing programs targeting AOL
subscribers. For those AOL customers that have not subscribed to the Company's
services online, the Company has a program with AOL for the referral of AOL
customers by AOL directly to the Company's telephone service centers. During
1998, the Company invested substantial sums to establish quickly its subscriber
base of AOL customers as part of the Company's e-commerce strategy.
The Company's own web site is located at www.tel-save.com and is the
platform for marketing the Company's telecommunications services and for
enabling customers to sign up for the Company's services through the internet.
With the development of the Company's advanced sign up and billing
systems, customers can purchase the Company's telecommunications services while
online on AOL's network or through the Company's own web site. The Company
employs its own proprietary billing systems to enable online billing and credit
card payment, eliminating the need for costly paper billing. The Company's
billing system enables a customer to view his or her bill online or over the
internet on a real-time basis with the call detail and cost for most calls
posted within minutes after a customer completes a call. The Company believes
that its online billing systems provide it with a competitive advantage in the
online market for telecommunications services.
6
The Company's rights to market long distance and wireless
telecommunications services on AOL on an exclusive basis expire on June 30,
2003. AOL may elect after June 30, 2000 to allow others to market long distance
and wireless telecommunications services over the AOL network if AOL elects to
forego annual payments from the Company under the agreement (at least $60
million in the 12 months ending June 30, 2001). Absent a termination of the AOL
agreement upon a breach of the agreement, the Company is entitled to continue
marketing its products and services on the AOL network through June 2003. The
minimum marketing rights available to the Company under the AOL agreement
throughout the term of the agreement until June 2003 include varying ranges of
the following rights and benefits:
o Regular, monthly and daily AOL welcome screen advertisements, pop-up
advertisements and other on-screen promotions and advertisements.
o Telemarketing and direct mail to advertise the Company's products to
AOL subscribers, other than subscribers who have elected not to receive
telemarketing calls or other promotional materials through AOL.
o A program for promoting the Company's products to specified percentages
of AOL subscribers who call AOL's customer inquiry centers.
o Specified relationship marketing rights, which extend beyond 2003 .
o The right (either exclusive or non-exclusive) to market and sell
wireless, long distance and other products and services over the AOL
online network.
Because of significant marketing rights that continue even after a
termination of the exclusivity period under the AOL agreement, the Company is
unable to determine at this date whether the early termination of the
exclusivity period and the release of the Company's obligation to make the fixed
payments to AOL will be beneficial or detrimental to the Company's business. The
Company believes that the exclusivity feature of the AOL agreement has given the
Company a valuable lead in marketing telecommunications services to AOL
subscribers. However, the Company is unable to predict: (1) whether potential
competitors of the Company will be willing to pay the substantial sums that the
Company believes would be required to compensate AOL for foregoing the fixed
payments to be paid by the Company during the long distance exclusivity period;
or (2) whether potential competitors would be required, or otherwise be willing,
to invest the substantial sums that the Company believes would be required to
acquire a base of AOL customers for telecommunications services comparable to
the Company's existing base of AOL subscribers.
Tel-Save.com also provides, as a declining portion of its business,
telecommunications services to small and medium-sized businesses through
independent resellers. Although the Company still serves many customers in this
manner, such partitions no longer comprise a majority of the Company's business
as they once did.
THE COMPANY'S NETWORK
To provide its telecommunications services to customers, the Company
predominantly uses its telecommunications network, One Better Net ("OBN"). The
Company generally uses OBN to provide services directly to its end users and
partitions. As of December 31, 1998, the Company provisioned more than 80% of
the lines using its services over OBN.
Controlling its own network provides the Company with advantages
compared to when the Company operated strictly as a reseller of the
telecommunications services of other carriers. With the deployment of OBN, the
Company has lowered its costs of providing long distance services to its
customers and has established greater control over those costs. This control
allows the Company to manage its growth as a telecommunications service provider
and to target its marketing efforts according to the overhead costs of
delivering its services.
Structure of the Network
The Company's network is comprised of equipment that is either owned or
leased by the Company and contracts for certain telecommunications services that
the Company maintains with a variety of other carriers. The Company owns,
operates and maintains five Lucent 5ESS-2000 switches in its network. These
switches are generally considered the most reliable in the telecommunications
industry and feature the Digital Networking Unit--SONET technology. The Digital
Networking Unit is a switching interface that is designed to increase the
reliability of the 5ESS-2000 and to provide much greater capacity in a
significantly smaller footprint.
The switches are connected to each other by connection lines and
digital cross-connect equipment that the Company leases. See "Service Agreements
with Other Carriers." The Company also has installed lines to connect its OBN
switches to switches owned by various local telecommunications service carriers.
The Company is responsible for maintaining these lines and has entered into a
contract with GTE with respect to the monitoring, servicing and maintenance of
this equipment.
7
The access charges that the Company pays to connect its switches to a
local carrier's switch represent a substantial portion of the total cost of
providing long distance services over OBN. As a result of the Telecommunications
Act of 1996 and the ongoing regulatory and judicial interpretations thereunder,
it is generally expected that the entry over time of competitors into the local
service market will result in the lowering of access fees, but there is no
assurance that this will occur. To the extent it does occur, the Company will
receive the benefit of any future reduction in such access fees for calls
serviced over OBN. See "Regulation" for a discussion of universal service
contributions imposed on carriers, which may offset some or all of the savings
from lower access charges.
In addition, the Company maintains contracts with other carriers that
provide it with a variety of other services. See "Service Agreements with Other
Carriers." These contracts include services for assisting with the overflow of
telecommunications traffic over OBN, for carrying calls internationally and for
providing directory assistance and other operator assisted calls. The
combination of these contracts permits the Company to obtain a particular type
of service from more than one carrier at a given time and gives the Company the
flexibility to seek the best rates available for a particular service at a given
time.
The fact that the Company operates its own switches subjects the
Company to risk of significant interruption. Fires or natural disasters, for
example, could cause damage to the Company's switching equipment or to
transmission facilities connecting its switches. Any interruption in the
Company's services over OBN caused by such damage could have a material adverse
impact on the Company's financial condition and results of operations. In such
circumstances, the Company could attempt to minimize the interruption of its
service by carrying traffic through its overflow and resale arrangements with
other carriers.
The Company has continued to expand the capacity of OBN to meet its
increased demand and believes that such capacity may be further expanded at
reasonable cost to meet the Company's needs in the foreseeable future, including
expansion resulting from the Company's relationship with AOL and the launch of
its own web site.
Service Agreements with Other Carriers
The Company historically obtained services from AT&T through multiple contract
tariffs. With the deployment of OBN, the Company requires fewer such services
from that carrier to sell its services. Instead of relying on exclusively on
AT&T, the Company has entered into and is currently negotiating contracts with
various long distance and local carriers of telecommunications services (of
which one contract is with AT&T) for both its OBN and reselling operations.
These services enable the Company to:
o Connect the Company's OBN switches to each other
8
o Connect the Company's switches to the switches of local
telecommunications service carriers
o Carry overflow traffic during peak call times
o Connect international calls
o Provide directory assistance and other operator assisted services
With respect to connections to local carriers, overflow, international
and operator assisted services, the Company maintains contracts with more than
one carrier for each of these services. The Company believes that it is no
longer dependent upon any single carrier for these services. Currently, many
price differences exist in the market for purchasing these services in bulk. For
example, one carrier may offer the lowest international rates to one country
while another offers the lowest rates to a different country. Under the terms of
the Company's contracts with its various carriers, the Company is able to choose
which services and in what volume (with some minimum commitments) the Company
wishes to obtain the services from each carrier. This flexibility enables the
Company to minimize its costs for such services by purchasing those services
that offer the Company the best rates at a given time.
