SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2002
Commission File Number: 000-28063
DELTATHREE, INC.
--------------------------------------------------
(Exact name of registrant as specified in charter)
Delaware 13-4006766
- ------------------------------- ------------------
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification no.)
75 Broad Street, 31st Floor
New York, New York 10004
- ---------------------------------------- ---------
(Address of principal executive offices) (Zip code)
Registrant's telephone number, including area code: (212) 500-4850
Securities registered pursuant to Section 12(b) of the Act:
None.
Securities registered pursuant to Section 12(g) of the Act:
Name of Each Exchange
Title of Each Class on Which the Securities
are Registered
- ------------------- ------------------------
Class A Common Stock, par value $0.001 Nasdaq SmallCap Market
per share
Indicate by a 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 the 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. X
---
The aggregate market value of the Class A common stock held by non- affiliates
of the Registrant based upon the closing price of the Class A common stock as
reported by The Nasdaq Stock Market on June 28, 2002 was $5,692,191. Solely for
purposes of this calculation, shares beneficially owned by directors and
officers of the Registrant and persons owning 5% or more of the Registrant's
Class A common stock have been excluded, in that such persons may be deemed to
be affiliates of the Registrant. Such exclusion should not be deemed a
determination or admission by the Registrant that such individuals or entities
are, in fact, affiliates of the Registrant.
The number of shares outstanding of the Registrant's capital stock as of March
27, 2003 is as follows:
Title of Each Class Number of Shares Outstanding
- -------------------------------- at March 27, 2003:
Class A Common Stock, $0.001 par ----------------------------
value 29,180,896
DOCUMENTS INCORPORATED BY REFERENCE
The following documents (or parts thereof) are incorporated by reference into
the following parts of this Form 10-K: Certain information required in Part III
of this Annual Report on Form 10-K is incorporated from the Registrant's Proxy
Statement for the 2003 Annual Meeting of Stockholders to be held on September
18, 2003.
DELTATHREE, INC.
2001 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
---------------------
Page
----
PART I
------
ITEM 1. Business 4
ITEM 2. Properties 15
ITEM 3. Legal Proceedings 15
ITEM 4. Submission of Matters to a Vote of Security Holders 16
PART II
-------
ITEM 5. Market for Registrant's Common Equity and Related Stockholder 17
Matters
ITEM 6. Selected Financial Data 19
ITEM 7. Management's Discussion and Analysis of Financial Condition 20
and Results of Operations
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk 35
ITEM 8. Financial Statements and Supplementary Data 35
ITEM 9. Changes in and Disagreements with Accountants on Accounting 35
and Financial Disclosure
PART III
----------
ITEM 10. Directors and Executive Officers of the Registrant 36
ITEM 11. Executive Compensation 36
ITEM 12. Security Ownership of Certain Beneficial Owners and Management 36
ITEM 13. Certain Relationships and Related Transactions 36
ITEM 14. Controls and Procedures 36
PART IV
-------
ITEM 15. Exhibits, Financial Statement Schedules and
Reports on Form 8-K 37
Index to Consolidated Financial Statement F-1
DELTATHREE, INC.
2002 ANNUAL REPORT ON FORM 10-K
The statements in this annual report that are not descriptions of historical
facts may be forward-looking statements. Those statements involve substantial
risks and uncertainties. You can identify those statements by the fact that
they contain words such as "anticipate," "believe," "estimate," "expect,"
"intend," "project" or other terms of similar meaning. Those statements reflect
management's current beliefs, but are based on numerous assumptions, which we
cannot control and that may not develop as we expect. Consequently, actual
results may differ materially from those projected in the forward-looking
statements. Among the factors that could cause actual results to differ
materially are: uncertainty of financial estimates and projections, the
competitive environment for Internet telephony, our limited operating history,
changes of rates of all related telecommunications services, the level and rate
of customer acceptance of new products and services, legislation that may
affect the Internet telephony industry, rapid technological changes, and the
risks, uncertainties and other matters discussed below under "Risk Factors" and
elsewhere in this annual report and in our other periodic reports filed with
the U.S. Securities and Exchange Commission.
