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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, 1997 OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
COMMISSION FILE NUMBER: 0-27898
IDT CORPORATION
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(Exact name of registrant as specified in its charter)
DELAWARE 22-3415036
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation and organization)
294 STATE STREET
HACKENSACK, NEW JERSEY 07601
(Address of principal executive offices, including zip code)
(201) 928-1000
(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, $.01
par value
(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 28, 1997
of $18.00, as reported on the Nasdaq National Market, was approximately $160
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 have been excluded
from this computation in that such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily a conclusive determination
for other purposes.
As of October 28, 1997 the Registrant had outstanding 11,788,321 shares of
Common Stock, $.01 par value, and 10,410,371 shares of Class A Common Stock,
$.01 par value.
INDEX
IDT CORPORATION
ANNUAL REPORT ON FORM 10-K
PAGE NO.
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PART I
Item 1. BUSINESS................................................................................... 1
RISK FACTORS............................................................................... 18
Item 2. PROPERTIES................................................................................. 30
Item 3. LEGAL PROCEEDINGS.......................................................................... 31
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........................................ 31
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS...................... 32
Item 6. SELECTED FINANCIAL DATA.................................................................... 33
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS...... 34
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................................................ 41
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE....... 41
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT......................................... 42
Item 11. EXECUTIVE COMPENSATION..................................................................... 44
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT............................. 51
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS............................................. 52
PART IV
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K........................... 53
SIGNATURES.............................................................................................. 55
PART I
ITEM 1. BUSINESS
THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND
UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE
DISCUSSED IN THESE FORWARD-LOOKING STATEMENTS. FACTORS THAT COULD CAUSE OR
CONTRIBUTE TO SUCH DIFFERENCES INCLUDE, BUT ARE NOT LIMITED TO, THOSE DISCUSSED
IN THE "RISK FACTORS" SECTION OF ITEM 1. THE TERM "FISCAL YEAR," AS SET FORTH
HEREIN, REFERS TO THE TWELVE- MONTH PERIOD ENDING ON JULY 31 OF THE INDICATED
YEAR.
IDT Corporation ("IDT" or the "Company") is an international
telecommunications company which offers a broad range of integrated and
competitively priced long-distance telephone, Internet access and Internet
telephony services in the U.S. and abroad. The Company is an innovator in the
international telecommunications industry with its August 1996 introduction of
Net2Phone--the first commercial telephone service to bridge live calls between
personal computers and telephones via the Internet. The Company operates a
telecommunications network of switches and leased lines with interconnections to
other domestic and foreign carriers. As a result of industry deregulation,
increasing traffic volume, and an installed base of international customers, the
Company continues to build an international telecommunications infrastructure of
Company-owned switches and leased lines. As of July 31, 1997, IDT provides
international and domestic long-distance telephone services to over 60,000
individuals, businesses, and other telephone carriers in more than 130
countries. The Company has grown considerably in recent years, generating
revenues of $135.2 million for Fiscal 1997, versus revenues of $57.7 million for
Fiscal 1996 and revenues of $11.7 million for Fiscal 1995.
The Company operates a growing facilities-based telecommunications network
consisting of Company-owned switches in the United States and the United
Kingdom, dedicated leased fiber optic lines between the United States and United
Kingdom, and interconnections with interexchange carriers ("IXCs"), local
exchange carriers ("LECs") and government-owned postal, telegraph and telephone
monopolies ("PTTs") around the world. The Company has considerably grown its
international long distance customer base and routes a sufficient number of
international long distance minutes to cost-justify further network expansion.
The Company plans to expand its global telecommunications switching
infrastructure in order to reduce its operating costs and to broaden its
potential customer base. IDT plans to install Company-owned switches in France,
Germany and Italy by the end of fiscal 1998 and continues to pursue operating
agreements with overseas carriers to enable the Company to terminate traffic
directly to foreign carriers at advantageous rates. IDT also operates a national
Internet network comprised of multiple leased DS3 lines creating a 45 mbps high
speed backbone, together with leased T1 lines connecting approximately 75
Company-owned points of presence ("POPs") to the Company's Internet backbone.
Supplemented by its alliance partners, including PSINet Inc. ("PSI"), IDT now
operates one of the nation's largest Internet networks, which connects over 450
POPs owned by the Company and its Internet alliance partners. Through this
network, the Company provides dial-up and dedicated Internet access and on-line
service to approximately 85,000 individuals and business customers.
The Company is in the process of integrating its telecommunications and
Internet networks by enabling portions of the domestic Internet backbone to be
used for the transmission of both traditional and Internet telephony. If
successfully implemented, this leveraging of the available capacity over IDT's
Internet network could provide considerable economic efficiencies for
transporting much of the Company's domestic voice traffic. The Company believes
that the planned expansion of its international telecommunications network and
the integration of its networks through combined voice and data services, could
allow the Company to realize certain efficiencies and position itself among
those global telecommunications companies offering full service solutions and
employing innovative and converging technologies, which will enable it to
provide competitively priced international communications services.
The Company entered the international call reorigination business in 1990 to
capitalize on the opportunity created by the spread between U.S. and
foreign-originated international long-distance rates.
1
IDT leveraged the expertise derived from, and calling volume generated by, its
call reorigination business to enter the domestic long-distance business in late
1993, by reselling long-distance telecommunications services of other carriers
to IDT's domestic customers. As a value-added service for its domestic long-
distance customers, the Company began offering Internet access in early 1994,
eventually offering dial-up and dedicated Internet access to individuals and
businesses as stand-alone services. Throughout 1994, the Company focused on
developing and marketing its Internet services and offerings. In 1995, IDT began
reselling to other long-distance carriers access to the favorable international
and domestic long-distance telephone rates the Company obtains as a result of
its significant calling volume generated by its call reorigination customers. In
early 1996, the Company focused on the convergence between the
telecommunications circuit-switch and Internet packet-switch network by
developing its proprietary Internet telephony products. In August 1996, IDT
released a commercial version of it Net2Phone software enabling users to call
any phone in the world via the Internet using a multimedia PC.
The Company was founded in August 1990 and originally incorporated in New
York as "International Discount Telecommunications Corp." The Company was
renamed IDT Corporation and incorporated in the State of Delaware in December
1995. The Company's principal offices are located at 294 State Street,
Hackensack, New Jersey 07601, its main telephone number is (201) 928-1000 and
its website address is www.idt.net.
SERVICES
IDT offers its customers a wide array of domestic and international
telecommunications, Internet and Internet telephony services.
TELECOMMUNICATIONS SERVICES
The Company's four primary telecommunications services are: (i) carrier
services (wholesale international long distance provided to other carriers) (ii)
international long-distance services for individuals and businesses via call
reorigination services and international direct-dial services; (iii) marketing
to individuals and businesses of domestic long-distance services provided by
WorldCom, Inc. ("WorldCom"); and (iv) prepaid calling cards. IDT provides
international and domestic long-distance telephone service to over 60,000
customers in 130 countries worldwide, including over 25,000 international call
reorigination customers, and over 30,000 domestic long-distance services
customers.
INTERNATIONAL CARRIER SALES
The Company resells its competitive long-distance domestic and international
rates to third party IXCs and Competitive Access Providers ("CAPs"). In offering
this service, the Company leverages the rates that it is able to obtain through
(i) its extensive relationships in the long-distance telecommunications
industry, (ii) its inclusion in special tariffs written for a number of large
call reorigination clients, (iii) its ability to generate a high volume of
long-distance call traffic, and (iv) from advantageous rates negotiated with
foreign PTTs and competitive carriers. The Company enhances its ability to
resell such rates by using its least-cost routing ("LCR") platform to minimize
the per-minute resale cost to the third party IXC. Service is provided by
routing the IXC customer's minutes through the Company's LCR switching platform,
enabling the carrier customer to benefit from the competitive rates offered by
the Company. In some instances, instead of routing a call directly between two
overseas points, the Company may "back-haul" an overseas carrier's minutes using
resold switched services to the Company's U.S.-based switch in order to
terminate the traffic in a third country while taking advantage of the Company's
competitive U.S.-based international long distance rates.
INTERNATIONAL LONG-DISTANCE SERVICES
CALL REORIGINATION. The Company offers customers outside of the United
States international call reorigination services. Through this service, the
Company enables customers to access a U.S. dial tone
2
from overseas and place international calls that are reoriginated in the U.S.,
thereby benefiting from attractive U.S. outbound long-distance rates,
transmission quality, and enhanced services. In a typical call reorigination
scenario, an overseas customer dials a U.S. phone number and after one ring,
contact is made and the customer hangs up, with no charge for the inbound call.
The Company's switch then calls back a pre-set number and provides a U.S. dial
tone for the customer to connect and complete the call.
The Company also provides its 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 pre-programmed number; access to U.S. toll-free 888 and
800 numbers; and one-leg billing that combines the cost of the call back to the
customer and the cost of the customer's outbound call from the United States in
one item for convenience and orderly presentation. The Company primarily markets
its call reorigination service to fixed site businesses and individuals. As of
July 31, 1997, the Company had more than 25,000 international call reorigination
customers in 120 countries.
INTERNATIONAL DIRECT-DIAL. As an alternative service, the Company provides
international long-distance services to certain overseas customers, currently in
the United Kingdom, via standard international direct-dial network services.
Through this service, the Company offers a foreign customer the ability to place
a direct call to an international destination over the Company's leased network
at competitive rates without the need for call reorigination. In those markets
that are deregulating, the Company's strategy is to migrate its call
reorigination customers to international direct-dial service, where the
operating environments warrant. The Company expects to offer international
direct dial service in France and Germany by the end of Fiscal 1998. However,
there can be no assurance that the Company will be able to offer this service in
these countries.
DOMESTIC LONG-DISTANCE SERVICES
The Company markets certain long-distance services directly to customers in
the United States. Under an agreement with a leading facilities-based U.S.
long-distance carrier, the Company resells domestic and international
long-distance services directly to U.S. retail customers at competitive rates.
The Company's customers save, on average, 10--50% off the rates for domestic
long-distance service charged by the major facilities-based carriers. The
Company markets the long-distance service as a value-added bundled service with
its dial-up Internet access, and offers customers who maintain minimum monthly
long-distance billing levels of $40 savings of approximately 20% off the rates
for dial-up Internet access that are charged by the major national Internet
service providers.