In February 1999, the Company terminated its old Master Carrier
Agreement and its IRU Agreements with AT&T and entered into a new Master Carrier
Agreement with AT&T. The agreement provides the Company with a variety of
services, including transmission facilities to connect the OBN switches as well
as services for international calls, overflow traffic and operator assisted
calls. The new contract eliminated a requirement for the Company to purchase the
majority of its requirements for these services from AT&T and replaced it with a
requirement for the Company to purchase minimum dollar amounts of services from
AT&T during the term of the agreement. The Company does not anticipate any
difficulty in satisfying these minimum requirements.
Information and Billing Services
In connection with its online billing area under the AOL agreement, the
Company developed advanced online billing and information systems in connection
with its online initiative with AOL. In March 1999, the Company began providing
its non-AOL customers with online access to billing information through its
website (www.tel-save.com) which enables customers to view their billing
information and call detail within minutes of completing a call. The Company
believes this online service provides the most current billing information to
customers offered by any telecommunications company. The Company also acquires
billing and customer care services from other carriers and third party
intermediaries.
The Company provides to each partition computerized management systems
that control order processing, accounts receivable, billing and status
information in a streamlined fashion. Furthermore, when applicable, the systems
interface with third party billing systems for order processing and billing
services. Enhancements and additional features are provided as needed.
9
The information functions of the system are designed to provide easy
access to all information about an end user, including volume and patterns of
use, which will help the Company and partitions identify other valuable services
that might be well suited for that end user. The Company also expects to use
such information to identify emerging end user trends and respond with services
to meet end users' changing needs. Such information also allows the Company and
its partitions to identify unusual or declining use by an individual end user,
which may indicate fraud or that an end user is switching its service to a
competitor. Recently released FCC rules, however, may limit the Company's use of
such customer proprietary network information. See "Regulation."
10
COMPETITION
Competition is intense in the long distance industry, even as the
market continues to expand. Based on published FCC estimates, toll service
revenues of U.S. long distance carriers have grown from $38.8 billion in 1984 to
$88.6 billion in 1997. Although the Company believes that it has the human and
technical resources to compete effectively, the Company's success will depend
upon its continued ability to provide profitably high quality, high value
services at prices generally competitive with, or lower than, those of its
competitors.
The Company has numerous competitors, many of which are substantially
larger and have greater financial, technical and marketing resources than the
Company. Three large carriers, AT&T, MCI WorldCom and Sprint, generate
approximately 80% of aggregate revenue in the U.S. long distance industry.
Approximately 140 other carriers account for the remainder of the long distance
market. The aggregate market share (based on operating revenues) of all long
distance carriers other than AT&T, MCI WorldCom and Sprint has grown from 2.6%
in 1984 to 19.8% in 1997. During the same period, the market share of AT&T
declined from 90.1% to 44.5%.
The long distance market is subject to pricing pressure. The major
carriers have targeted price plans at residential customers (the Company's
primary target market under the AOL Agreement and its internet offering) with
significantly simplified rate structures, which may lower overall long distance
prices. Competition is fierce for the small to medium-sized businesses that the
Company also serves. Additional pricing pressure may come from the introduction
of new technologies, such as a internet telephony, which seek to provide voice
communications at a cost below that of traditional circuit-switched long
distance service. Reductions in prices charged by competitors may have a
material adverse effect on the Company.
The Company also competes on the basis of the quality of customer
service that it provides to end users. The Company believes that its online and
web-enabled billing and information systems have been an important factor in
attracting customers from the AOL subscriber base and will be an important
factor in determining the success of its overall e-commerce initiatives. There
can be no assurance that competitors will not develop online billing and
information systems that are comparable to the Company's systems.
The impending entry of the Bell operating companies ("BOCs") into the
long distance market may further heighten competition. Under the
Telecommunications Act of 1996, the BOCs were authorized to provide long
distance service that originates outside their traditional services areas, and
may gain authority to provide long distance service that originates within their
region after satisfying certain market opening conditions. No BOC has yet been
certified as having met all of the conditions. The FCC, the Department of
Justice and state regulators, however, have been working with the BOCs to ensure
they satisfy the conditions, and some analysts are predicting the BOCs' entry
into the long distance market could begin in some states by the end of 1999. BOC
entry into the long distance market means new competition from well-capitalized,
well-known companies. While the Telecommunications Act includes certain
safeguards against anti-competitive conduct by the BOCs, it is impossible to
predict whether such safeguards will be adequate or what effect such conduct
would have on the Company. Because of the BOCs' name recognition in their
existing markets, the established relationships that they have with their
existing local service customers, and their ability to take advantage of those
relationships, as well as the possibility of interpretations of the
Telecommunications Act favorable to the BOCs, it may be more difficult for other
providers of long distance services, such as the Company, to compete.
11
Consolidation and alliances across geographic regions (e.g., Bell
Atlantic/Nynex/GTE and SBC/Pacific Telesis Group/SNET/Ameritech) and in the long
distance market (e.g., MCI/WorldCom domestically and France Telecom/Deutsche
Telekom/Sprint and AT&T/British Telecom internationally) and across industry
segments (e.g., MCI WorldCom/MFS/UUNet and AT&T/Teleport/TCI) may also intensify
competition from significantly larger, well-capitalized carriers. Such
consolidation and alliances are providing some of the Company's competitors with
the capacity to offer a "bundle" of services, including local, long distance and
wireless telephone service, as well as Internet access and cable television
service.
The competitive telecommunications marketplace is marked by a high rate
of customer attrition. The Company's competitors engage in national advertising
campaigns, telemarketing programs and offer cash payments and other incentives
to the Company's end users, who are not obligated to purchase any minimum usage
amount and can discontinue service, without penalty, at any time. There can be
no assurance that the Company will be able to continue to replenish its end user
base, and failure to do so would have a material adverse effect on the Company.
Although the Company currently enjoys exclusive marketing rights with
AOL, the Company's online marketing and provision of telecommunications services
has been widely imitated, by competitors on the internet and through their own
web site offerings, numerous competitors now offer over the internet and on
their own web sites or through links from other web sites sign-up and billing
and automatic payment through a credit card. The Company believes that its
real-time, online billing system is unique in the marketplace and currently
gives the Company a competitive advantage in the e-commerce market for
telecommunications services. There can be no assurance, however, that potential
competitors will not develop comparable billing and information systems. The
Company from time to time considers providing telecommunications services it has
not previously provided, such as wireless services, and which new services, if
offered, would face the same competitive pressures that affect the Company's
existing services. The Company faces competition not only from other providers
of presubscribed long distance service, but also from dial-around long distance
service and prepaid long distance calling cards.
One of the Company's principal competitors, AT&T, is also a major
supplier of services to the Company. The Company links some of its switching
equipment with transmission facilities and services purchased or leased from
AT&T and resells services obtained from AT&T. The Company also utilizes AT&T and
ACUS to provide certain billing services.
REGULATION
The Company's provision of communications services is subject to
government regulation. The Federal Communications Commission ("FCC") regulates
interstate and international telecommunications, while the states regulate
telecommunications that originate and terminate within the same state. Changes
in existing regulations could have a material adverse effect on the Company.
12
The Company's marketing of its AOL based services, the Company's
marketing over the internet, the Company's other current and past direct
marketing efforts, and the marketing efforts of the Company's partitions all
require compliance with relevant federal and state regulations that govern the
sale of telecommunications services. The FCC and some states have rules that
prohibit switching a customer from one long distance carrier to another without
the customer's consent and specify how that consent can be obtained and must be
verified. Most states also have consumer protection laws that further define the
framework within which the Company's marketing activities must be conducted.
While directed at curbing abusive marketing practices, unless carefully designed
and enforced, such rules can have the incidenta
l effect of entrenching incumbent
carriers and hindering the growth of new competitors, such as the Company.
Restrictions on the marketing of telecommunications services are
becoming stricter in the wake of widespread consumer complaints throughout the
industry about "slamming" (the unauthorized conversion of a customer's
preselected telecommunications carrier) and "cramming" (the unauthorized
provision of additional telecommunications services). The Telecommunications Act
of 1996 strengthened penalties against slamming, and the FCC recently issued
rules tightening federal requirements on the verification of orders for
telecommunications services and establishing additional financial penalties for
slamming. The FCC is also considering new rules that would require that sales of
telecommunications services made over the internet be verified through a
telephone call or other off-line method. In addition, many states have been
active in restricting marketing through new legislation and regulation, as well
as through enhanced enforcement activities. The constraints of federal and state
regulation, as well as increased FCC and state enforcement attention, could
limit the scope and the success of the Company's and its partitions' marketing
efforts and subject them to enforcement action.