PART I
ITEM 1. BUSINESS
General
We are a provider of integrated Voice over Internet Protocol (VoIP) telephony
services. We were founded in 1996 to capitalize on the growth of the Internet
as a communications tool by commercially offering Internet Protocol (IP)
telephony services. IP telephony is the real time transmission of voice
communications in the form of digitized "packets" of information over the
Internet or a private network, similar to the way in which e-mail and other
data is transmitted. Our business currently includes: the provision of enhanced
Web-based and other communications services to individual consumers, under our
iConnectHere brand name; the provision of enhanced Web-based and other
communications services to international resellers, under either their own
brand name, a white-label brand, and/or our iConnectHere brand name; the
provision of a total "Hosted Communications Solution" that enables corporate
customers and service providers to offer private label telecommunications to
their customer bases, and; the transmission of voice and data traffic for
communications carriers.
We have built a privately-managed, global network using IP technology and offer
our customers a unique suite of IP telephony products, including: PC-to-Phone,
Phone-to-Phone, and Broadband Phone. We differentiate ourselves from our
competitors by providing a robust set of value-added services that enables us
to effectively address the challenges that have traditionally made the
provision of telecommunications services difficult. These operations management
tools include: account provisioning; payment processing systems; billing and
account management; and customer care. We are able to provide our services at a
cost to users that is generally lower than that charged by traditional carriers
because we minimize our network costs by using efficient packet-switched
technology and we generally avoid local access charges and by-pass
international settlement charges by routing international long distance calls
over our privately-managed network.
Prior to 1999, our focus was to build a privately-managed, global network
utilizing IP technology, and our business primarily consisted of carrying and
transmitting traffic for communications carriers over our network. Beginning in
1999, we began to diversify our offerings by layering enhanced IP telephony
services over our network. These enhanced services were targeted at consumers
and were primarily accessible through our consumer Web site. During 2000, we
began offering services on a co-branded or private-label basis to service
providers and other businesses to assist them in diversifying their product
offerings to their customer bases. Our privately-managed IP network received
the Best Built Public Network Award for excellence in IP services/applications
at SUPERCOMM 2000. We were also recognized as the best IP telephony provider by
SmartMoney magazine and PC World Magazine during 2000. We were recognized for
our innovative Broadband Phone offering during 2001, receiving both the TMC
Labs Innovation Award, and the Communications SOLUTIONSr magazine Product of
the Year Award. In 2001, we continued to enhance our unique strengths through
our pioneering work with the Session Initiation Protocol (SIP), an Internet
Engineering Task Force standard that has been embraced by industry leaders such
as Microsoft and the 3rd Generation Partnership Project (3GPP), which is a
global cooperation between six organizational partners who are recognized as
the world's major standardization bodies from the United States, Europe, China,
Japan and Korea. In 2001, we also announced the launch of our state-of-the-art
SIP (Session Initiation Protocol) infrastructure, and we became one of the
first service providers to have built an end-to-end SIP network. During 2002,
our continuing SIP efforts resulted in our launch of our SIP-based dialer.
These efforts continue to position us as one of the leading providers of VoIP
services.
Recent Developments
On February 6, 2003, we announced that we had received a letter from D3
Acquisition, Inc. relating to a proposal to purchase all of our outstanding
shares not held by Atarey Hasharon Chevra Lepituach Vehashkaot Benadlan (1991)
Ltd. ("Atarey") and its affiliates for a price of $0.70 per share in cash by
means of a cash tender offer. The proposal contemplates that upon successful
completion of the tender offer, D3 Acquisition would merge into us and we would
survive and continue as a wholly owned private subsidiary of Atarey. D3
Acquisition is a wholly owned special purpose acquisition corporation formed by
Atarey. Together, Atarey and its affiliates currently own approximately 71%
(20,655,402 shares) of our outstanding common stock. Our board of directors
has formed a special committee comprised of independent directors to evaluate
the proposal and negotiate its terms. The special committee of our board of
directors has retained Kaufman Bros., L.P. as its financial advisor to assist
the special committee in evaluating strategic alternatives, including a
possible sale of the company. Among other things, Kaufman Bros. is assisting
the special committee in its continuing assessment of the D3 Acquisition
proposal. Upon completion of this review process, the special committee of
independent directors will make its recommendation to our board of directors in
due course. There can be no assurance that Atarey or we will proceed with the
proposed transaction or any of the other strategic alternatives considered or
when any resulting transaction would occur. Upon our announcement that we were
evaluating the D3 Acquisition offer, litigation was commenced against our Board
members and us with respect to the transaction contemplated by the proposal.