PREPAID CALLING CARDS
The Company also markets prepaid calling cards providing access to more than
230 countries and territories and international call origination and
termination. The Company's debit cards provide payment convenience and are
rechargeable. The Company's customers save on average 10-50% off the rates for
international calls that are charged by the major facilities-based carriers.
INTERNET TELEPHONY
In August 1996, the Company began offering the first commercial telephone
service to bridge live calls between personal computers and regular telephones
via the Internet, and to charge for this service on a per minute basis. Through
the Company's Net2Phone service, which is based upon its proprietary technology,
customers can place calls from multimedia computers and have the calls terminate
at regular telephones. Upon installation of the Net2Phone software, which is
provided by the Company without
3
charge, a Net2Phone user receives a unique account number, and chooses his or
her own 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. Upon a user's payment for Net2Phone "minutes," which
are currently required to be purchased in advance, the user may begin using
Net2Phone to place telephone calls worldwide.
All telephone calls made with Net2Phone are routed over the Company's
telecommunications switches. The Company takes advantage of its existing LCR
platform to increase the savings realized by international callers using
Net2Phone. For calls originating overseas, the cost of placing and terminating
the call with Net2Phone is up to 95% below the rates generally charged by
traditional foreign carriers to place and terminate standard international
telephone calls.
Net2Phone is currently used by over 300,000 customers in over 180 countries.
Total usage of Net2Phone increased from approximately 220,000 minutes in October
1996 to approximately 9 million minutes in October 1997. More than 5,000,000
calls have been placed worldwide through Net2Phone subscribers since its launch.
In July 1997, Net2Phone was recognized as the "Product of the Week" by PC
Magazine.
In October 1997, the Company released for beta testing in Cleveland, Ohio,
and Portland, Oregon, Net2Phone Direct, a commercial telephone service that
allows for international phone-to-phone calling via the Internet using packet
switching technology. The Company expects to shortly introduce Net2Phone Direct
for beta testing in the cities of Charlotte, South Carolina, and Cincinnati,
Ohio, and has entered into agreements to provide Net2Phone Direct service in
South Korea. Net2Phone Direct enables phone-to-phone calling between two parties
using regular telephones while using the Internet to transport the long-haul
components of the call. Users of Net2Phone Direct are able to call a local or
toll-free access number, which connects the call to an outbound switch server,
which connects the call to the Internet. Through such use of the Internet, the
Company expects to reduce significantly the cost of international calling while
extending the benefits of placing Internet telephone calls to customers with
access to a regular telephone without requiring the use of personal computers or
individual Internet access. The Company also has announced its intention to
develop a global network of switches and servers, thereby expanding the
Company's reach for providing competitively priced Internet telephony solutions.
The Company believes that any delays in the deployment of Net2Phone and
Net2Phone Direct switches and servers could delay final product introduction.
There can be no assurance that Net2Phone or Net2Phone Direct will gain market
acceptance for the technology or for the quality of the completed call, or that
the Company's competitors will not develop the ability to provide similar or
better services. The Company believes that Internet telephony applications are
an important emerging niche in the Internet industry and that other companies
will enter the market to offer additional Internet telephony products. The
Company believes that Net2Phone and Net2Phone Direct expand the role of the
Internet as a communications medium and allow substantial long-distance
telecommunications savings. However, because of the Company's extensive
experience in both the Internet access and telecommunications industries, the
Company believes that it is well-positioned to gain a competitive advantage in
offering personal computer-to-telephone and telephone-to-telephone Internet
telephony solutions.
INTERNET AND ON-LINE SERVICES
The Company's three primary Internet and on-line services are: (i) dial-up
Internet access for individuals and businesses; (ii) direct-connect dedicated
Internet services for corporate customers; and (iii) the Genie on-line
entertainment and information services. IDT has become one of the nation's
largest Internet access providers, providing local dial-up access to 85,000
customers and providing dedicated access to approximately 400 corporate
customers as of July 31, 1997. Through the build-out of its own infrastructure
and the recent agreement to utilize the PSI network as well the local networks
of its alliance
4
partners, IDT now operates one of the nation's largest networks providing local
dial-up Internet access through over 450 POPs, of which the Company owns
approximately 75 POPs.
DIAL-UP ACCESS SERVICES
The Company markets a dial-up service that allows individuals to obtain
unrestricted Internet access with an easy-to-use point-and-click graphical user
interface for a fixed monthly fee. IDT provides its customers with access to a
full range of Internet applications, including e-mail functions, Web sites,
USENET news groups, databases and public domain software, as well as a full
graphics package and browser software.
The Company provides its individual customer base with various pricing
options. Currently, the Company offers Basic Accounts for $19.95 per month, and
Premium Accounts for $29.95 per month. Each is a fully graphical SLIPP/PPP
account bundled with an Internet browser, unlimited dial-up Internet access, and
an e-mail account. Premium Account customers are entitled to the Reuters news
service, a second e-mail address, 8MB of personal Web space storage, and special
customer support services. The Company also offers basic Internet access
accounts for $15.95 per month for those customers who sign up for IDT's
long-distance telephone service and maintain their monthly long-distance
telephone billings at or above $40 per month. The Company offers free Basic
Accounts for those customers who sign up for IDT's long-distance telephone
service and maintain their monthly telephone billings at or above $150 per
month.
DIRECT-CONNECT DEDICATED SERVICES
The Company offers a variety of Internet access options and applications
specifically designed to address the unique needs of corporations, as well as
business professionals. These direct-connect clients typically require
high-speed dedicated circuits because either they desire to put up a Web site,
the nature of their business requires the transfer of large data files, or it
would be impractical for them to maintan dial-up accounts for all their
employees who require Internet access. IDT employs both frame relay technology
and dedicated connections to connect its clients' computers to the Internet
through local area networks ("LANs") and both 56Kbps and T1 lines. Currently,
the Company maintains a corporate client base comprised principally of
medium-sized to large businesses. The Company currently charges clients using
56Kbps lines approximately $350 per month for direct-connect service and clients
utilizing full T1s approximately $1,400 per month for direct connect service. As
of July 31, 1997, the Company had 400 direct connect subscribers.
GENIE SERVICES
In addition, the Company offers the legacy Genie on-line service, giving
subscribers access to roundtables, bulletin boards and chat areas, individual
and multi-player games, and premium news, travel, entertainment, weather and
other information services. Currently, the Company markets the Genie content as
an on-line service available only to subscribers. The Company offers Internet
access to Genie on-line subscribers for an additional fee, and intends to offer
the basic Genie Interactive service as a value-added service for the Company's
premium Internet access customers.
NETWORK INFRASTRUCTURE
The Company maintains an international telecommunications switching
infrastructure and U.S. domestic network of leased lines that enable it to
provide an array of telecommunications, Internet and Internet telephony services
to its customers. IDT believes it enjoys competitive advantages by utilizing
this network to carry both voice and Internet traffic, resulting in the
optimization of both its network utilization and associated capital.
5
TELECOMMUNICATIONS NETWORK
PRIVATE LINE NETWORK
The Company operates a growing telephone network consisting of resold
international switched services, U.S. domestic dedicated leased fiber optic
lines, and Company-owned switch equipment in the United States which are
interconnected to major international and domestic IXCs, LECs and Competitive
Local Exchange Carriers. IDT's major switching facilities are located in
Piscattaway, NJ, Westfield, NJ, New York, NY and London. 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 LECs, allowing the Company to interconnect with all
major IXCs to switch traffic via the Company's leased private line DS3 network.
Furthermore, all of the Company's locations are interconnected via leased lines
to enhance network reliability and redundancy as each location interconnects
with the various carriers from diverse POPs.
In addition, the Company obtains switched services to connect its U.S.
facilities and London. These services are used for the origination of traffic
from IDT's customer base in the United Kingdom and to terminate existing carrier
and call reorigination traffic to the United Kingdom. The Company has recently
signed terminating agreements to the Dominican Republic, Italy, Bangladesh,
Cyprus and Peru, in addition to other countries and plans to obtain leased lines
to these destinations which will result in reduced costs for termination to
these countries. The Company has also targeted countries such as France, Italy
and Germany for network expansion due to the large number of minutes the Company
presently terminates to these countries and the Company's installed base of
telecommunications customers in these countries.
SWITCHING PLATFORMS
The Company utilizes two major switching platforms for different tasks. The
Excel LNX is a smart switch which the Company uses for its application-based
products such as callback, direct dial, call through, debit cards, calling
cards, and value added services such as voice prompts, speed dialing, voice mail
and conferencing. The other platform is the Northern Telecom DMS250-300, which
serves as an international gateway and generic carrier switch.
The Company also plans to use certain technologies, such as Northern Telecom
ERS switches, which allow for the dynamic allocation of voice and data traffic,
to enable the Company's Internet network to be used for the transmission of
traditional telephone minutes. If successfully developed, this leveraging of
IDT's Internet network could provide considerable economic efficiencies for
transporting much of the Company's domestic voice traffic.
The Company's Excel LNX switch incorporates Company-developed software which
efficiently performs all the applications the Company requires to provide
value-added services as well as billing and traffic analysis. The software
enables the Excel to route all calls via the Company's LCR platform. LCR is a
process by which the Company optimizes the routing of calls over the least cost
route on its switch for over 230 countries. In the event that traffic cannot be
handled over the least cost route due to overflow, the LCR system is designed to
transmit the traffic over the next least cost route. The LCR system analyzes the
following variables that may effect the cost of a long distance call: different
suppliers, different time zones and multiple choices of terminating carrier per
country. The LCR system is continually reviewed in light of rates available from
different suppliers to different countries to determine whether the Company
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. The Excel is flexible and programmable, designed
to implement network-based intelligence quickly and efficiently. All the
Company's 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.
6
INTERNET NETWORK
IDT operates a national Internet "network" comprised of a leased DS3 45 mbps
backbone of high speed fiber optic lines connecting eight major cities across
the United States, 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 Northern Telecom ERS Magellan
switches. The DS3 backbone drains traffic at four major Internet "meet" points
where the Company maintains switching and routing equipment and has peering
arrangements to exchange Internet traffic with over twenty other Internet
backbone providers. To minimize the potential detrimental effects of single
points of failure, the Company deploys 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
"bottlenecks" in the network. Also, major IDT backbone nodes employ routing
switches for directing network traffic. To further enhance network performance,
the "Open Shortest Path First" protocol is employed to optimally configure
Internet routing tables and to allow data traffic to be routed most efficiently.