Allegedly to combat slamming, many local exchange carriers have
initiated "PIC freeze" programs that, once selected by the customer, then
require a customer seeking to change long distance carriers to contact the local
carrier directly instead of having the long distance carrier contact the local
carrier on the customer's behalf. Many local carriers have imposed burdensome
requirements on customers seeking to lift PIC freezes and change carriers, and
thereby made it difficult for customers to switch to the Company's long distance
service.
Statutes and regulations designed to protect consumer privacy also may
have the incidental effect of hindering the growth of newer telecommunications
carriers such as the Company. The FCC has released rules that severely restrict
the use of "customer proprietary network information" (information that a
carrier obtains about its customers through their use of the carrier's
services). These rules may make it more difficult for the Company to market
additional telecommunications services (such as local and wireless), as well as
other services and products, to its existing customers, if and when the Company
begins to offer such services and products.
The FCC requires the Company and other providers of telecommunications
services to contribute to the universal service fund, which helps to subsidize
the provision of local telecommunications services and other services to
low-income consumers, schools, libraries, health care providers, and rural and
insular areas that are costly to serve. The Company's contributions to the
universal service fund could increase over time, and some of the Company's
potential competitors (such as providers of Internet telephony) are not
currently, and in the future may not be, required to contribute to the universal
service fund.
13
The FCC imposes additional reporting, accounting, record-keeping and
other regulatory obligations on the Company. The Company must offer interstate
services under rates, terms and conditions that are just, reasonable and not
unreasonably discriminatory. The Company must file tariffs listing the rates,
terms and conditions of the Company's service, but the FCC has proposed to
abolish some tariff filing requirements and instead mandate the posting of
similar information on the Internet. Although the Company's tariffs, and the
rates and charges they specify, are subject to FCC review, they are presumed to
be lawful and have never been contested. The Company may be subject to
forfeitures and other penalties for violating the FCC's rules.
The vast majority of the states require the Company to apply for
certification to provide intrastate telecommunications services, or at least to
register or to be found exempt from regulation, before commencing intrastate
service. The vast majority of states also require the Company to file and
maintain detailed tariffs listing its rates for intrastate service. Many states
also impose various reporting requirements and/or require prior approval for
transfers of control of certified carriers, corporate reorganizations,
acquisitions of telecommunications operations, assignments of carrier assets,
including subscriber bases, carrier stock offerings and incurrence by carriers
of significant debt obligations. Certificates of authority can generally be
conditioned, modified, canceled, terminated or revoked by state regulatory
authorities for failure to comply with state law and the rules, regulations and
policies of the state regulatory authorities. Fines and other penalties,
including the return of all monies received for intrastate traffic from
residents of a state, may be imposed for such violations.
The Company's partitions are also subject to the same federal and state
regulations as the Company, and any change in those regulations, or any
enforcement action, could adversely affect the partitions and their demand for
the Company's services. To the extent that the Company makes additional
telecommunications service offerings, the Company may encounter additional
regulatory constraints.
EMPLOYEES
As of December 31, 1998, the Company employed 525 persons. The Company
considers relations with its employees to be good.
ITEM 2. PROPERTIES
The Company leases an approximately 19,200 square foot facility in New
Hope, Pennsylvania that currently serves as the Company's headquarters. On
January 20, 1999, the Company entered into a lease for a 3,700 square foot
facility in Reston, Virginia, which will serve as the Company's future
headquarters for a majority of the Company's executives and marketing personnel.
The Company also leases properties in the cities in which OBN switches have been
installed.
14
With respect to the Company's customer service operations in connection with its
agreement with AOL, the Company owns a 32,000 square foot facility located in
Clearwater, Florida.
ITEM 3. LEGAL PROCEEDINGS
On June 16, 1998, a purported shareholder class action was filed in the United
States District Court for the Eastern District of Pennsylvania against the
Company and certain of its officers alleging violation of the securities laws in
connection with certain disclosures made by the Company in its public filings
and seeking unspecified damages. Thereafter, additional lawsuits making
substantially the same allegations were filed by other plaintiffs in the same
court. At this point, no classes have been certified. The Company believes the
allegations in the complaints are without merit and intends to defend the
litigations vigorously. The Company also is a party to certain legal actions
arising in the ordinary course of business.
The Company believes that the ultimate outcome of the foregoing actions will not
result in liability that would have a material adverse effect on the Company's
financial condition or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a) The Company's Annual Meeting of Stockholders was held on December 30,
1998 ("Annual Meeting");
(b) Not applicable.
(c) At the Annual Meeting, the stockholders of the Company considered and
approved the following proposals:
(i) Election of Directors. The following sets forth the nominees
who were elected directors of the Company for the term
expiring in the year indicated as well as the number of votes
cast for, against or withheld:
VOTES
Term (year expires) Name For Against Withheld
2001 Daniel Borislow* 32,947,114 0 23,088
2001 Ronald R. Thoma 32,947,114 0 23,088
* Effective January 5, 1999, Mr. Borislow resigned as Director and Chairman of the Board of Directors of the Company.
15
(ii) At the Annual Meeting, the stockholders approved a proposal to
approve the Company's 1998 Long-Term Incentive Plan, which
provides for the issuance of up to 5,000,000 shares of the
Company's Common Stock to employees and directors of the
Company selected at the discretion of a committee (initially,
the Compensation Committee) of the Board of Directors of the
Company. The proposal received 26,750,198 votes in favor,
6,218,455 votes in opposition and 1,529 votes abstained from
such matter.
(iii) At the Annual Meeting the stockholders approved the
appointment of BDO Seidman LLP as independent certified
public accountants of the Company. The appointment received
32,967,942 votes in favor, 2,111 votes in opposition and 129
votes abstained from such matter.
16
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock, $.01 par value per share ("Common Stock"), is traded
on the Nasdaq National Market under the symbol "Talk". High and low quotations
listed below are actual sales prices as quoted in the Nasdaq National Market and
as reported by Tradeline:
Common Stock Price Range of Common Stock
- - ------------ ---------------------------
High Low
---- ---
1997
First Quarter 20 5/8 12 1/4
Second Quarter 17 1/2 13 1/4
Third Quarter 24 3/16 13 3/4
Fourth Quarter 26 1/16 16 5/16
1998
First Quarter 30 19 1/4
Second Quarter 24 5/16 13 9/16
Third Quarter 19 3/8 9 1/16
Fourth Quarter 19 3/8 4 23/32
1999
First Quarter (through March 30, 1999 22 1/2 7 1/2
As of March 24, 1999, there were approximately 366 record holders of Common
Stock.
The Company has never declared or paid any cash dividends on its capital stock.
The Company currently intends to retain any future earnings to finance the
growth and development of its business and, therefore, does not anticipate
paying any cash dividends in the foreseeable future.
RECENT SALES OF UNREGISTERED SECURITIES
On or about December 30, 1998, the Company issued 500,000 shares of Common
Stock, in the aggregate, to Menachem Goldstone and Avrohom Oustatcher in
connection with a settlement among Mssrs. Goldstone, Oustatcher and the Company.
Messrs. Goldstone and Outstatcher are former employees and consultants of the
Company.
On or about December 16, 1998, the Company issued 130,000 shares of Common Stock
to Michael Ferezacca in connection with his execution of an employment agreement
with the Company.