Please see "Legal Proceedings" for a description of such litigation.
The Increasing Significance of IP Communications
Historically, the communications services industry has transmitted voice and
data over separate networks using different technologies. Traditional carriers
have typically built telephone networks based on circuit switching technology,
which establishes and maintains a dedicated path for each telephone call until
the call is terminated. Although a circuit-switched system reliably transmits
voice communications, circuit switching does not efficiently utilize
transmission capacity. When a telephone call is placed, a circuit is
established, and the circuit remains dedicated for transmission of the call and
is therefore unavailable to transmit any other call.
Data networks have typically been built utilizing packet switching technology,
such as IP, which divides signals into packets that are simultaneously routed
over different channels to a final destination where they are reassembled in
the original order in which they were transmitted. Packet switching provides
for more efficient use of the capacity in the network because the network does
not establish dedicated circuits and does not require a fixed amount of
bandwidth to be reserved for each transmission. As a result, substantially
greater traffic can be transmitted over a packet-switched network, such as the
Internet, than a circuit-switched network.
Traditional telecommunications carriers have historically avoided the use of
packet switching for transmitting voice calls due to poor sound quality
attributable to delays and lost packets which prevent real-time transmission.
However, recent improvements in packet switching, compression and broadband
access technologies, improved hardware and the use of privately-managed
networks (such as our network) have significantly improved the quality of
packet-switched voice calls, allowing for real-time transmission. Service
providers that use privately-managed networks are able to reduce packet loss
and latency, or delay, because they are able to control the amount, timing and
route of data transmitted.
As a result, packet switching technology enables service providers to converge
their traditional voice and data networks and more efficiently utilize their
networks by carrying voice, fax and data traffic over the same network. The
improved efficiency of packet-switching technology creates network cost savings
that can be passed on to the consumer in the form of lower long distance rates.
In addition, international telephone calls carried over the Internet or private
IP networks are less expensive than similar calls carried over circuit-switched
networks primarily because they bypass the international settlement process,
which represents a significant portion of international long distance tariffs.
Frost & Sullivan, a market research firm, estimates that VoIP communications
services will grow to represent approximately 75% of worldwide voice services
and revenues from the VoIP marketplace will surpass $171 billion by the end of
2007. Beyond cost savings, we believe that advanced IP communications
technologies will further the potential for the Internet to become the
preferred medium of communications and commerce.
Limitations of Existing IP Communications Solutions
Although the growth of IP telephony historically has been limited by poor sound
quality attributable to delays and packet loss, recent technological
advancements have significantly improved the quality of packet-switched
telephone calls. As a result, several large long distance carriers, including
AT&T and Sprint, have announced IP telephony service offerings.
In addition, many smaller service providers have begun to offer low-cost
Internet telephony services from PCs to telephones and from telephones to
telephones. Many of these service providers, however, offer their services only
in certain geographic areas and provide limited services. In addition, many of
these service providers rely soley on the public Internet for transmission,
rather than a privately-managed IP network. In using only the public Internet
rather than a privately-managed IP network for transmission, these service
providers have less control over the network management and monitoring
functions that are necessary to ensure quality of service.
Our Products and Services
Products.
We have built a privately-managed, global network using IP technology and offer
our customers a unique suite of IP telephony products. Our enhanced IP
communication products (which represented 60.2% and 54.8% of our revenues in
2002 and 2001, respectively) include:
PC-to-Phone. Our PC-to-Phone offering enables a user to conveniently and
inexpensively place a call to a standard telephone anywhere in the world
directly from a personal computer while remaining on-line. In order to use this
product, a user need only download our software from our Web site and have
access to the Internet. Once our software is downloaded, the user is able to
place a call from the user's personal computer and, while browsing the Web,
speak to a party who uses a standard telephone. Alternatively, users of
Microsoft's MSN Messenger software can access our PC-to-Phone product through
the "Make a phone call" function without the need to download any other
software.