The Company seeks to retain flexibility and to maximize its opportunities by
utilizing a continuously changing mix of routing alternatives. This diversified
approach is intended to enable the Company to take advantage of the rapidly
evolving Internet market in order to provide low cost service to its customers.
The Company utilizes the local dial-up switching infrastructure of several
alliance partners across the country to supplement the Company's owned and
operated local dial up infrastructure. The alliance partners, which are
independently-owned Internet Service Providers ("ISPs"), employ routing and
modem equipment which meet the Company's standards for providing dial-up access
services. The Company offers the alliance partners a monthly fee for each
customer account funneled through their local access networks. The Company also
provides the 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 the Company from constructing its own local installed POP where
warranted. Finally, the Company entered into an agreement with PSI in June 1996
to use PSI as the primary alliance partner for the Company's dial-up Internet
access customers in areas where PSI has POPs and where there are no pre-existing
alliance partners. The Company leases and operates a dedicated T3 connection to
the PSI network in order to maintain control of the Company's provisioning of
customers and to provide customers with access to electronic mail and newsfeeds.
The Company's Internet network includes over 405 POPs owned by PSI and the
alliance partners, and approximately 75 Company-owned POPs.
IDT's network is monitored on a 24 hours a day, 7 days a week, and 365 days
a year basis 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, two proprietary monitoring systems are
used to manage modem pools.
RESEARCH AND DEVELOPMENT
The Company employs a technical staff that is devoted to the improvement and
enhancement of the Company's existing Internet and telecommunications products
and services, including switching technologies and the development of new
technologies and products, such as Net2Phone and Net2Phone Direct. The Company
believes 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 Internet and
telecommunications industries. There can be no assurance that the Company 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. See "Risk Factors-Rapid Technological Development; Proprietary
Rights."
7
SALES, MARKETING AND DISTRIBUTION
The Company's overall marketing strategy is to leverage its promotional and
advertising resources to sell the Company's full range of telecommunications and
Internet services. By marketing its telephone and Internet services as bundled
and integrated solutions, the Company believes it can gain a competitive
advantage while enhancing its international recognition as a comprehensive
provider of competitively priced communications services. The Company has
changed its customer acquisition strategy from direct sales via heavy
advertising to a wholesale, OEM approach. While this has slowed the growth of
its customer base, the Company has been able to successfully lower its costs of
acquiring new subscribers.
TELECOMMUNICATIONS
The Company primarily markets its international call reorigination services
through its overseas network of independent sales representatives. The foreign
sales representatives, who are supervised by the Company's U.S.-based sales
managers, provide the Company with access to local business clientele and
residential customers and continually emerging opportunities in the local
markets they serve. The Company pays its foreign sales representatives on a
commission basis. As of July 31, 1997, the Company was represented by 200
foreign sales representatives in 70 countries. In recent months, the Company
also has commenced direct sales efforts, primarily through overseas advertising
in international print media, to penetrate particular market segments not
currently served.
The Company's internal international carrier sales staff obtains and
remarkets competitive rates to other IXCs. The staff primarily relies on, and
benefits from, (i) the Company's extensive relationships within and increasing
international exposure and recognition throughout the long-distance industry for
marketing its carrier services, (ii) the Company's self-perpetuating
telecommunications model which should enable the Company to negotiate for lower
rates, and (iii) favorable terminating rates negotiated with foreign PTTs and
carriers.
INTERNET
The Company established itself as a leading national provider of Internet
access services primarily through extensive broadcast print advertising to the
consumer market. During Fiscal 1997 the Company has refocused the marketing
efforts of its Internet operations. While the Company intends to continue
various means of broadcast advertising in select markets, the Company's sales
and marketing efforts now are focused primarily on increasing its Internet
customer base through (i) OEM transactions, including hardware, software and
operating system bundling, (ii) retail channel distribution agreements and (iii)
bundling Internet access with long-distance telephone service. By applying the
above strategies, the Company believes it will increase its exposure to the
millions of computer users who are potential customers of the Company's Internet
access services, while reducing its customer acquisition costs as compared to
traditional broadcast and print advertising. As of July 31, 1997, the Internet
sales force consisted of approximately 25 salespersons. The Company's Internet
sales staff is closely supervised and undergoes customized and ongoing training
to ensure the highest level of knowledge and service.
INTERNET/LONG-DISTANCE BUNDLING
The Company bundles its Internet access services with its domestic
long-distance telephone services in order to maximize the Company's marketing
efforts for its Internet services while allowing for the acquisition of
telephone customers. By bundling its long-distance phone service with its $15.95
per month discounted dial-up Internet access, the Company is currently able to
compete with many major national providers of Internet access by offering rates
that are, on average 20% lower, and at the same time differentiate itself from
its competitors in the Internet access market who are unable to offer their
customers significant savings on their monthly long-distance bills. The Company
leverages its existing inbound Internet telesales group for the sale of its
bundled long-distance and Internet access service.
8
INTERNET TELEPHONY
The Company is currently marketing its Net2Phone Internet telephony solution
by distributing its Net2Phone software for free via the Internet and acquiring
commercial Net2Phone customers through its pre-paid, virtual debit-card system.
IDT currently promotes its Net2Phone service through on-line and Internet-based
advertising venues, traditional print advertising in international publications,
and electronic media. In addition, the Company has entered into agreements to
bundle the required software for Net2Phone, as a value-added component, with the
software of other companies, and with other PC and computer equipment. The
Company has entered into exclusive agreements with resellers in certain
countries, pursuant to which such resellers purchase millions of Net2Phone
"minutes" in advance, and have resold such minutes to users in thier own
countries as direct sellers of Net2Phone. The Company is also seeking to sell
its Net2Phone Direct switch servers to third parties in strategic markets
world-wide by leveraging its existing international network of independent sales
representatives.
CUSTOMER SUPPORT AND BILLING
The Company provides customer support for its call reorigination customers
to deal with both technical questions and billing issues. The customer support
staff focuses on responding rapidly to customers and is generally capable of
activating call reorigination service for new customers in 24 to 48 hours from
the time of subscription.
The Company believes that, in order to successfully compete in the
international call reorigination business, effective billing and collection
procedures and policies are necessary because the geographic dispersal of call
reorigination clients creates the potential for billing and collection
difficulties. Call reorigination customers have the option of either providing
the Company with a credit card or giving a security deposit or advance payment.
The Company reviews all account usage on a daily basis, regardless of the
payment mechanism. The Company charges credit card customers throughout the
month, whenever accumulated usage equals $250 dollars, and provides detailed
billing statements once a month. For cash customers, the Company generally
accepts either a two-month deposit or a prepayment. Via the daily monitoring
system, the Company attempts to prevent such customers from exceeding their
balance on hand at the Company. If a charge or credit card is declined or if the
customer has inadequate funds on deposit, the Company suspends the account to
minimize the Company's exposure to unauthorized usage. In addition, the Company
is developing a real-time billing platform for its call reorigination customers.
The Company expects this service to both provide more efficient customer service
and allow the Company to further limit its exposure to bad debt.
The Company believes that its ability to provide adequate customer support
services is a crucial component of its ability to retain customers. While the
Company has experienced difficulty in the provision of support services in the
past, it has successfully focused on improving such service through 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. The Company requires
that each customer support staff member field a minimum number of calls and
e-mails each day. The Company also employs liaisons between the customer support
and technical staffs to ensure maximum responsiveness to changing customer
demands.
9
COMPETITION
The markets in which the Company operates are extremely competitive and can
be significantly influenced by the marketing and pricing decisions of the larger
industry participants. Their barriers to entry are not insurmountable in either
the Internet access or any of the telecommunications markets in which the
Company competes. The Company expects competition in these markets to intensify
in the future.
TELECOMMUNICATIONS
Currently, the Company competes with (i) IXCs engaged in the provision of
long-distance access and other long-distance resellers and providers including
large carriers such as AT&T Corp. ("AT&T"), MCI Communications Corp. ("MCI"),
Sprint Corp. ("Sprint"), and WorldCom, (ii) foreign PTTs, (iii) other marketers
of international long-distance and call reorigination services such as Viatel,
Inc., Kallback, and RSL Communications, Ltd., (iv) wholesale providers of
international long distance services such as Pacific Gateway Exchange, Inc., (v)
alliances for providing wholesale carrier services such as "Global One" (Sprint,
Deutsche Telekom AG, and France Telecom S.A.) and "Concert" (British Telecom Plc
and MCI), and Uniworld (AT&T and Unisource--Telecom Netherlands, Telia AB, Swiss
Telecom PTT and Telefonica de Espana S.A.), (vi) new entrants to the long
distance market such as the regional bell operations companies ("RBOCs") in the
United States, who have entered or have announced plans to enter the U.S. intra
and interstate long-distance market pursuant to recent legislation authorizing
such entry, and utilities such as RWE AG in Germany, and (vii) small resellers
and facility-based IXCs. Moreover, some of the Company's competitors have
announced business plans similar to the Company's regarding the expansion of
telecommunications networks into Europe. Many of the Company's competitors are
significantly larger and have substantially greater market presence as well as
financial, technical, operational, marketing and other resources and experience
than the Company.
Because of their close ties to their national regulatory authorities,
foreign PTTs and newly-privatized versions thereof can directly pressure the
Company in their home countries by influencing regulatory authorities to outlaw
the provision of call reorigination services or by blocking access to the call
reorigination services the Company markets. There can be no assurance that such
behavior will not have a material adverse effect on the Company's business,
financial condition or results of operations. With the increasing privatization
of international telecommunications in foreign countries, it is also possible
that new foreign service providers, with close ties to their national regulatory
authorities and customer bases, will enter the call reorigination services
market in competition with the Company, or that PTTs will become deregulated and
gain the pricing flexibility to compete more effectively with the Company. The
ability of a deregulated PTT to compete on the basis of greater size and
resources and long-standing relationships with customers in its own country
could have a material adverse effect on the Company's business, financial
condition or results of operations.