On or about December 30, 1998, the Company issued 758,359 shares of Common
Stock, in the aggregate, to the entities described below in connection with the
conversions of certain convertible notes that had been issued by the Company to
such as entities, as follows: 150,922 shares of Common Stock to Kennilworth
Partners LP II, 236,900 shares to Taft Securities, L.L.C., 194,380 shares to
Aragon Investments, Ltd. and 176,157 shares to Olympus Securities, Ltd. The
Company has been advised that Citadel Limited Partnership is the trading manager
of each of Taft Securities, L.L.C., Aragon Investments, Ltd. and Olympus
Securities, Ltd. and consequently has voting control and investment discretion
over securities held by those entities. Citadel Limited Partnership, Taft
Securities, L.L.C., Aragon Investments, Ltd. and Olympus Securities, Ltd. each
disclaims beneficial ownership of the securities held by the other entities.
Each of the above issuances were made by the Company in reliance in Section 4(2)
of the Securities Act of 1933.
17
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data should be read in conjunction
with, and are qualified in their entirety by, "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and the Company's
Consolidated Financial Statements included elsewhere in this Form 10-K.
YEAR ENDED DECEMBER 31,
--------------------------------------------------------------------------------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
(In thousands, except per share amounts)
Consolidated Statements of Income Data:
Sales $448,600 $304,768 $232,424 $180,102 $82,835
Cost of sales 361,957 294,484 200,597 156,121 70,104
Gross profit 86,643 10,284 31,827 23,981 12,731
General and administrative expenses 41,939 34,650 10,039 6,280 3,442
Promotional, marketing and advertising -
primarily AOL 210,552 60,685 -- -- --
Significant other charges 91,025 -- -- -- --
Operating income (loss) (256,873) (85,051) 21,788 17,701 9,289
Investment and other income (expense),
net (11,175) 50,715 10,585 331 66
Income (loss) before income taxes (268,048) (34,336) 32,373 18,032 9,355
Provision (benefit) for income taxes (1)(2) 40,388 (13,391) 12,205 7,213 3,742
Income (loss) before extraordinary gain (1) (308,436) (20,945) 20,168 10,819 5,613
Extraordinary gain 87,110 -- -- -- --
Net income (loss) (1) $(221,326) $(20,945) $ 20,168 $ 10,819 $ 5,613
Income (loss) before extraordinary gain $ $ $
per share - Basic (1) $ (5.20) (0.33) 0.38 0.34 $ 0.20
Extraordinary gain per share - Basic 1.47 -- -- -- --
Net income (loss) per share - Basic (1) $ (3.73) $ (0.33) $ 0.38 $ 0.34 $ 0.20
Weighted average common shares outstanding
- Basic 59,283 64,168 52,650 31,422 28,650
Income (loss) before extraordinary gain $ (5.20) $ $ $ $ 0.18
per share - Diluted (1) (0.33) 0.35 0.32
Extraordinary gain per share - Diluted 1.47 -- -- -- --
Net income (loss) per share - Diluted(1) $ (3.73) $ (0.33) $ 0.35 $ 0.32 $ 0.18
Weighted average common and common
equivalent shares outstanding -Diluted 59,283 64,168 57,002 33,605 30,663
AT DECEMBER 31,
--------------------------------------------------------------------------------------------
1998(3) 1998 1997 1996 1995 1994
------- ---- ---- ---- ---- ----
Pro Forma (In thousands)
Consolidated Balance Sheets Data:
Working capital $ 12,658 $ 13,061 $634,788 $175,597 $38,171 $12,265
Total assets 215,749 272,560 814,891 257,008 71,388 21,435
Convertible debt 114,762 242,387 500,000 -- -- --
Total stockholders' equity (65,971) (136,785) 222,828 230,720 41,314 14,042
(deficit)
(1) For the year and period ended December 31, 1994 and September
19, 1995, the Predecessor Corporation elected to report as an
S corporation for federal and state income tax purposes.
Accordingly, the Predecessor Corporation's stockholders
included their respective shares of the Company's taxable
income in their individual income tax returns. The pro forma
income taxes reflect the taxes that would have been accrued if
the Company had elected to report as a C corporation.
(2) The provision for income taxes in 1998 represents a valuation
allowance for deferred tax assets recorded in prior periods
and current tax benefits which may result from the 1998 loss.
The Company provided the valuation allowances in view of the
loss incurred in 1998, the uncertainties resulting from
intense competition in the telecommunications industry and the
lack of any assurance that the Company will realize any tax
benefits.
(3) The pro forma financial data as of December 31, 1998 gives
effect to the January 5, 1999 investment of $55.0 million by
America Online, Inc. and the January 5, 1999 repurchase of
$127,625,000 face amount of convertible debt for $109.1
million from trusts for the benefit of the children of the
former Chairman and Chief Executive Officer, consisting of a
cash payment of $55.4 million and the transfer of the $53.7
million principle amount of the note receivable from
WorldxChange.
18
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with the
Consolidated Financial Statements included elsewhere in this Form 10-K.
RESULTS OF OPERATIONS
The following table sets forth for the periods indicated certain
financial data as a percentage of sales:
1998 1997 1996
---- ---- ----
Sales 100.0% 100.0% 100.0%
Cost of sales 80.7 96.6 86.3
------ ------ ------
Gross profit 19.3 3.4 13.7
General and administrative expenses 9.3 11.4 4.3
Promotional, marketing and advertising expenses - primarily
AOL 46.9 19.9 --
Significant other charges 20.3 -- --
------ ------ ------
Operating income (loss) (57.2) (27.9) 9.4
Investment and other income (expense), net (2.5) 16.6 4.5
------ ------ ------
Income (loss) before income taxes (59.7) (11.3) 13.9
Provision (benefit) for income taxes 9.0 (4.4) 5.2
------ ------ ------
Income (loss) before extraordinary gain (68.7) (6.9) 8.7
Extraordinary gain 19.4 -- --
------ ------ ------
Net income (loss) (49.3)% (6.9)% 8.7%
========= ======== =======
19
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
Sales. Sales increased by 47.2% to $448.6 million in 1998 from $304.8
million in 1997. The increase in sales resulted primarily from the Company's
marketing campaign directed at generating new customers under the AOL Agreement.
This AOL-related sales increase offset a decrease in the Company's non-AOL
sales, and reflected, to a lesser extent, the Company's focus on marketing under
the AOL Agreement.
Since entering into the AOL Agreement in February 1997, the Company and
AOL have had frequent discussions, and have negotiated a number of changes
including a substantial amendment in January 1999, regarding the marketing of
services under the AOL Agreement and expenditures by the Company in connection
with such marketing, particularly off-line marketing programs. While these
marketing agreements, principally those related to off-line marketing, have
significantly contributed to the rate of growth in the Company's AOL-related
business, AOL-related sales could be affected adversely by the intense
competition in this industry and have continued to be affected adversely by the
PIC freezes implemented by the local telephone companies. Accordingly, there can
be no assurance that the Company will continue to increase sales on a
quarter-to-quarter or year-to-year basis.
Cost of Sales. Cost of sales increased by 22.9% to $362.0 million in
1998 from $294.5 million in 1997 as a result of increased sales offset by
certain charges in 1997, totaling $41.5 million, discussed below.
Gross Margin. Gross margin increased to 19.3% in 1998 from 17.0%,
excluding certain charges totaling $41.5 million (as described below) in 1997.
The increase in gross margin was primarily due to lower network usage costs for
OBN services and lower local and international access charges, in each case on a
per call basis. The Company anticipates that gross margins will continue to
increase; however, price competition continues to intensify for the Company's
products and this trend can be expected to continue to put downward pressure on
gross margins.
General and administrative expenses. General and administrative
expenses increased by 21.0% to $41.9 million in 1998 from $34.7 million in 1997.
The increase in general and administrative expenses was due primarily to the
costs associated with hiring additional personnel to support the Company's
continuing growth, the general and administrative expense incurred as a result
of the acquisitions of Compco, Inc. and ADS which were acquired in November 1997
and January 1998, respectively and increased fees for professional services.