We are able to provide our PC-to-Phone offering at rates generally lower than
those charged for traditional circuit switched calls. We are able to charge
lower rates because our service utilizes packet-switched technology and because
it routes calls directly from the user's Internet connection onto our
privately-managed IP network and to the called destination, thus avoiding
access and settlement rates associated with traditional international and
domestic long distance telecommunications services. PC-to-phone is currently
our most popular product offering.
Phone-to-Phone. Our Phone-to-Phone offering enables a user to inexpensively
place a call or send a fax from a standard telephone or a fax machine to
anywhere in the world. Phone-to- Phone calls originate and terminate on the
public switched telephone network (PSTN), but travel primarily over our
privately-managed IP network. Similar to our PC-to-Phone product, our
Phone-to-Phone product is generally less expensive than services of traditional
carriers. Users can access our Phone-to- Phone product by dialing a local or
toll-free access number and providing a PIN number. We currently offer
toll-free access numbers in Austria, Canada, Finland, France, Germany, Hong
Kong, Italy, Sweden, Switzerland, the United Kingdom and the United States.
Users are charged for toll and long distance calls on a per-minute basis. We
and our private-label partners receive payment for these calls by debiting
pre-paid user accounts opened on-line and through the sale of pre-paid calling
cards.
Broadband Phone. In early 2001, we successfully deployed the world's first
commercially available Broadband Phone offering. Our Broadband Phone product is
a complete phone replacement solution available to business and consumer
customers over the "last mile" through broadband connections via cable modem,
DSL or fixed wireless. Broadband Phone challenges the traditional PSTN and
circuit switched networks with a full VoIP solution. With our high call
quality, "always on" reliability and increased functionality provided by the
high bandwidth access line, we are able to offer potential partners and their
customers some of the most sophisticated VoIP solutions available in the market
through a highly scalable, low-cost and easily implemented product. Broadband
Phone is designed to take advantage of how people communicate, building on the
current customer experience by allowing them to use their existing phone. In
addition to offering traditional telecommunications capabilities, Broadband
Phone enables a user to conveniently retrieve e-mail, voice mail and faxes, as
well as send e-mail, from a single source. For our potential partners, the
turnkey solution is delivered with our full back-end infrastructure, including
customer service for end users, customer service for service providers, pricing
information, billing and provisioning and fraud services. Additionally,
Broadband Phone is a technology-neutral solution, easily integrated (a variety
of devices are available to plug directly into a PC or IP network) so as to
allow broadband providers to begin delivering our voice solution rapidly.
Carrier transmission services. In addition to our enhanced IP communication
products, in order to maximize the use of our available network capacity, we
offer carrier transmission services over our privately-managed IP network to
telecommunications carriers.
Services.
We differentiate ourselves from our competitors by providing a robust set of
value-added services that enables us to effectively address the challenges that
have traditionally made the provision of telecommunications services difficult.
These operations management tools include the following:
- - account provisioning: we provide our customers with a dedicated Web page
through which they can order additional services or accounts, generate and
activate PINs and perform other customary implementation functions;
- - payment processing systems: we provide our customers with a fraud detection
and prevention system to permit secure credit card transactions over the Web;
- - billing and account management: we provide our customers with real-time,
Web-based access to billing records to check billing and usage information or
to increase prepaid accounts; and
- - customer care: we have moved and consolidated traditional first tier
customer care functions onto the Web for ease and flexibility and support this
with second tier customer care via toll-free access.
iConnectHere
We began marketing our on-line consumer offering under the iConnectHere brand
name in September 2000 in connection with the formal roll-out of our Hosted
Communications Solution. At that time, we decided to eliminate our free on-line
service and to move away from a business model focused on consumers with a high
acquisition cost. We have positioned iConnectHere as a powerful showcase and
test facility for our current and future products and services. iConnectHere
demonstrates our products, services and hosting capabilities to other business
customers and service providers. Through iConnectHere, an account holder can
access PC- to-Phone, Phone-to-Phone, Broadband Phone and the full range of our
back-end infrastructure and support. Additionally, iConnectHere permits us to
collect usage information on our products and services and enables us to
provide our partners with key information and recommendations regarding
implementation of our products and services.