The large U.S. long-distance carriers have, in the past, been reluctant to
compete directly with the PTTs by entering the international call reorigination
business and attempting to capture significant market share of the domestic
customers of the incumbent foreign PTTs. However, there can be no assurance that
other large carriers will not enter the call reorigination industry. Because of
their ability to compete on the basis of superior financial and technical
resources, the entry of AT&T or any other large U.S. long-distance carrier into
the international call reorigination business could have a material adverse
effect on the Company's business, financial condition or results of operations.
Also, the FCC's approval of call reorigination services where no foreign country
proscribes it is likely to stimulate additional entry by small carriers who
might target the same customer base as the Company does, which could have a
material adverse effect on the Company's business, financial condition or
results of operations.
Competition for customers in the telecommunication markets the Company
competes in is primarily on the basis of price and, to a lesser extent, on the
basis of the type and quality of service offered. Increased competition could
force the Company to reduce its prices and profit margins if the Company's
10
competitors are able to procure rates or enter into service agreements
comparable to or better than those the Company obtains, or to offer other
incentives to existing and potential customers. Similarly, the Company has no
control over the prices set by its competitors in the long-distance resale
carrier-to-carrier market. The Company could also face significant pricing
pressure if it experiences a decrease in its market share of international
long-distance traffic, as the Company's ability to obtain favorable rates and
tariffs depends, in large part, on the volume of international long-distance
call traffic the Company can generate for third-party IXCs. There is no
guarantee that the Company will be able to maintain the volume of domestic and
international long-distance traffic necessary to obtain favorable rates and
tariffs. Although the Company has no reason to believe that its competitors will
pursue directly aggressive pricing policies that could adversely affect the
Company, there can be no assurance that such price competition will not occur or
that the Company will be able to compete successfully in the future. In
addition, the Company is aware that its ability to market its carrier services
depends upon the existence of spreads between the rates offered by the Company
and those offered by the IXCs with whom it competes as well as those from whom
it obtains service. A decrease in such spreads could have a material adverse
effect on the Company's business, financial condition or results of operations.
INTERNET ACCESS
The Company's current and prospective competitors include many large
companies that have substantially greater market presence and financial,
technical, operational, marketing and other resources and experience than the
Company. The Company's Internet access business competes or expects to compete
directly or indirectly with the following categories of companies: (i) other
national and regional commercial Internet access providers, such as Netcom
On-Line Communications Services, Inc. ("NETCOM") and PSI; (ii) established
on-line services companies that offer Internet access, such as America Online,
Inc. ("AOL"), CompuServe Corp. ("CompuServe") and Prodigy Services Company
("Prodigy"); (iii) software and technology companies such as Microsoft
Corporation ("Microsoft"); (iv) national long-distance telecommunications
carriers, such as AT&T, MCI, and Sprint; (v) RBOCs; (vi) cable television
operators, such as Comcast Corporation ("Comcast"), Tele-Communications, Inc.
("TCI") and Time Warner Inc. ("Time Warner"); (vii) nonprofit or educational
Internet service providers; (viii) newly licensed providers of spectrum-based
wireless data services; and (ix) competitive local telephone service providers
such as Teleport Communications Group ("TCG") and Metropolitan Fiber Systems
("MFS").
Many of the established on-line services companies and telecommunications
companies, such as AT&T and the RBOCs, have begun to offer or announced plans to
offer expanded Internet access services. The Company expects that all of the
major on-line services companies will eventually compete fully in the Internet
access market. In addition, the Company believes that new competitors, including
large computer hardware and software, cable, media, wireless, and wireline
telecommunications companies such as the RBOCs, will enter the Internet access
market, resulting in even greater competition for the Company. The ability of
these competitors or others to bundle services and products not offered by the
Company with Internet access services could place the Company at a significant
competitive disadvantage. In addition, certain of the Company's competitors that
are telecommunications companies may be able to offer customers reduced
communications charges in connection with their Internet access services or
other incentives, reducing the overall cost of their Internet access services
and increasing price pressures on the Company. This price competition could
reduce the average selling price of the Company's services. In addition,
increased competition for new subscribers could result in increased sales and
marketing expenses and related subscriber acquisition costs, which could
materially adversely affect the Company's profitability. There can be no
assurance that the Company will be able to offset the effects of any such price
reductions or incentives with an increase in the number of its customers, higher
revenue from enhanced services, cost reductions or otherwise.
Competition is also expected to increase in overseas markets, where Internet
access services have only recently been introduced. There can be no assurance
that the Company will be able to increase its presence
11
in the overseas markets it presently serves, or to enter other overseas markets.
There can be no assurance that the Company will be able to obtain the capital
required to finance such continued expansion. In addition, there can be no
assurance that the Company will be able to obtain the permits and operating
licenses required for it to operate, hire and train employees or market, sell
and deliver services in foreign countries. Further, entry into foreign markets
will result in competition from companies that may have long-standing
relationships with or possess a better understanding of their local markets,
regulatory authorities, customers and suppliers. There can be no assurance that
the Company can obtain similar levels of local knowledge, and failure to obtain
that knowledge could place the Company at a significant competitive
disadvantage. To the extent the ability to provide access to locations and
services overseas becomes a competitive advantage in the Internet access
industry, failure of the Company to penetrate overseas markets or to increase
its presence in the overseas markets it presently serves may result in the
Company being at a competitive disadvantage relative to other Internet access
providers.
The Company believes that its ability to compete successfully in the
Internet access market depends upon a number of factors, including: market
presence; the adequacy of the Company's customer support services; the capacity,
reliability and security of its network infrastructure; the ease of access to
and navigation of the Internet; the pricing policies of its competitors and
suppliers; regulatory price requirements for interconnection to and use of
existing local exchange networks by Internet services; the timing of
introductions of new products and services by the Company and its competitors;
the Company's ability to support existing and emerging industry standards; and
trends within the industry as well as the general economy. There can be no
assurance that the Company will have the financial resources, technical
expertise or marketing and support capabilities to continue to compete
successfully in the Internet access market.
INTERNET TELEPHONY
Numerous companies have entered the Internet telephony market in the past
year and a half and have established their Internet telephony products in the
marketplace before the Company's August 1996 introduction of its Net2Phone
service and imminent release of Net2Phone Direct. Most of the current Internet
telephony products enable voice communications over the Internet between two
parties simultaneously connected to the Internet via multimedia-equipped
personal computers, where both parties are using identical Internet telephony
software products. These products include Internet Phone form VocalTec Ltd.
("VocalTec"), WebPhone from QuarterDeck Corporation ("QuarterDeck") and
NetMeeting from Microsoft. Recently, Intel Corporation announced a new
technology aimed at standardizing and improving the compatibility of the various
Internet telephony software products, enabling customers of different Internet
telephony software products to communicate with one another over the Internet.
Furthermore, a number of companies including Dialogic Corp. ("Dialogic") and
Northern Telecom Limited ("Northern Telecom") have developed or announced their
intentions to offer server-based products which are expected to allow
communications over the Internet between parties using a personal computer and
regular telephone and between two parties using telephones where both parties
have these specialized servers at both ends of the call. While the Company's
Net2Phone and Net2Phone Direct services differ from the above mentioned products
in that they allow PC-to-telephone and phone-to-phone communications over the
Internet, with the Internet transmission service connected to the public
switched telephone network at centralized switching platforms owned by the
Company, and where users of the service are billed on a per-minute basis, there
can be no assurance that the Company will be able to successfully compete in the
developing Internet telephony market. Although Internet telephony continues to
be an area of intense focus from various Internet software providers,
traditional telephone service companies and telephone equipment manufacturers,
there can be no assurance that Internet telephony will gain market acceptance or
prove to be a viable alternative to traditional telephone service. Many
international telephone callers, accustomed to the convenience and quality of
phone-to-phone international calling via traditional circuit switch telephone
networks, may not switch to Internet telephony services notwithstanding the
potential cost savings.
12
REGULATION
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 in the United States, the Company's provision of
international and national long distance telecommunications services is
generally regulated on a streamlined basis. 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 not yet
open to switched voice service competition, the Company provides services to
closed user groups ("CUGs") and a variety of value-added services as permitted
by each country's laws.
REGULATION OF DOMESTIC TELECOMMUNICATIONS SERVICES. In the United States,
provision of the Company's services is subject to the provisions of the
Communications Act, as amended by the Telecommunications Act of 1996 and the FCC
regulations promulgated thereunder, as well as the applicable laws and
regulations of the various states administered by the relevant state PSCs. The
recent trend in the United States, for both federal and state regulation of
telecommunications service providers, has been in the direction of reducing
regulation. Nonetheless, the FCC and relevant state PSCs 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. On March 21, 1997, the FCC initiated a proceeding in
which it proposed to eliminate the requirement that non-dominant interstate
carriers such as the Company maintain tariffs on file with the FCC for domestic
interstate services. The FCC's proposed rules are pursuant to authority granted
to the FCC in the Telecommunications Act to "forbear" from regulating any
telecommunications service provider if the FCC determines that the public
interest will be served. The FCC subsequently adopted its proposal and
eliminated the requirement that interstate carriers file domestic tariffs. That
decision has been appealed to the Federal Court of Appeals for the 8th Circuit
and a stay has been issued pending a decision on the merits of the appeal. It is
unclear when the Court will rule on the appeal.
On May 8, 1997, the FCC issued an order to implement the provisions of the
Telecommunications 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 a fund (the
"Universal Service Fund"). Universal service contributions will be assessed
based on intrastate, interstate, and international "end-user" gross
telecommunications revenues effective January 1, 1998. All carriers were
required to submit a Universal Service Fund Worksheet in September 1997. The
Company has filed its Universal Service Fund worksheet. Although the FCC has not
yet determined the contribution assessment rate, the Company estimates the
assessment could be as much as 4.5% or more of such revenues for the calendar
year 1998, and would increase in subsequent years.
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 is certified to
provide intrastate interexchange telecommunications services in 43 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.
U.S. REGULATION OF INTERNATIONAL TELECOMMUNICATIONS SERVICES. International
common carriers, such as the Company, are required to obtain authority under
Section 214 of the Communications Act and file a tariff containing the rates,
terms and conditions applicable to their services prior to initiating their
international telecommunications services. The Company has obtained a "global"
Section 214 authority
13
from the FCC to use, on a facilities and resale basis, various transmission
media for the provision of international switched and private line services.