Promotional, Marketing and Advertising Expense - Primarily AOL. During
1998 the Company incurred $210.6 million of expenses to expand its online
customer base. These expenses included $49.7 million for online advertising
under the AOL Agreement, $22.0 million for the value of performance warrants
granted to AOL for net customer gains and $138.9 for offline advertising. During
1997, the Company incurred $60.7 million that consisted of $35.9 million for
exclusivity under the AOL Agreement, $13.2 million for production of
advertising, $7.9 million for online advertising for the fourth quarter of 1997,
$1.2 million representing the value of performance warrants paid to AOL for net
customer gains and $2.5 million for other advertising.
Significant Other Charges. Significant other charges consist of $91.0
million of expenses incurred in the fourth quarter of 1998 related to changes in
the Company's basic business operations.
As discussed above the Company negotiated substantial amendments to the
AOL and CompuServe agreements which among other things reduced the amount of
online advertising that the Company was entitled to over the remaining term of
the agreement and eliminated payments and issuance of warrants to AOL for
subscriber gains and profit sharing payments to AOL. The Company agreed to fixed
quarterly payments ranging from $10 - $15 million during the exclusivity period
of the agreement and AOL agreed to contribute up to $4.0 million per quarter for
offline marketing. As a result of the amendment the Company wrote off prepaid
AOL, CompuServe and other marketing expenses of $37.6 million.
In connection with hiring a new Chairman and Chief Executive Officer
and several other key executive personnel and severance payments relating to
this change in management, the Company incurred $12.7 million of incentive and
severance expense.
The Company acquired ADS Holdings, Inc. (formerly Symetrics, Inc.), a
manufacturer of digital telephone switching equipment, in January, 1998 for
$18.6 million. This Company planned to complete development of a digital switch
to provide state of the art features for use in the Company's operations as a
competitive local exchange carrier. The Company allocated $21 million of the
acquisition cost to purchased research and development expense in the first
quarter of 1998 and continued to invest in additional research and development
throughout 1998. In November 1997, the Company acquired Compco, Inc, a provider
of communications software in the college and university marketplace for $13.7
million which exceeded the net assets acquired by $10.6 million. In the
20
fourth quarter of 1998, the Company decided to sell the assets of ADS Holdings,
Inc. and to delay entry into the college and university marketplace. As a result
the assets of ADS Holdings, Inc. and Compco, Inc. were written down to expected
realizable value. The Company recorded $15 million relating to the impairment of
these assets and reclassified $22.2 million of research and development expense
to significant other costs.
In the fourth quarter of 1998, the Company reconfigured its
telecommunications network, OBN, to provide for fiber optic connections among
its switches and incurred $3.5 million of expense.
Investment and Other Income (Expense), Net. Investment and other income
(expense), net was $(11.2) million in 1998 versus $50.7 million in 1997. During
1998, investment and other income (expense), net consists primarily of
investment income and trading losses of $11.0 million offset by interest expense
related to the Company's Convertible Notes of $22.2 million.
Provision for Income Taxes. The Company had recorded net deferred tax
assets at December 31, 1997and March 31, 1998 primarily representing net
operating loss carry-forwards and other temporary differences because the
Company believed that no valuation allowance was required for these assets due
to future reversals of existing taxable temporary differences and expectation
that the Company will generate taxable income in future years. In June 1998, the
Company decided to make substantial marketing and advertising expenditures to
establish a broad base of online customers from AOL's membership. As discussed
above, these expenditures led to a significant loss for 1998. In view of these
losses, the uncertainties resulting from intense competition in the
telecommunications industry and the lack of any assurance that the Company will
realize any of the tax benefits, the Company decided in June 1998 to provide a
100% valuation allowance for the previously recorded deferred tax benefits and
to provide a 100% valuation allowance for the current and future tax benefits
resulting from the 1998 loss. Valuation allowances of approximately $78.4
million were included in provision for income taxes, for the year ended December
31, 1998.
Extraordinary Gain. During 1998, the Company recorded an extraordinary
gain of $87.1 million in connection with the acquisition of the Company's
convertible debt at a discount.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
Sales. Sales increased by 31.1% to $304.8 million in 1997 from $232.4
million in 1996. The increase in sales resulted primarily from the marketing of
the Company's OBN services and the addition of new partitions. One partition,
Group Long Distance Inc., accounted for approximately 13% of the Company's sales
in 1997.
Cost of Sales. Cost of sales increased by 46.8% to $294.5 million in
1997 from $200.6 million in 1996 as a result of increased sales and charges of
$11.5 million primarily as a result of the Company's change in its accounting
for customer acquisition costs, and $30.0 million primarily related to the
restructuring of its sales and marketing efforts (Note 3).
Gross Margin. Gross margin decreased to 3.4% in 1997 from 13.7% in
1996. The decrease in gross margin was primarily due to the charges discussed
above. Absent these charges, gross margin increased to 17.0% in 1997 from 13.7%
in 1996, due to lower network costs for OBN services which were lower on a per
call basis when compared to the costs of purchasing these services.
General and administrative expenses. General and administrative
expenses increased by 245.2% to $34.7 million in 1997 from $10.0 million in
1996. The increase in general and administrative expenses was due primarily to
compensation expenses related to the issuance of options to and the purchase of
shares of Company common stock by executive officers of the Company in
connection with the commencement of their employment with the Company, the costs
associated with hiring additional personnel to support the Company's continuing
growth, the development costs associated with AOL and increased fees for
professional services.
21
Other Income. Other income was $50.7 million in 1997 versus $10.6
million in 1996. Other income in 1997 consists primarily of fees for customer
service and support for the marketing operations of the Company's carrier
partitions in 1997 of $8.1 million and investment income earned by the Company.
In 1997, other income also includes $32.1 million, net of related costs,
associated with the break-up of a proposed merger between the Company and STF.
Provision for income taxes. The Company's effective tax rate increased
to 39.0% in 1997 from the effective tax rate of 37.7% in 1996 primarily due to
an anticipated higher effective state tax rate in 1997.
LIQUIDITY AND CAPITAL RESOURCES
The Company's working capital was $13.1 million and $634.8 million at
December 31, 1998 and 1997, respectively. The significant decrease in working
capital at December 31, 1998, when compared to historical amounts, is primarily
a result of the repurchase of the Company's securities, the loss for the year
which was primarily attributble to the advertising and marketing expenditures
incurred in connection with the AOL Agreement and significant other charges, the
advance to WXC described below, and the increase in accounts payable, primarily
reflecting recent rapid growth in the Company's AOL business.
The Company expended an aggregate of $429.9 million and $125.4 million
of cash, Company common stock and other consideration for the repurchase of
outstanding securities during 1998 and 1999, respectively. Under various
authorizations from the Board of Directors during 1998 the Company repurchased
approximately 18.8 million shares for an aggregate of $265.1 million ($239.9
million cash and $25.2 million in other consideration) and repurchased
approximately $257.6 million principal amount of the Company's Convertible Notes
for approximately $164.8 million ($86.3 million in cash, $69.5 million in
Company common stock and $9.0 million in other consideration). In the first
quarter of 1999, the Company (a) purchased from Mr. Borislow and two trusts for
the benefit of Mr. Borislow's children $76,557,000 aggregate principal amount of
the Company's Convertible Notes for $65.4 million in cash (b) exchanged the
$53.7 million remaining on the WXC Notes (as defined below) to a trust for the
benefit of Mr. Borislow's children for $62,545,000 aggregate principal amount of
the Company's Convertible Notes and (c) purchased $9,000,000 aggregate principal
amount of the Company's Convertible Notes for $6.3 million in Company common
stock. To date, with these most recent acquisitions, the Company had reduced the
principal amount outstanding of its Convertible Notes to $94.3 million ($66.9
million of 4 1/2% notes and $27.4 million of 5% notes) of which approximately
$52.4 million continues to be held by one of such trusts.
The Company invested $16.9 million in capital equipment during 1998.