Through iConnectHere, consumer users can:
- - sign up for any of our services, including PC-to-Phone, phone-to-Phone, and
Broadband Phone;
- - download our software;
- - recharge their accounts, either by entering their credit card information or
authorizing automatic recharging;
- - send a PC-to-phone call;
- - check real-time billing and usage information;
- - communicate by e-mail with a customer service representative;
- - view answers to frequently-asked questions.
iConnectHere Marketing, Advertising and Promotional Programs
We have developed and will continue to develop diversified marketing,
advertising and promotional programs to stimulate demand for our iConnectHere
services. Our marketing, advertising and promotional programs include:
On-line agent commission program. We have developed a Web- based agent program
that allows for rapid agent enrollment and agent account maintenance. Agents
may devise their own marketing programs, including Web-links, direct mail
campaigns or co- branding of our services in select markets. Agents receive as
commissions a percentage of revenue generated from end users who sign up for
our services through the agent's Web site. We believe that providing our agents
with easy, on-line access to these marketing tools helps us to maximize the
number of agents selling our services while significantly reducing the
resources needed to recruit agents.
Off-line agent commission program. Our off-line agent commission program allows
non-Web agents to design their own marketing programs to solicit sales of our
services. Off-line agents market and advertise through traditional channels
such as newspaper and magazine advertisements, direct mail campaigns and
telemarketing campaigns. Off-line agents receive a percentage of revenue
generated from users who sign up for our services through the agent's programs.
We currently have relationships with more than 30 off-line agents that have
generated revenue for us.
Reseller program. We offer individuals and businesses the opportunity to become
resellers of our services through our reseller program. Resellers are able to
purchase bulk iConnectHere account numbers at reseller specific rates that they
are then able to resell to private individuals as either Phone-to- Phone
calling cards or PC-to-Phone accounts.
Microsoft Messenger Affiliation. Through our relationship with Microsoft, we
provide PC-to-Phone service for Microsoft MSN Messenger users, to any phone
number in the world. Within the Microsoft MSN Messenger program, choosing us
is similar to choosing a long distance provider. With a click of the mouse,
consumers can select us (under our iConnectHere brand) when utilizing the voice
function bundled into the Microsoft software applications. When consumers
choose us, we provide the network call delivery and termination as well as all
the billing and customer relationship aspects of the service. By way of this
relationship, we gain exposure to millions of current Microsoft MSN Messenger
users.
Our Hosted Communications Solution
Our "Hosted Communications Solution" leverages our VoIP expertise and delivers
to our corporate customers and service providers a highly customizable,
private-label suite of VoIP products and services. Using our award-winning
infrastructure, we enable these enterprises to offer their customers any
combination of our basic products and services, accessible through a single
account. We believe that our Hosted Communications Solution brings our
customers the value-added services they need to leverage their strong customer
bases and generate new revenues. We have dedicated significant resources to
this area of our business and anticipate significant growth in the number of
businesses to which we provide our Hosted Communications Solution.
With each new module that is added to our suite of VoIP products and services,
customers can realize new revenue streams from their existing customer base and
make their own offering even more powerful in attracting new customers. The
products and services delivered under our Hosted Communications Solution are
operative 24 hours a day, 7 days a week and are supported at all times by our
Network Operations Center ("NOC") and our customer care center.
Future Products-Broadband focus
The market for broadband access services is projected to grow significantly
over the next several years. Broadband access alone, however, is not a complete
solution. As infrastructure pipes become commodities, maintaining margin and
profitability on them is becoming increasingly difficult for service providers.
We believe that broadband market success will be determined by the ability to
layer high-margin enhanced services and applications over the infrastructure.
Market leaders will need innovative, value-added solutions to maintain
customers, reduce churn and grow their customer base.
We have been developing a suite of next-generation Broadband Phone products
that we believe will encompass a rich sub-set of the voice-related services
broadband providers will seek to deploy in the near-term. These products will
build on our original Broadband Phone offering, and include a more diverse set
of devices (both hardware devices as well as "soft-phones") along with
additional value-added functionality and features that will appeal to a wide
potential customer-base.