Non-dominant international carriers such as the Company must file their
international tariffs and any revisions thereto with one day's notice.
Additionally, international telecommunications service providers are required to
file copies of their contracts with other carriers, including foreign carrier
agreements, with the FCC within 30 days of execution. The FCC's rules also
require that the Company file periodically a variety of reports regarding the
volume of its international traffic and revenues and use of international
facilities. In addition to the general common carrier principles, and as
discussed below, the Company is also required to conduct its facilities-based
international business in compliance with the FCC's International Settlements
Policy ("ISP"), or an FCC approved alternative accounting rate arrangement.
The Company's FCC authorizations also permit the Company to resell
international private lines interconnected to the PSTNs for the provision of
switched services in those countries that have been found by the FCC to offer
"equivalent opportunities" to U.S. carriers. To date, the FCC has found that
only Canada, the United Kingdom, Sweden and New Zealand offer such
opportunities. The FCC currently imposes certain restrictions upon the use of
the Company's private lines between the United States and "equivalent"
countries. The Company may not route traffic to or from the United States over a
private line between the United States and an "equivalent" country (I.E., the
united Kingdom) if such traffic originates or terminates in a third country, if
the third country has not been found by the FCC to offer "equivalent" resale
opportunities. Following implementation of the Full Competition Directive by EU
member states, and the World Trade Organization ("WTO") Agreement by the
signatories, the FCC may authorize the Company to originate and terminate
traffic over its private line between the United States and the United Kingdom
and (pursuant to ISR authority) over additional private lines to additional
member states if the FCC finds that such additional member states provide
equivalent resale opportunities or that such authority would otherwise promote
competition. The FCC has also recently proposed to permit U.S. carriers to
provide ISR to WTO member countries without a finding of equivalency.
With regard to international services, the FCC administers a variety of
international service regulations, including the International Settlements
Policy ("ISP"). The ISP governs the permissible arrangements between U.S.
carriers and their foreign correspondents to settle the cost of terminating
traffic over each other's networks, the rates for such settlement and
permissible deviations from these policies. As a consequence of the increasingly
competitive global telecommunications market, the FCC has adopted a number of
policies that permit carriers to deviate from the ISP under certain
circumstances that promote competition. The FCC also requires carriers such as
the Company to report any affiliations, as defined by the Commission, with
foreign carriers.
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. Indeed, the FCC recently adopted new
lower accounting rate "benchmarks" that become effective in January 1, 1998.
Under the FCC's new benchmarks, after a transition period of one to four years
depending on a country's income level, U.S. carriers will be required to pay
foreign carriers significantly lower rates for the termination of international
services. These rates range from $.15/minute benchmark for upper income
countries such as the United Kingdom to $.23/minute for lower income countries
such as China. Moreover, the FCC recently initiated a proceeding proposing to
revise its Foreign Carrier Entry Policy as part of its efforts to change its
rules to implement the WTO Agreement. In addition, the FCC is currently
considering whether to limit or prohibit the practice whereby a carrier routes,
through its facilities in a third country, traffic originating from one country
and destined for another country. The FCC has permitted third country calling
where all countries involved consent to the routing arrangements (referred to as
"transiting"). Under certain arrangements referred to as "refiling," the carrier
in the destination country does not consent to receiving traffic from the
originating country and does not realize
14
the traffic it receives from the third country is actually originating from a
different country. The FCC to date has made no pronouncement as to whether
refiling arrangements are inconsistent with U.S. or ITU regulations, although it
is considering these issues in connection with MCI's 1995 petition to the FCC
for declaratory ruling regarding Sprint's FONACCESS service. It is possible that
the FCC will determine that refiling violates U.S. and/or international law.
EUROPEAN REGULATION OF TELECOMMUNICATIONS SERVICES. In Europe, the
regulation of the telecommunications industry is governed at a supra-national
level by the EU (consisting of the following member states: Austria, Belgium,
Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the
Netherlands, Portugal, Spain, Sweden, and the United Kingdom), which is
responsible for creating pan-European policies and, through legislation, has
developed a regulatory framework to ensure an open, competitive
telecommunications market. The EU was established by the Treaty of Rome and
subsequent conventions and is authorized by such treaties to issue EU
"directives." EU member states are required to implement these directives
through national legislation. If an EU 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 1990, the EU issued the Services Directive requiring each EU member state
to abolish existing monopolies in telecommunications services, with the
exception of voice telephony. The intended effect of the Services Directive was
to permit the competitive provision of all services other than voice telephony,
including value-added services and voice services to CUGs. However, as a
consequence of local implementation of the Services Directive through the
adoption of national legislation, there are differing interpretations of the
definition of prohibited voice telephony and permitted value-added and CUG
services. Voice services accessed by customers through leased lines are
permissible in all EU member states. The European Commission has generally taken
a narrow view of the services classified as voice telephony, declaring that
voice services may not be reserved to the ITOs if (i) dedicated customer access
is used to provide the service, (ii) the service confers new value-added
benefits on users (such as alternative billing methods) or (iii) calling is
limited by a service provider to a group having legal, economic or professional
ties.
In March 1996, the EU adopted the Full Competition Directive containing two
provisions which required EU member states to allow the creation of alternative
telecommunications infrastructures by July 1, 1996, and which reaffirmed the
obligation of EU member states to abolish the ITOs' monopolies in voice
telephony by 1998. The Full Competition Directive encouraged EU member states to
accelerate liberalization of voice telephony. To date, Sweden, Finland, Denmark
and the United Kingdom have liberalized facilities-based services to all routes.
Certain EU countries may delay the abolition of the Voice Telephony monopoly
based on exemptions established in the Full Competition Directive. These
countries include Spain (1998), Portugal and Ireland (January 1, 2000) and
Greece (2003).
Each EU member state in which the Company currently conducts or plans to
conduct its business has a different regulatory regime and such differences are
expected to continue beyond January 1998. The requirements for the Company to
obtain necessary approvals vary considerably from country to country and are
likely to change as competition is permitted in new service sectors.
OTHER OVERSEAS MARKETS.
The Company is subject to the regulatory regimes in each of the countries in
which it conducts business. Local regulations range from permissive to
restrictive, depending upon the country. In the past, the Company has
experienced problems in certain countries and has, in certain instances,
modified or terminated its services to comply with local regulatory
requirements.
15
INTERNET
Internet access providers are generally considered "enhanced service
providers" and are exempt from federal and state regulations governing common
carriers. Accordingly, the Company's provisioning of Internet services are
currently exempt from tariffing, certification, and rate regulation.
Nevertheless, regulations governing disclosure of confidential communications,
copyright, excise tax, as well as other requirements may apply to IDT's
provision of Internet services. The Company cannot predict the likelihood that
state, federal or foreign governments will impose additional regulation on the
Company's Internet business, nor can it predict the impact that future
regulation will have on the Company's operations.
The 1996 Telecommunications Act imposes criminal liability on persons
sending or displaying in a manner available to minors indecent material on an
interactive computer service such as the Internet. The 1996 Telecommunications
Act also imposes criminal liability on an entity knowingly permitting facilities
under its control to be used for such activities. Entities solely providing
access to facilities not under their control are exempted from liability, as are
service providers that take good faith, reasonable, effective and appropriate
actions to restrict access by minors to the prohibited communications. The
constitutionality of these provisions has been successfully challenged in
federal appellate court, and the interpretation and enforcement of them is
uncertain. The Act may decrease demand for Internet access, chill the
development of Internet content, or have other adverse effects on Internet
access providers such as the Company. In addition, in light of the uncertainty
attached to interpretation and application of this law, there can be no
assurances that the Company would not have to modify its operations to comply
with the statute, including prohibiting users from maintaining home pages on the
WWW, and increasing its control over the GENIE INTERACTIVE content.
In December 1997, the FCC initiated a Notice of Inquiry ("NOI") regarding
whether to impose regulation or surcharges upon providers of Internet access and
Information Service ("Internet NOI"). The Internet NOI seeks public comment upon
whether to impose or continue to forebear from regulation of Internet and other
packet-switched network service providers. The Internet NOI specifically
identifies Internet telephony as a subject for FCC consideration. The Company
can not predict the outcome of the FCC proceeding or the impact of any
additional regulations or charges the FCC may impose on IDT's Internet and
Internet telephony businesses.
INTERNET TELEPHONY
The Company knows of no domestic or foreign laws that prohibit voice
communications over the Internet. As identified above, the FCC is currently
considering whether or not to impose surcharges or additional regulation upon
providers of Internet telephony. In addition, several efforts have been made to
enact federal legislation that would either regulate or exempt from regulation
services provided over the Internet. State public utility commissions may also
retain jurisdiction to regulate the provision of intrastate Internet telephone
services and could initiate proceedings to regulate Internet telephony. If a
foreign government, Congress, the FCC, or a state utility commission regulate
Internet telephony, there can be no assurances that any such regulation will not
materially adversely affect the Company's business, financial condition or
results of operation.
INTELLECTUAL PROPERTY
The Company's success and ability to compete is dependent in part upon its
technology, although the Company believes that its success is more dependent
upon its technical expertise than its proprietary rights. The Company relies on
a combination of patent, copyright, trademark and trade secret laws and
contractual restrictions to establish and protect its technology. The Company
does not have any issued patents or registered copyrights, although it has
registered trademarks in connection with the Genie services and other pending
applications for a patent and certain trademarks. The Company requires
16
employees and consultants to execute confidentiality agreements upon the
commencement of their relationships with the Company. These agreements provide
that confidential information developed or made known during the course of a
relationship with the Company is to be kept confidential and may not be
disclosed to third parties except in specific circumstances. There can be no
assurance that the steps taken by the Company will be adequate to prevent
misappropriation of its technology or other proprietary rights or that the
Company's competitors will not independently develop technologies that are
substantially equivalent or superior to the Company's technology. In addition,
there can be no assurance that licenses for any intellectual property that might
be required by the Company for it to provide its services or products would be
available on reasonable terms, if at all.