In connection with the Company entering into the Telecommunications
Service Agreement ("TSA") with Communication Telesystems International d/b/a/
WorldxChange Communication ("WXC"), the Company advanced $56.2 million to WXC
which was due and payable on November 30, 2000 ("WXC Notes"). Interest on the
WXC Notes is payable quarterly commencing November 25, 1998 at a rate of 12.5%
per annum. The Company purchases international termination telecommunication
services pursuant to the TSA. The note which had a remaining principal balance
of $53.7 million was exchanged for $62,545,000 face amount of Convertible Notes
on January 5, 1999.
On January 5, 1999, pursuant to an Investment Agreement between AOL and
the Company, AOL made a significant equity investment in the Company, acquiring
4,121,372 shares of common stock for $55.0 million in cash and the surrender of
rights to acquire up to 5,076,016 shares of common stock pursuant to various
warrants held by AOL. Under the terms of the Investment Agreement with AOL, the
Company has agreed to reimburse AOL for losses AOL may incur on the sale of any
of the 4,121,372 shares during the period from June 1, 1999 through September
30, 2000. The reimbursement amount would be determined by multiplying the number
of shares, if any, that AOL sells during the applicable period by the difference
between the purchase price per share paid by AOL, or $19 per share, and the
price per share that AOL sells the shares for, if less than $19 per share. The
reimbursement amount may not exceed $14 per share for 2,894,737 shares or $11
for 1,226,635 shares. Accordingly, the maximum amount payable to AOL as
reimbursement on the sale of AOL's shares would be approximately $54.0 million
plus AOL's reasonable expenses incurred in connection with the sale. Assuming
AOL were to sell all of its shares subject to the Company reimbursement
obligation at the closing price of the Company's common stock as of March 26,
1999, the reimbursement amount would be approximately $35.5 million. AOL also
has the right on termination of long distance exclusively to require the Company
to repurchase 2,721,984 warrants to purchase common stock of the Company held by
AOL for a minimum price of $36.3 million. The Company has agreed to fund an
escrow account of up to $35 million from 50% of the proceeds of any debt
financing, other than a bank, receivable or other asset based financing of up to
$50 million, to secure its obligations under the Investment Agreement with AOL.
AOL has not advised the Company that it intends to sell any shares during the
relevant period. Mr. Borislow has agreed to guarantee up to $20,000,000 of the
Company's reimbursement obligations under the Investment Agreement with AOL.
22
The Company is subject to certain restrictions under the terms of
certain registration rights agreements that could affect the Company's ability
to raise capital. Under these agreements, entered into by the Company for the
benefit of Mr. Borislow and two trusts for the benefit of his children (the
"Trusts"), the Company has agreed that so long as Mr. Borislow continues to own
at least 2% of the Company's outstanding common stock, the Company will use up
to 40% of the proceeds from the sale of any public or private debt securities,
excluding borrowings from a commercial bank or financial institution, to
repurchase the Company's Convertible Notes held by Mr. Borislow or the Trusts
and that until June 2000, the Company will not sell any shares of captial stock
of the Company without the consent of Mr. Borislow (other than sales of common
stock on exercise of options on rights so long as the proceeds are used to
repurchase common stock of the Company held by Mr. Borislow or the Trusts).
The Company generally does not have a significant concentration of
credit risk with respect to accounts receivable due to the large number of end
users comprising the Company's customer base and their dispersion across
different geographic regions. The Company maintains reserves for potential
credit losses and, to date, such losses have been within the Company's
expectations.
The Company does not, and has not historically, required significant
amounts of working capital for its day to day operations. The Company believes
that its current cash positions and the cash flow expected to be generated from
operations, will be sufficient to fund its capital expenditures, working capital
and other cash requirements for at least the next twelve months. The Company
believes that, at its current market price, its cash flow from operations will
be sufficient to fund any reimbursement amount in the event that AOL elects
after May 31, 1999 to sell its shares of the Company's common stock at a price
below $19 per share and that , alternatively, it also has the ability to obtain
the necessary financing to find its obligations under the AOL Investment
Agreement. Should the Company seek to raise additional capital, there can be no
assurance that, given current market conditions, the Company would be able to
raise such additional capital on terms acceptable to the Company.
YEAR 2000
The "Year 2000 issue" refers to the potential harm from computer
programs that identify dates by the last two digits of the year rather than
using the full four digits. Such programs could fail due to misidentification of
dates on or after January 1, 2000. If such a failure were to occur to the
Company's internal computer-based systems or to the crucial computer-based
systems operated by third parties, the Company could be unable to continue to
provide telecommunications services, to sign up new customers or to bill
existing customers for services. Such failures, if they occurred, would have a
material adverse effect on the Company's business, results of operations and
financial condition. However, because of the complexity of the issues, the
number of parties involved and the fact that many of the issues are outside the
Company's control, the Company cannot reasonably predict with certainty the
nature or likelihood of such effects.
The Company, using its internal staff, has conducted a review of most
of its internal computer-based systems. Most of the Company's systems are
relatively new. Much of the software used by the Company has been developed
internally and is regularly modified and updated to meet the changing
requirements of its business. The Company expects that its critical internal
systems will be able to process relevant date information in the future to
permit the Company to continue to provide its services without significant
interruption or material adverse effect on its business, results of operations
and financial condition. However, there can be no assurances that the Company
will not experience unanticipated negative consequence caused by undetected
errors or defects in the technology used in its internal systems.
Notwithstanding the Company's expectation that its own systems will be
able to process Year 2000 date information, the Company's business depends
significantly on receiving uninterrupted services by other parties. The
principal service suppliers to the Company include other switch-based
lonf-distance providers, the local exchange carriers throughout the country and
AOL. Other parties whose ability to deal with year 2000 issues could affect the
Company include the Company's partitions and the credit card companies through
which most of the Company's AOL customers are billed. The Company has made
inquiries of some of these parties regarding their respective levels of
preparedness for Year 2000 issues as they may affect the Company. The Company
will continue to make such inquiriesand will monitor the public disclosures of
such companies regarding their Year 2000 status. So, far, the responses to such
inquiries have been generally non-committal regarding levels of preparedness or
willingness to provide assurances to the Company. In almost all cases, the
Company is not in a position to require either affirmative action or assurances
by these parties regarding continued provision of services in the Year 2000.
Accordingly, while the Company has not been advised by any of these other
companies on which it depends that they do not expect to be ready for Year 2000
issues, the Company does not believe it is in a position to project the
likelihood of such parties' abilities to provide uninterrupted services to the
Company. The Company has considered possible contingency plans should one of
these significant suppliers fail, including entering into multiple contracts
with other long-distance service providers OBN network. However, given the
nature of the Company's relationships with most of these significant suppliers,
it may be impracticable for the Company to replace them should they be unable to
continue to provide these services. The failure of any of these companies to
provide uninterrupted service to the Company would likely have a material
adverse effect on the Company's business and its results of operations and
financial condition.
23
The Company does not separately identify costs incurred in connection
with Year 2000 compliance activities. To date, however, the Company does not
believe such costs to be significant because they generally have been incurred
in the normal course of internally modifying and updating the Company's software
programs. Future expenditures are not expected to be significant and will be
funded out of operating cash flows.
* * * * *
Certain of the statements contained herein may be considered
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. Such
statements are identified by the use of forward-looking words or phrases,
including, but not limited to, "estimates," "expects," "expected,"
"anticipates," and "anticipated." These forward-looking statements are based on
the Company's current expectations. Although the Company believes that the
expectations reflected in such forward-looking statements are reasonable, there
can be no assurance that such expectations will prove to have been correct.
Forward-looking statements involve risks and uncertainties and the Company's
actual results could differ materially from the Company's expectations.
Important factors that could cause such actual results to differ materially
include, among others, adverse developments in the Company's relationship with
AOL, increased price competition for long distance services, failure of the
marketing of long distance services under the AOL Agreement, attrition in the
number of end users, and changes in government policy, regulation and
enforcement. The Company undertakes no obligation to update its forward-looking
statements.