Our Network
In order to deliver unique VoIP services, we operate a privately-managed IP
telephony network. By managing our network, we have the ability to regulate
traffic volumes and to directly control the quality of service from each
originating point of presence ("POP") to the termination point via a variety of
termination options. In addition, our network allows us to avoid the
significant transmission delays associated with the Internet, which may impede
delivery of high quality, reliable services to our users. Since the protocols
used by the network are highly standard protocols, our IP network has a tight
connection to the public Internet, allowing us to use the Internet as a backup
facility. This unique situation, where our IP network is considered a
high-quality extension of the Internet, allows our customers to enjoy
best-of-breed functionality: high quality, low jitter and low connection delay,
on the one hand, and global reach and universal access, on the other hand.
During 2001, in conjunction with our relationship with Microsoft and over 12
months of work, we rolled out our state of the art SIP (Session Initiation
Protocol) infrastructure. Our SIP network currently powers the majority of our
offerings, including our Microsoft relationship. The SIP protocol is one of
the most advanced VoIP protocols and unlike its predecessors, which were
modeled after traditional telephony protocols, SIP has the ability to scale
with a distributed architecture and at a lower cost. SIP's superior attributes
also include faster and more cost effective development and lower hardware
requirements, which allows us to incur lower capital expenditure costs. During
2003, we intend to continue to expand our offerings on this network. At the
same time, we continue to build our SIP expertise through relationships with
other SIP leaders such as
Cisco and Microsoft.
Backbone
Our network is built around a redundant, high availability backbone that
connects Los Angeles, New York and London. In each of these locations there are
multiple interconnections or peering arrangements with Internet backbone
providers. These points are strategically located to allow access from our
network to and from the Internet with the best performance. The backbone is
based on Cisco routing equipment utilizing Hot Standby Routing Protocol. In
order to achieve maximum redundancy, our network has several connections to the
public Internet. While operating as a private extension of the Internet, the
backbone has a high level of security designed to isolate it from security
threats found on the public Internet.
Origination Access
Access to our network is possible through several points. Users may access
services through PSTN connections (toll free and local access). Carrier
transmission access is aggregated through our switch in New York or through any
one of our POPs directly. Call origination is possible from the PC-to-Phone
product, using our downloadable software client or using a Web browser,
Microsoft Messenger or Broadband Phone. These calls enter our network from the
Internet through our interconnect points with the Internet. We carefully manage
each originating port and utilize innovative capacity planning tools and
techniques to provide the best and most cost effective service to customers.
Termination
Our network can terminate calls through any of our POPs and termination
providers' POPs. Termination decisions are based on a sophisticated Least Cost
Routing system which applies routing rules based on origination point, time of
day, termination cost and other factors. These rules are constantly updated to
ensure maximum economic and quality efficiency. Our network has termination
facilities that enable us to interconnect with multiple carriers. This allows
us to refile traffic to our own switch, giving us the ability to route calls to
virtually anywhere in the world. Each termination port is carefully managed
with innovative capacity planning tools and techniques to provide the best and
most cost effective service to customers, along with multiple termination
options to ensure the highest possible levels of redundancy.
Network Services
Our network supports several application building services on the network
level, including:
Programmable Interactive Voice Response (PIVR). Our network is capable of
playing a configurable voice prompt to enable it to provide applications such
as pre-paid calling cards. PIVR services are highly programmable and can be
customized to fulfill a variety of customer needs. The configuration of the
PIVR is controlled from a central location, enabling efficient management and
faster maintenance in the event of malfunctions.
Real Time AAA. We are able to authenticate, authorize and account (AAA) for
inbound services through the network's real time radius protocol. Whether
services are pre-paid or post-paid, the network will disconnect the call when
the user's account balance runs out. These protocols interface with the billing
system to rate the calls correctly and allow access to permitted services only.
Authentication may be customized to utilize numbers, textual strings, credit
card numbers and more.
Reporting Tools. All network services are accounted for in real time,
generating Call Detail Records. These records are aggregated in real time to
both the billing systems, for rating, and to the data warehouse, which provides
access to the information by the marketing, financial, capacity planning and
operational groups through a client or Web interface using advanced OLAP cubes.