The Company owns a trademark registrations for the mark GENIE. The Company
has also registered the service mark IDT and its logo. In addition, the Company
has applications pending with respect to the registration of the service marks
IDT, NET2PHONE, N2P, AMTALK, Amtalk design, and NET2FAX. In addition, the
Company has applied for a patent in connection with its development of the
systems and methodology comprising the technologies underlying Net2Phone. There
can be no assurance that the Company's competitors will not develop the ability
to provide similar or better services than that of Net2Phone. In addition, there
can be no assurance that the Company's patent application relating to the
systems and methodology comprising the technologies underlying Net2Phone will
result in any patent being issued or that, if issued, any patent will provide
protection against competitive technology or will be held valid and enforceable
if challenged, or that the Company's competitors would not be able to design
around such patent; nor can there be any assurance that others will not obtain
patents that the Company would need to license or circumvent to practice its
patent. See "Risk Factors-Dependence on Technological Development."
EMPLOYEES
As of July 31, 1997, the Company had approximately 360 full-time employees,
including approximately 120 in technical support and customer service, 75 in
sales and marketing, 50 in its technical staff, 75 in general operations and 40
in management and finance. The Company believes that its relations with its
employees are good. None of the Company's employees is represented by a labor
union or covered by a collective bargaining agreement and the Company has never
experienced a work stoppage.
17
RISK FACTORS
FORWARD-LOOKING STATEMENTS. THIS 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. SUCH
FORWARD-LOOKING STATEMENTS INCLUDE, AMONG OTHER THINGS, THE COMPANY'S PLANS TO
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 COMPANY'S EXPECTATIONS CONCERNING FACTORS AFFECTING
THE MARKETS FOR ITS PRODUCTS, SUCH AS DEMAND FOR LONG-DISTANCE
TELECOMMUNICATIONS, INTERNET ACCESS AND ON-LINE AND INTERNET TELEPHONY SERVICES.
ACTUAL RESULTS COULD DIFFER FROM THOSE PROJECTED IN ANY FORWARD-LOOKING
STATEMENTS FOR THE REASONS DETAILED IN THE "RISK FACTORS" BELOW AS WELL AS IN
OTHER SECTIONS OF THIS REPORT ON FORM 10-K. THE FORWARD-LOOKING STATEMENTS ARE
MADE AS OF THE DATE OF THIS 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 THE RISK FACTORS AND THE OTHER INFORMATION
SET FORTH FROM TIME TO TIME IN THE COMPANY'S REPORTS ON FORM 10-Q, 8-K, 10-K AND
ANNUAL REPORT TO STOCKHOLDERS.
LIMITED OPERATING HISTORY; OPERATING LOSSES; FLUCTUATIONS IN OPERATING RESULTS
The Company commenced operations in August 1990 as one of the first
providers of international call reorigination, or call-back services and entered
the Internet access business in February 1994. Accordingly, the Company has only
a limited operating history upon which an evaluation of it and its prospects can
be based. Although the Company has experienced substantial revenue growth since
its incorporation, it has incurred losses of approximately $300,000, $2.1
million, $15.6 and $3.8 million in Fiscal 1994, Fiscal 1995, Fiscal 1996, and
Fiscal 1997 respectively. As of July 31, 1997, the Company had an accumulated
deficit of approximately $21.9 million. The Company's current focus is on
expanding its network infrastructure to achieve economies of scale, improve
network performance, and enable the Company to expand its geographic reach for
potential telecommunications and Internet subscribers. Consequently, the Company
continues to make capital expenditures and incur additional operating costs to
hire additional personnel and increase its expenses related to product
development, marketing, network infrastructure, technical resources and customer
support. The pursuit of such objectives can be expected to have an adverse
impact on the Company's profit margins for at least the near-term and until the
Company can increase its customer bases sufficiently to recover the costs of
such expansions. In addition, an acceleration in the growth of the Company's
subscriber bases or changes in usage patterns among subscribers may also
increase the Company's costs as a percentage of revenues. There can be no
assurance that revenue growth will continue or that the Company will be
profitable in Fiscal 1998 or will at any time in the future achieve or sustain
profitability.
The Company's quarterly operating results have fluctuated in the past as the
Company's business has evolved, and may fluctuate significantly in the future as
a result of a variety of factors, some of which are outside of the Company's
control. These factors include general economic conditions, acceptance and use
of the Internet, user demand for long-distance telecommunications services,
capital expenditures and other costs relating to the expansion of operations,
the timing and costs of any acquisitions of technologies or businesses,
government regulation, the timing of new product announcements by the Company or
its competitors, changes in pricing strategies by the Company or its
competitors, changes in the mix of services sold by the Company market
availability and acceptance of new and enhanced versions of the Company's or its
competitors' products and services and the rates of new subscriber acquisition
and retention. These factors could also have a material adverse effect on the
Company's business, financial condition or results of operations. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations-Quarterly Results of Operations."
RISKS OF EXPANSION AND IMPLEMENTATION OF GROWTH STRATEGY
The Company's rapid growth and expansion into new businesses have placed,
and may continue to place, a strain on the Company's management, administrative,
operational, financial and technical
18
resources and increased demands on its systems and controls. Demands on the
Company's network resources and technical staff and resources have grown rapidly
with the Company's expanding customer bases, and the Company has in the past
experienced difficulties satisfying the demand for its services. The Company has
experienced delays in shipping the Company's software, resulting in billing
subscribers in advance of software receipt, and from time to time, subscribers
have experienced significant delays both in accessing the Internet through the
Company's modems and in contacting, and in receiving responses from, the
Company's customer and technical support personnel. In certain situations, these
events have created customer relations issues for the Company and resulted in
cancellations of subscriptions. There can be no assurance that the Company's
improved technical staff and resources will be adequate to facilitate the
Company's growth. A failure to effectively provide customer and technical
support services will affect adversely the Company's ability to attract and
maintain its customer base. The Company expects to experience continued strain
on its operational systems as it develops, operates and maintains its network.
Expected increases in the Company's telecommunications customer and Internet
subscriber bases will produce increased demands on its sales, marketing and
administrative resources, its engineering and technical resources, and its
customer and technical support resources, as well as on its switching and
routing capabilities and network infrastructure. As of July 31, 1996 and July
31, 1997, the Company had approximately 462 and 360 employees, respectively. The
Company believes that it will need, both in the short-term and the long-term, to
hire additional sales and marketing and technical personnel as well as qualified
administrative and management personnel in its accounting and finance areas to
manage its financial control systems. Although the Company has hired additional
personnel and upgraded certain of its systems, there can be no assurance that
the Company's administrative, operating and financial control systems,
infrastructure, personnel and facilities will be adequate to support the
Company's future operations or to maintain and effectively adapt to future
growth.
There can be no assurance that the Company will be able to install
additional POPs, or expand its telecommunications infrastructure, add services,
expand its customer bases and geographical markets or implement the other
features of its business strategy at the rate or to the extent presently
planned. There can be no assurance that IDT's business strategy will be
successful. The Company's ability to continue to grow may be affected by various
factors, many of which are not within the Company's control, including U.S. and
foreign regulation of the telecommunications and Internet industries,
competition and technological developments. Part of the Company's growth
strategy is dependent upon the continued deregulation of foreign
telecommunications markets. There can be no assurance that such deregulation
will occur when or to the extent anticipated. The effect of foreign deregulation
on the Company is also uncertain. While the Company expects that deregulation
will give rise to new opportunities, the increase in competition expected to
result from deregulation could cause the Company's call reorigination business
to suffer and could have other material adverse effects on the business,
financial condition or results of operations of the Company. The inability to
continue to upgrade the networking systems or the operating and financial
control systems, the inability to recruit and hire necessary personnel or the
emergence of unexpected expansion difficulties could have a material adverse
effect on the Company's business, financial condition or results of operations.
INCREASING COMPETITION
The markets in which the Company operates are extremely competitive and can
be significantly influenced by the marketing and pricing decisions of the larger
industry participants. There are no substantial barriers to entry in either the
Internet access or any of the telecommunications markets in which the Company
competes. The Company expects competition in these markets to intensify in the
future.
TELECOMMUNICATIONS
Currently, the Company competes with (i) IXCs engaged in the provision of
long-distance access and other long-distance resellers and providers including
large carriers such as AT&T, MCI, Sprint, and
19
WorldCom, (ii) foreign PTTs, (iii) other marketers of international
long-distance and call reorigination services such as Viatel, Kallback, and RSL
Communications, (iv) wholesale providers of international long distance services
such as Pacific Gateway, (v) alliances for providing wholesale carrier services
such as "Global One" (Sprint, Deutsche Telekom, and France Telecom), "Concert"
(British Telecom and MCI) and Uniworld (AT&T and Unisource--Telecom Netherlands,
Telia AB, Swiss Telecom PTT and Telefonica de Espana S.A.), (vi) new entrants to
the long distance market such as the RBOCs in the United States, who have
entered or have announced plans to enter the U.S. interstate long-distance
market pursuant to recent legislation authorizing such entry, and utilities such
as RWE in Germany, and (vii) small resellers and facility-based IXCs. Moreover,
some of the Company's competitors have announced business plans similar to the
Company's regarding the expansion of telecommunications networks into Europe.
Many of the Company's competitors are significantly larger and have
substantially greater market presence and financial, technical, operational,
marketing and other resources and experience than the Company.
Because of their close ties to their national regulatory authorities,
foreign government-owned PTTs may directly pressure the Company in their home
countries by influencing regulatory authorities to outlaw the provision of call
reorigination services or by blocking access to the call reorigination services
the Company markets. Similar pressure can be applied by newly-privatized former
PTTs and other home country competitors in nations that have eliminated
government ownership of the PTT. Although the Company has not suffered a
material adverse effect due to anti-competitive behavior on the part of the PTTs
(or former PTTs) to date, there can be no assurance that such behavior will not
in the future cause a material adverse effect on the Company's business,
financial condition or results of operations. With the increasing privatization
of international telecommunications in foreign countries, PTTs may increasingly
become deregulated and free to compete more effectively with the Company at
competitive rates. Deregulation in foreign countries also could result in
competition from other service providers with large, established customer bases
and close ties to governmental authorities in their home countries. Deregulation
and increased competition in foreign markets could cause prices for direct-dial
international calls to decrease so much that customers are no longer willing to
use the Company's international call reorigination services. The ability of a
deregulated PTT or another home country service provider to compete on the basis
of greater size and resources, pricing flexibility and long-standing
relationships with customers in its own country could have a material adverse
effect on the Company's business, financial condition or results of operations.