24
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
TEL-SAVE.COM, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE
----
Report of Independent Certified Public Accountants...................... 26
Consolidated balance sheets as of December 31, 1998 and 1997............ 27
Consolidated statements of operations for the years ended
December 31, 1998, 1997, and 1996....................................... 28
Consolidated statements of stockholders' equity for the years
ended December 31, 1998, 1997 and 1996.................................. 28
Consolidated statements of cash flows for the years ended
December 31, 1998, 1997 and 1996........................................ 29
Notes to consolidated financial statements.............................. 30
25
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors
and Stockholders of Tel-Save.com, Inc.
We have audited the accompanying consolidated balance sheets of
Tel-Save.com, Inc. and subsidiaries as of December 31, 1998 and 1997, and the
related consolidated statements of operations, stockholders' equity (deficit)
and cash flows for each of the three years in the period ended December 31,
1998. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of
Tel-Save.com, Inc. and subsidiaries as of December 31, 1998 and 1997, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1998, in conformity with generally accepted
accounting principles.
BDO Seidman, LLP
New York, New York
February 22, 1999, except for Note 8, which is as
of March 26, 1999
26
TEL-SAVE.COM, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT FOR SHARE DATA)
PRO FORMA
DECEMBER 31, 1998 DECEMBER 31,
------------------------ --------------------------------
UNAUDITED-NOTE 1(C)) 1998 1997
---- ----
ASSETS
CURRENT:
Cash and cash equivalents $2,660 $ 3,063 $316,730
Marketable securities 89,649 89,649 212,269
Accounts receivable, trade net of allowance for uncollectible
accounts of $1,669, $1,669 and $2,419, respectively 46,587 46,587 44,587
Advances to partitions and notes receivable 1,870 1,870 26,110
Due from broker -- -- 21,087
Prepaid AOL marketing costs - current -- -- 30,857
Deferred taxes - current -- -- 30,916
Prepaid expenses and other current assets 8,600 8,600 8,495
-------- --------- ---------
Total current assets 149,366 149,769 691,051
------- ------- --------
Property and equipment, net 56,703 56,703 55,835
Intangibles, net 1,150 1,150 10,590
Prepaid AOL marketing costs -- -- 32,722
Other assets 8,530 64,938 24,693
------- --------- ---------
Total assets $215,749 $272,560 $814,891
======== ======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
CURRENT:
Margin account indebtedness $ 49,621 $ 49,621 $ --
Accounts payable and accrued expenses:
Trade and other 64,794 64,794 16,858
Partitions 4,380 4,380 7,740
Interest and other 17,913 17,913 10,578
Securities sold short -- -- 21,087
----------- ------------ ----------
Total current liabilities 136,708 136,708 56,263
Convertible debt 114,762 242,387 500,000
Deferred revenue 28,400 28,400 35,800
Other liabilities 1,850 1,850 --
-------- ---------- ------------
Total liabilities 281,720 409,345 592,063
------- --------- ---------
Commitments and Contingencies
Stockholders' equity (deficit):
Preferred stock, $.01 par value, 5,000,000 shares authorized;
no shares outstanding -- -- --
Common stock - $.01 par value, 300,000,000 shares authorized;
66,934,635, 66,934,635 and 67,249,635 issued, respectively 669 669 672
Additional paid-in capital 262,131 265,325 291,952
Retained earnings (accumulated deficit) (202,415) (218,229) 3,097
Treasury stock (126,356) (184,550) (72,893)
--------- ----------- ----------
Total stockholders' equity (deficit) (65,971) (136,785) 222,828
--------- ---------- --------
Total liabilities and stockholders' equity (deficit) $215,749 $272,560 $814,891
======== ======== ========
See accompanying notes to consolidated financial statements.
27
TEL-SAVE.COM, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
YEAR ENDED DECEMBER 31,
--------------------------------------------
1998 1997 1996
---- ---- ----
Sales $448,600 $304,768 $232,424
Cost of sales 361,957 294,484 200,597
--------- ---------- ---------
Gross profit 86,643 10,284 31,827
General and administrative expenses 41,939 34,650 10,039
Promotional, marketing and advertising expenses -
primarily AOL 210,552 60,685 --
Significant other charges 91,025 -- --
---------- ------------ -------------
Operating income (loss) (256,873) (85,051) 21,788
Investment and other income (expense), net (11,175) 50,715 10,585
---------- --------- ----------
Income (loss) before provision for income taxes (268,048) (34,336) 32,373
Provision (benefit) for income taxes 40,388 (13,391) 12,205
---------- ---------- ---------
Income (loss) before extraordinary gain (308,436) (20,945) 20,168
Extraordinary gain 87,110 -- --
---------- ------------ ------------
Net income (loss) $(221,326) $(20,945) $ 20,168
========== ========= ========
Income (loss) before extraordinary gain per share - Basic $ (5.20) $ (.33) $ .38
Extraordinary gain per share - Basic 1.47 -- --
---------- ------------ ------------
Net income (loss) per share - Basic $ (3.73) $ (.33) $ .38
=========== =========== ==========
Weighted average common shares outstanding - Basic 59,283 64,168 52,650
========= ========= =========
Income (loss) before extraordinary gain per share - $ (5.20) $ (.33) $ .35
Diluted
Extraordinary gain per share - Diluted 1.47 -- --
---------- ------------ -------------
Net income (loss) per share - Diluted $ (3.73) $ (.33) $ .35
=========== =========== ==========
Weighted average common and common equivalent shares
outstanding - Diluted 59,283 64,168 57,002
========= ========= ========
See accompanying notes to consolidated financial statements.
28
TEL-SAVE.COM, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
(IN THOUSANDS)
RETAINED
ADDITIONAL EARNINGS
COMMON STOCK PAID-IN (ACCUMU- TREASURY STOCK
SHARES AMOUNT CAPITAL LATED DEFICIT) SHARES AMOUNT TOTAL
---------- --------- ------------- ---------------- ----------- -------- ------
Balance, January 1, 1996 50,619 $506 $36,934 $ 3,874 -- $ -- $41,314
Net income -- -- -- 20,168 -- -- 20,168
partitions -- -- 1,077 -- -- -- 1,077
Sale of common stock 8,534 85 138,984 -- -- -- 139,069
options 1,079 11 4,927 -- -- -- 4,938
Exercise of warrants 2,006 20 7,383 -- -- -- 7,403
Income tax benefit related to
exercise of common stock
options and warrants -- -- 21,311 -- -- -- 21,311
Acquisition of treasury stock -- -- -- -- (428) (4,560) (4,560)
------------ ----------- ------------- --------------- ----------- ---------- --------
Balance, December 31, 1996 62,238 622 210,616 24,042 (428) (4,560) 230,720
Net loss -- -- -- (20,945) -- -- (20,945)
Issuance of warrants to AOL -- -- 21,200 -- -- -- 21,200
Issuance of common stock for
acquired business 141 1 2,217 -- -- -- 2,218
Exercise of common stock
warrants 2,662 27 11,977 -- -- -- 12,004
Exercise of common stock
options 2,209 22 9,318 -- -- -- 9,340
Purchase of common stock
warrants -- -- (4,400) -- -- -- (4,400)
Issuance of common stock
options for compensation -- -- 13,372 -- -- -- 13,372
Acquisition of treasury stock -- -- -- -- (3,520) (71,959) (71,959)
Issuance of treasury stock for
acquired businesses -- -- 1,999 -- 340 3,626 5,625
Income tax benefit related to
exercise of common stock
options and warrants -- -- 25,653 -- -- -- 25,653
------------ ----------- ------------- --------------- ----------- ---------- -------
Balance, December 31, 1997 67,250 672 291,952 3,097 (3,608) (72,893) 222,828
Net loss -- -- -- (221,326) -- -- (221,326)
Issuance of warrants to AOL -- -- 33,086 -- -- -- 33,086
Exercise of common stock
warrants -- -- (3,620) -- 250 5,052 1,432
Exercise of common stock
options -- -- (41,493) -- 2,853 55,550 14,057
Exercise of AOL warrants -- -- (7,693) -- 381 7,693 --
Retirement of common stock (315) (3) (1,467) -- -- -- (1,470)
Acquisition of treasury stock -- -- -- -- (18,809) (265,054) (265,054)
Issuance of common stock and
options for compensation -- -- (3,123) -- 895 13,224 10,101
Issuance of common stock for
convertible debt -- -- (2,317) -- 5,089 71,878 69,561
------------ ----------- ------------- --------------- ----------- ---------- --------
Balance, December 31, 1998 66,935 $669 $265,325 $(218,229) (12,949) $(184,550) $ (136,785)
============ =========== ============= =============== =========== ========== ==========
See accompanying notes to consolidated financial statements.
29
TEL-SAVE.COM, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEAR ENDED DECEMBER 31,
------------------------------------------
1998 1997 1996
---- ---- ----
Cash flows from operating activities:
Net income (loss) $(221,326) $ (20,945) $ 20,168
Adjustment to reconcile net income to net cash provided by
operating activities:
Unrealized loss on securities -- 1,865 179
Provision for bad debts (235) 1,579 38
Depreciation and amortization 5,499 5,429 2,462
Vested AOL warrants and amortization of prepaid AOL marketing
costs 71,665 58,185 --
Charge for customer acquisition costs -- 11,550 --
Significant other charges 55,034 -- --
Write-off of intangibles -- 23,032 --
Deferred revenue (7,400) -- --
Deferred credits -- -- (280)
Compensation charges 8,402 13,372 --
Income tax benefit related to exercise of options and 25,653
warrants -- 21,311
Valuation allowance for deferred tax assets 40,388 -- --
Extraordinary gain (87,110) -- --
(Increase) decrease in:
Accounts receivable, trade (1,250) (26,048) (1,065)
Advances to partitions and notes receivable 24,241 (12,700) (20,797)
Prepaid AOL marketing costs -- (100,564)
Prepaid expenses and other current assets (23,712) (38,259) (10,183)
Other assets (49,127) (20,769) (3,924)
Increase (decrease) in:
Accounts and partition payables and accrued expenses 56,419 9,608 7,978
Deferred revenue -- 35,800 --
Other liabilities (1,302) -- (5,184)
-------------- --------------- ---------------
Net cash (used in) provided by operating activities (129,814) (33,212) 10,703
-------------- --------------- ---------------
Cash flows from investing activities:
Acquisition of intangibles (285) (9,293) (9,800)
Acquisition of Symetrics Industries, Inc. (26,707) -- --
Capital expenditures, net (16,928) (28,876) (27,679)
Securities sold short (21,087) 17,700 (411)
Due from broker 21,087 (20,220) 233
Loans to stockholder -- -- (3,034)
Repayment of stockholder loans -- -- 5,109
Sale (purchase) of marketable securities, net 122,620 (62,377) (149,238)
-------------- --------------- ---------------
Net cash provided by (used in) investing activities 78,700 (103,066) (184,820)
-------------- --------------- ---------------
Cash flows from financing activities:
Proceeds from margin account indebtedness 49,621 -- --
Proceeds from sale of convertible debt -- 500,000 --
Acquisition of convertible debt (86,301) -- --
Payment of note payable to stockholder -- -- (5,921)
Proceeds from sale of common stock -- -- 139,069
Proceeds from exercise of options and warrants 15,489 21,344 12,341
Purchase of common stock warrants -- (4,400) --
Retirement of common stock (1,470) -- --
Acquisition of treasury stock (239,892) (71,959) (4,560)
-------------- --------------- ---------------
Net cash (used in) provided by financing activities (262,553) 444,985 140,929
-------------- --------------- ---------------
Net (decrease) increase in cash and cash equivalents (313,667) 308,707 (33,188)
Cash and cash equivalents, at beginning of year 316,730 8,023 41,211
-------------- --------------- ---------------
Cash and cash equivalents, at end of year $ 3,063 $316,730 $ 8,023
============== =============== ===============
See accompanying notes to consolidated financial statements.
30
TEL-SAVE.COM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
NOTE 1 -- SUMMARY OF ACCOUNTING POLICIES
(a) Business
Tel-Save.com, Inc., a Delaware corporation, together with its
consolidated subsidiaries (the "Company"), provides long distance services
throughout the United States to increasing numbers of residential customers as a
result of the Company's recent online marketing efforts and to small and
medium-sized businesses. The Company's long distance service offerings include
outbound service, inbound toll-free 800 service and dedicated private line
services for data. The Company sells these services through its exclusive
relationship with AOL and through its recently launched web site located at
www.Tel-Save.com, as well as through partitions, which are independent marketing
companies.
(b) Basis of financial statements presentation
The consolidated financial statements include the accounts of
Tel-Save.com, Inc. and its wholly-owned subsidiaries and have been prepared as
if the entities had operated as a single consolidated group since their
respective dates of incorporation. All intercompany balances and transactions
have been eliminated.
In preparing financial statements in conformity with generally accepted
accounting principles, management is required to make estimates and assumptions
that affect the reported amounts of assets and liabilities and the disclosure of
contingent assets and liabilities at the date of the financial statements and
revenues and expenses during the reporting period. Actual results could differ
from those estimates.
Certain amounts relating to 1997 have been reclassified to conform to
the current year presentation.
(c) Pro forma balance sheet
The pro forma balance sheet as of December 31, 1998 gives effect to the
January 5, 1999 investment of $55.0 million by America Online, Inc. ("AOL")
(Note 2) and the January 5, 1999 repurchase of $127,625,000 face amount of
convertible debt for $109.1 million from two trusts for the benefit of the
children of the former Chairman and Chief Executive Officer of the Company for a
cash payment of $55.4 million and the transfer of the $53.7 million principal
amount of the 12.5% note receivable from WorldxChange.
(d) Recognition of revenue
The Company recognizes revenue upon completion of telephone calls by
end users. Allowances are provided for estimated uncollectible usage.
(e) Cash and cash equivalents
The Company considers all temporary cash investments purchased with a
maturity of three months or less to be cash equivalents.
(f) Marketable securities
Securities bought and held principally for the purpose of selling them
in the near term are classified as "trading securities" and carried at market.
Securities bought and held for the purpose of long-term investment are
classified as "securities held for sale". Unrealized holding gains and losses
(determined by specific identification) on investments classified as "trading
securities" are included in earnings. Unrealized holding gains and losses on
"securities held for sale" are included in Stockholders Equity (Deficit).
(g) Advances to partitions and notes receivable
The Company made advances to partitions to support their marketing
activities. The advances are secured by partition assets, including contracts
with end users and collections thereon.
31
(h) Property and equipment and depreciation
Property and equipment are recorded at cost. Depreciation and
amortization is calculated using the straight-line method over the estimated
useful lives of the assets, as follows:
Buildings and building improvement...................... 39 years
Switching equipment..................................... 15 years
Equipment, vehicles and other........................... 5-7 years
(i) Intangibles and amortization
Intangibles of $1,150,000 and $10,590,000 at December 31, 1998 and
1997, respectively, respesent goodwill arising from business acquisitions.
Amortization is computed on a straight-line basis over the estimated useful
lives of the intangibles which is 15 years.
(j) Deferred revenue
Deferred revenue is recorded for a non-refundable prepayment received
in connection with an amended telecommunications services agreement with Shared
Technologies Fairchild, Inc. ("STF") and is amortized over the five year term of
the agreement. This agreement is terminable by either party on thirty days
notice. Termination by either party would accelerate recognition of the deferred
revenue.
(k) Long-lived assets
The Company adopted SFAS No. 121, "Accounting For the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed of" as of January 1,
1996. Certain of the Company long-lived assets were considered impaired at
December 31, 1998 (Note 3).
(l) Income taxes
The Company has provided a full valuation allowance for deferred tax
assets and liabilities for the estimated future tax effects attributable to
temporary differences between the basis of assets and liabilities for financial
and tax reporting purposes (Note 10).
(m) Net income (loss) per share
Basic earnings per share includes no dilution and is computed by
dividing income available to common shareholders