The large U.S. long-distance carriers have, in the past, been reluctant to
compete directly with the PTTs by entering the international call reorigination
business and attempting to capture significant market share of the domestic
customers of the incumbent overseas PTTs. However, there can be no assurance
that other large carriers will not enter the call reorigination industry.
Because of their ability to compete on the basis of superior financial and
technical resources, the entry of AT&T or any other large U.S. long-distance
carrier into the international call reorigination business could have a material
adverse effect on the Company's business, financial condition or results of
operations. Also, the FCC's approval of call reorigination services where no
foreign country proscribes it is likely to stimulate additional entry by small
carriers who might target the same customer base as the Company does, which
could have a material adverse effect on the Company's business, financial
condition or results of operations.
Competition for customers in the telecommunication markets the Company
competes in is primarily on the basis of price and, to a lesser extent, on the
basis of the type and quality of service offered. Increased competition could
force the Company to reduce its prices and profit margins if the Company's
competitors are able to procure rates or enter into service agreements
comparable to or better than those the Company obtains or markets or are able to
offer other incentives to existing and potential customers. Similarly, the
Company has no control over the prices set by its competitors in the
long-distance resale market. The Company could also face significant pricing
pressure if it experiences a decrease in its market share of international
long-distance traffic because the Company's ability to obtain favorable rates
and tariffs from its carrier suppliers depends, in large part, on the Company's
total volume of long-distance traffic. There is no guarantee that the Company
will be able to maintain the volume of domestic and
20
international long-distance traffic necessary to obtain favorable rates and
tariffs. The Company is aware that its ability to market its long-distance
resale services depends upon the existence of spreads between the rates offered
by the Company and those offered by the IXCs with whom it competes as well as
those from whom it obtains service. A decrease in such spreads or price
competition in the Company's markets could have a material adverse effect on the
Company's business, financial condition or results of operations. See "Risk
Factors--Dependence on Others" and "Business-Competition."
INTERNET ACCESS
The Company's current and prospective competitors include many large
companies that have substantially greater market presence as well as financial,
technical, operational, marketing and other resources and experience than the
Company. The Company's Internet access business competes or expects to compete
directly or indirectly with the following categories of companies: (i) other
national and regional commercial Internet access providers, such as NETCOM and
PSI; (ii) established on-line services companies that currently offer or are
expected to offer Internet access, such as AOL, CompuServe, and Prodigy; (iii)
computer hardware and software and other technology companies, such as
Microsoft; (iv) national long-distance telecommunications carriers, such as
AT&T, MCI, and Sprint; (v) RBOCs; (vi) cable television system operators, such
as Comcast, TCI, and Time Warner; (vii) nonprofit or educational ISPs; and
(viii) newly-licensed providers of spectrum-based wireless data services. See
"Business-Competition."
Many of the established on-line services companies and telecommunications
companies, such as AT&T and the RBOCs, have begun to offer or announced plans to
offer expanded Internet access services. The Company expects that all of the
major on-line services companies will eventually compete fully in the Internet
access market. In addition, the Company believes that new competitors, including
large computer hardware and software, cable, media, wireless, and wireline
telecommunications companies, will enter the Internet access market, resulting
in even greater competition for the Company. The ability of these competitors or
others to bundle with Internet access services other services and products not
offered by the Company could place the Company at a significant competitive
disadvantage. In addition, certain of the Company's competitors that are
telecommunications companies may be able to provide customers with reduced
communications costs in connection with their Internet access services or other
incentives, reducing the overall cost of their Internet access solution and
significantly increasing price pressures on the Company. This price competition
could result in significant reductions in the average selling price of the
Company's services. In addition, increased competition for new subscribers could
result in increased sales and marketing expenses and related subscriber
acquisition costs, which could materially adversely affect the Company's
profitability. There can be no assurance that the Company will be able to offset
the effects of any such price reductions or incentives with an increase in the
number of its customers, higher revenue from enhanced services, cost reductions
or otherwise.
Moreover, the Company uses LEC networks to connect its Internet customers to
its POPs. Under current federal and state regulations, the Company and its
Internet customers pay no charges for this use of the LECs' networks other than
the flat-rated, monthly service charges that apply to basic telephone service.
LECs have asked the FCC to change its rules and require Internet access
providers to pay additional, per minute charges for their use of local networks.
Per minute access charges could significantly increase the Company's costs of
doing business and could, therefore, have a material adverse effect on the
Company's competitive position and on its business, financial condition or
results of operations. The FCC is currently considering whether to propose such
rule changes.
Competition is also expected to focus increasingly on overseas markets,
where Internet access services are just beginning to be introduced. The Company
does not currently plan to increase its Internet access services outside the
United States. To the extent the ability to provide access to locations and
services overseas becomes a competitive advantage in the Internet access
industry, failure of the Company to penetrate overseas markets or to increase
its presence in the few overseas markets it presently serves may result in the
Company being at a competitive disadvantage relative to other Internet access
providers.
21
The Company believes that its ability to compete successfully in the
Internet access market depends upon a number of factors, including: market
presence; the adequacy of the Company's customer support services; the capacity,
reliability and security of its network infrastructure; the ease of access to
and navigation of the Internet; the pricing policies of its competitors and
suppliers; regulatory price requirements for interconnection to and use of
existing local exchange networks by Internet services; the timing of
introductions of new products and services by the Company and its competitors;
the Company's ability to support existing and emerging industry standards; and
trends within the industry as well as the general economy. There can be no
assurance that the Company will have the financial resources, technical
expertise or marketing and support capabilities to continue to compete
successfully in the Internet access market.
INTERNET TELEPHONY
In August 1996, the Company began offering the first commercial telephone
service to bridge live calls between personal computers and regular telephones
via the Internet, and to charge on a per minute basis. Through the Company's
Net2Phone service, customers can place calls from sound-equipped computers and
have the calls terminate at regular telephones, with no requirement of
specialized equipment at the receiving telephone.
Numerous companies have entered the Internet telephony market in the past
year and a half and have established their Internet telephony products in the
marketplace before the Company's introduction of its Net2Phone service. Most of
the current Internet telephony products enable voice communications over the
Internet between two parties simultaneously connected to the Internet via
multimedia-equipped personal computers, where both parties are using identical
Internet telephony software products. These products include Internet Phone from
VocalTec, WebPhone from QuarterDeck and NetMeeting from Microsoft. Recently,
Intel Corporation announced a new technology aimed at standardizing and
improving the compatibility of the various Internet telephony software products,
enabling customers of different Internet telephony software products to
communicate with one another over the Internet. Furthermore, a number of
companies including Northern Telecom and Dialogic have announced server-based
products and switches which are expected to allow communications over the
Internet between parties using a personal computer and regular telephone and
between two parties using telephones where both parties have these specialized
servers at both ends of the call. There can be no assurance that other large
companies will not enter the market as suppliers of Internet telephony services
or equipment or that the Company's competitors in this market will not introduce
Internet telephony products that permit termination of the call at a standard
telephone as does Net2Phone. There can be no assurances that the Company will be
able to successfully compete in the developing Internet telephony market.
Although Internet telephony continues to be an area of intense focus of various
Internet software providers, traditional telephone service companies and
telephone equipment manufacturers, there can be no assurance that Internet
telephony will gain market acceptance or prove to be a viable alternative to
traditional telephone service. Many international telephone callers, accustomed
to the convenience and quality of phone-to-phone international calling, may not
switch to Internet telephony services notwithstanding the potential cost
savings.
DEPENDENCE ON OTHERS
The Company is dependent on third-party suppliers of network transmission
services for many of its services and generally does not have long-term
contracts with its suppliers. Certain of these suppliers are or may become
competitors of the Company, and such suppliers generally are not subject to
restrictions upon their ability to compete with the Company. To the extent that
any of these suppliers raise their rates or change their pricing structure, the
Company may be adversely affected. Also, the Company faces the risk that there
will be a disruption in the service provided by these suppliers, and can give no
assurance that there will not be a significant disruption in such service in the
future, causing a disruption in the services provided by the Company to its
customers. The Company is dependent upon WorldCom and MFS
22
Communications Company, Inc. ("MFS") which are the primary providers to the
Company of leased-line network capacity and data communications facilities, and
lease to the Company physical space for switches, modems and other equipment. If
these suppliers are unable to expand their networks or unwilling to provide or
expand their current level of service to the Company in the future, the
Company's operations could be adversely affected. The Company is also dependent
upon the LECs and MFS to provide telecommunications services to the Company's
customers. Although certain leased data communications services are currently
available from several alternative suppliers, including, for example, AT&T, MCI,
and Sprint, there can be no assurance that the Company could obtain substitute
services from other suppliers at reasonable or comparable terms and prices or in
a timely fashion.
The Company's ability to compete in the long-distance telecommunications
market depends, in part, on its ability to procure advantageous rates from other
IXCs, and on the ability of such IXCs to carry the calls the Company routes to
their networks. If the Company, as a result of a termination of its relationship
with an IXC or an IXC's inability to carry traffic routed to it, routed the
traffic to another IXC providing service at a less advantageous rate, or with
lesser quality, there could be an adverse effect on the Company's profit margins
and network service quality. Such harm to the Company's profit margins and
service quality could in turn have an adverse effect on the Company's results of
operations and its ability to prevent subscription cancellation. Similarly, if
the facility-based providers whose services the Company resells were unable to
sell such services to the Company, there could be a material adverse effect on
the Company's business, financial condition, or results of operations.
IDT also depends on other companies to provide Internet access in areas not
serviced by the Company's POPs. The Company depends upon the continued viability
and financial stability of PSI, other alliance partners and other suppliers as
well as on the performance of their networks. If a material number of such
networks were to suffer operational problems or failure, or were unable to
expand to satisfy customer demand, there could be a material adverse effect on
the Company. The Company has from time to time experienced delays in the timely
connection of customer accounts to the Internet by suppliers other than PSI. If
a material number of suppliers other than PSI fail to serve accounts on a timely
basis or are unable to serve accounts generated by the Company's growth, there
could be a loss of customers which may have a material adverse effect on the
Company's business, financial condition or results of operations.
The Company currently is dependent on software licensed from Netscape
Communications Corp. ("Netscape") for the front end software for its Internet
access services. Under its non-exclusive agreement with Netscape (the "Netscape
Agreement"), the Company can use and reproduce certain Netscape products, and
distribute such products to distributors and end users in conjunction with IDT
configuration software. The Company has experienced difficulty in integrating
third party software into the Company's Internet software. The occurrence of
operating difficulties in connection with Netscape software could deter
customers from using the Company's Internet services. If another software
manufacturer challenges Netscape's market position and the Company is unable to
provide such software to its customers or the Company continues to experience
difficulty integrating Netscape software into the Company's Internet services,
there could be a material adverse effect on the Company's business, financial
condition or results of operations.
The Company is dependent on certain third-party suppliers of equipment and
hardware components, including, for example, Northern Telecom, Excel
Communications, Inc., and Ascend Communications, Inc. A failure by a supplier to
deliver quality services or products on a timely basis, or the inability to
develop alternative sources if and as required, could result in delays which
could have a material adverse effect on the Company.
In addition, the Company is dependent on its independent sales
representatives, particularly in key foreign markets. Most of the Company's
independent sales representatives also sell services or products of other
companies. There can be no assurance that the Company's sales representatives
will devote sufficient efforts to promoting and selling the Company's services.
23
DEPENDENCE ON KEY PERSONNEL
The Company is highly dependent on the technical and management skills of
its key employees, including technical, sales, marketing, financial and
executive personnel, and on its ability to identify, hire and retain qualified
personnel. Competition for such personnel is intense and there can be no
assurance that the Company will be able to retain existing personnel or identify
or hire additional personnel. In particular, the Company is highly dependent on
the services of Howard S. Jonas, its Chief Executive Officer, Chairman of the
Board and founder, and Howard S. Balter, its Chief Operating Officer and Vice
Chairman of the Board. The loss of either Mr. Jonas's or Mr. Balter's services
could have a material adverse effect on the Company's business, financial
condition or results of operations.
RAPID TECHNOLOGICAL DEVELOPMENT; PROPRIETARY RIGHTS
The markets the Company services are characterized by rapidly changing
technology, evolving industry standards, emerging competition and the frequent
introduction of new services, software and other products. The Company's success
is dependent in part upon its ability to enhance existing products, software and
services and to develop new products, software and services that meet changing
customer requirements on a timely and cost-effective basis. There can be no
assurance that the Company can successfully identify new opportunities and
develop and bring new products, software and services to market in a timely and
cost-effective manner, or that products, software, services or technologies
developed by others will not render the Company's products, software, services
or technologies noncompetitive or obsolete. In addition, there can be no
assurance that products, software or service developments or enhancements
introduced by the Company will achieve or sustain market acceptance or be able
to effectively address the compatibility and inoperability issues raised by
technological changes or new industry standards.
There can be no assurance that the Company's patent application relating to
the systems and methodology comprising the technologies underlying Net2Phone
will result in any patent being issued or that, if issued, any patent will
provide adequate protection against competitive technology or will be held valid
and enforceable if challenged, or that the Company's competitors would not be
able to design around any such patent; nor can there be any assurance that
others will not obtain patents that the Company would need to license or
circumvent in order to exploit the Company's patent.
The Company is also at risk to fundamental changes in the technologies for
delivering telephone, Internet telephony and Internet access and content
provision services. For example, although Internet services currently are
accessed primarily by computers through telephone lines, several companies have
recently introduced, on an experimental basis, delivery of Internet access
services through cable television lines. If the Internet becomes accessible by
other methods or if there are advancements in the delivery of telephone
services, the Company will need to develop new technology or modify its existing
technology to accommodate these developments. The Company's pursuit of these
technological advances may require substantial time and expense, and there can
be no assurance that the Company will succeed in adapting its businesses to
alternate access devices, conduits or other technological developments.
The Company relies on a combination of patent, copyright, trademark and
trade secret laws and contractual restrictions to establish and protect its
technology. The Company does not currently have any issued patents or registered
copyrights, although it has registered trademarks in connection with the Genie
services and other pending applications for certain trademarks. The Company has
a policy to require employees and consultants to execute confidentiality and
technology ownership agreements upon the commencement of their relationships
with the Company. There can be no assurance that the steps taken by the Company
will be adequate to prevent misappropriation of its technology or other
proprietary rights, or that the Company's competitors will not independently
develop technologies that are substantially equivalent or superior to the
Company's technology. There can be no assurance that the Company's trademark
applications will result in any trademark registrations, or that, if registered,
any registered trademark will be held valid and enforceable if challenged. In
addition, there can be no assurance that licenses for any
24
intellectual property that might be required for the Company's services or
products would be available on reasonable terms if at all. See
"Business-Intellectual Property."
Although the Company does not believe that its products infringe the
proprietary rights of any third parties, and no third parties have asserted
patent infringement or other such claims against the Company, there can be no
assurance that third parties will not assert such claims against the Company in
the future or that any such claims will not be successful. The Company is aware
that patents have been granted recently to others on fundamental technologies in
the communications, multimedia and Internet telephony areas, and patents may
issue which relate to fundamental technologies incorporated in the Company's
services and products. Since patent applications in the United States are not
publicly disclosed until the patent issues, applications may have been filed
which, if issued as patents, could relate to the Company's services. The Company
could incur substantial costs and diversion of management resources in defending
or pursuing any claims relating to proprietary rights, which could have a
material adverse effect on the Company's business, financial condition or
results of operations. Furthermore, parties making such claims could secure a
judgment awarding substantial damages, as well as injunctive or other equitable
relief which could effectively block the Company's ability to provide services
in the United States or abroad. Such a judgment could have a material adverse
effect on the Company's business, financial condition or results of operations.
RISKS OF NETWORK FAILURE
The success of the Company is largely dependent on its ability to deliver
high quality, uninterrupted access to the Internet and low-cost, uninterrupted
domestic and international long-distance telephone services. Any system or
network failure that causes interruptions in the Company's operations could have
a material adverse effect on the business, financial condition or results of
operations of the Company. The Company has experienced failures relating to
individual POPs and the Company's subscribers have experienced difficulties in
accessing, and maintaining connection to, the Internet. The Company at times has
experienced failures of its call reorigination switching equipment, which
temporarily prevented customers from using IDT's call reorigination services.
The Company's operations are dependent on its ability to successfully expand its
network and integrate new and emerging technologies and equipment into its
network, which are likely to increase the risk of system failure and to cause
unforeseen strain upon the network. The Company's operations also are dependent
on the Company's protection of its hardware and other equipment from damage from
natural disasters such as fires, floods, hurricanes, and earthquakes, or other
sources of power loss, telecommunications failures or similar occurrences. The
Company maintains a substantial portion of its Internet accounts, electronic
mail services, and other systems essential to the Company's service offerings at
its primary operational facilities in Hackensack, New Jersey. Significant or
prolonged system failures, such as were experienced in 1996 by AOL and NETCOM,
or difficulties for subscribers in accessing, and maintaining connection with
the Internet could damage the reputation of the Company and result in the loss
of subscribers. Similarly, significant or prolonged telephone network failures,
or difficulties for customers in completing long-distance telephone calls could
damage the reputation of the Company and result in the loss of customers. Such
damage or losses could have a material adverse effect on the Company's ability
to obtain new subscribers and customers, and on the Company's business,
financial condition or results of operation.
25
RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS
In Fiscal 1995, 1996, and 1997, international customers accounted for
approximately 56%, 23%, and 25%, respectively, of the Company's total revenues.
The Company anticipates that revenues from international customers will continue
to account for a significant percentage of its total revenues. In addition, part
of the Company's growth strategy is to develop a network switching
infrastructure in foreign countries. Therefore, a significant portion of the
Company's total revenues as well as a portion of its equipment and other
property will be subject to risks associated with international operations,
including unexpected changes in legal and regulatory requirements, changes in
tariffs, exchange rates and other barriers, political and economic instability,
difficulties in accounts receivable collection, longer payment cycles,
difficulties in establishing, maintaining and managing independent foreign sales
organizations, difficulties in staffing and managing international operations,
difficulties in maintaining and repairing equipment abroad, difficulties in
protecting the Company's intellectual property overseas, possible confiscation
of property and equipment, potentially adverse tax consequences and the
regulation of Internet access providers and telecommunications companies by
foreign jurisdictions. Although the Company's sales to date have generally been
denominated in U.S. dollars, the value of the U.S. dollar in relation to foreign
currencies may also adversely affect the Company's sales to international
customers as well as the cost of procuring, installing and maintaining equipment
abroad. To the extent the Company expands its international operations or
changes its pricing practices to denominate prices in foreign currencies, the
Company will be exposed to increased risks of currency fluctuation as the
Company does not, and has no plans to, engage in hedging activities designed to
manage currency fluctuations. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and "Business-Sales and
Marketing."
NEW AND UNCERTAIN MARKETS
Many of the overseas markets in which the Company currently markets
long-distance telephone services are undergoing dramatic changes as a result of
privatization and deregulation. The European Union has mandated competitive
markets for the European telecommunications industry by January 1998 and the
various European countries are at different stages of opening their
telecommunications markets. As a result of privatization and deregulation, a new
competitive environment is emerging in which major European telephone companies,
media companies and utilities are entering the telecommunications market and
forming new alliances which are radically changing the landscape for domestic
and international telephone services. Open markets for telecommunications
services are expected to evolve in other parts of the world as well. While the
Company is focused on exploiting the imbalances brought about by the often
fragmented nature of deregulation, the Company is entering new and often unknown
markets and, therefore, is unable to predict how such deregulating markets will
evolve. There can be no assurance that changes in the marketplace and new
strategic alliances among companies with greater resources than the Company will
not adversely affect the Company's ability to continue to offer and to sell call
reorigination services, its efforts to increase its overseas telecommunications
customer base or its ability to recover the cost of building out its
international telecommunications switching infrastructure.
The markets for Internet connectivity, telephony and content services and
related software products are relatively new, current and future competitors are
likely to introduce competing Internet connectivity and/or on-line services and
products. Therefore, it is difficult to predict the rate at which these markets
will grow or at which new or increased competition will result in market
saturation. If demand for Internet services fails to grow, grows more slowly
than anticipated, or becomes saturated with competitors, the Company's business,
operating results and financial condition could be adversely affected. Although
the Company intends to support emerging standards in the market for Internet
connectivity, there can be no assurance that industry standards will emerge or
if they become established, that the Company will be able to conform to these
new standards in a timely fa