The Network Operations Center (NOC). Our NOC monitors and manages our network
from a central location, seven days a week, 24 hours a day. The NOC monitors
all aspects of our network, including the routers, databases, switches, leased
lines, Internet connections, gatekeepers and gateways, to ensure that they are
functioning at optimal levels. In the event of a failure of any of these
network components, NOC personnel are provided with a real time, systems
generated notification via an instant messaging system consisting of pagers,
cellular phones, screen pop-ups and e-mail, which identifies the malfunction so
that proper measures can be taken to restore service in a timely fashion. Our
NOC utilizes a combination of proprietary and leading industry technologies,
including Hewlett-Packard Open View software and Ericsson IPT management
console, as well as unique applications developed by us. The NOC serves all of
the different parts of our operations environment, including network nodes, Web
servers and specific applications.
Customer Care. Our services are supported by our on-line interactive customer
service and billing center, which enables an end user to set up an account,
receive an account number and a PIN, pay by credit card for services, find
answers to frequently asked questions and contact customer service
representatives. Once a user has established an account, the user can prepay
for additional usage by credit card as well as access real-time detailed
information such as call logs and transaction records. Through the on-line
billing system, a user can personalize the billing information to select the
data most relevant to them. This on-line interactive customer service and
billing center is supported by a human customer care contact center that
provides voice and e-mail support to the customers.
Proprietary Rights
We rely or expect to be able to rely on trademark and trade secret laws,
confidentiality agreements and other contractual arrangements with our
employees, strategic partners and others to protect our proprietary rights.
We have registered trademarks for "deltathreeT" and "iConnectHere.comT" in the
United States. However, these trademarks may not provide adequate protection
against competitive technology and may not be held valid and enforceable if
challenged. We do not own any registered copyrights.
To further safeguard our intellectual property, we have a policy that requires
our employees to execute confidentiality and technology ownership agreements
when they begin their relationships with us.
Regulatory Environment
Regulation of IP Telephony
The use of the Internet and private IP networks to provide telephone service is
a recent market development. While the provision of voice communication
services over the Internet and private IP networks is currently permitted under
United States law, some foreign countries have laws or regulations that may
prohibit voice communications over the Internet or using private IP networks.
Increased regulation of the Internet may slow its growth, particularly if many
countries impose restrictive regulations. Increased regulation of the Internet
and/or IP telephony providers or the prohibition of Internet and IP telephony
in one or more countries, more aggressive enforcement of existing regulations
in such countries or our failure or the failure of our network partners to
comply with applicable regulations could materially adversely affect our
business, financial condition, operating results and future prospects.
United States. Based on information users provide to us when they signed up
to use our services, we estimate that approximately 60% of our IP
communications services are provided to carriers or users in the United States.
We believe that, under United States law, based on specific regulatory
classifications and recent regulatory decisions, the IP communications services
that we provide constitute information services (as opposed to regulated
telecommunications services). As such, our services are not currently regulated
by the Federal Communications Commission (FCC) or state agencies charged with
regulating telecommunications carriers. Nevertheless, aspects of our operations
may be subject to state or federal regulation, including regulation governing
universal service funding, payment of access charges, disclosure of
confidential communications and tax issues. However, we cannot assure you that
our services will not be regulated in the future. Several efforts have been
made in the United States to enact federal legislation that would either
regulate or exempt from regulation communications services provided over the
Internet.
In addition, the FCC is currently considering reforms to universal service
funding and may consider whether to impose various types of charges or other
common carrier regulations upon some providers of Internet and IP telephony.
The FCC stated in April 1998 that it did not have an adequate record on which
to make a definitive ruling, but that the record suggested that certain forms
of phone-to-phone IP telephony appear to have the same functionality as non-IP
telecommunications services and lack the characteristics that would render them
information services. More recently, the FCC has stated that the development of
new technologies, such as IP telephony, may increase the strain on universal
service funding. In that regard, the FCC is currently reviewing whether to
extend universal service obligations to non- traditional providers such as
facilities-based providers of broadband Internet services.
Two other carriers have asked the FCC to make definitive rulings regarding the
classification of their IP telephony services. Thus, the regulatory
classification issue is now before the FCC, although only in the context of
these two specific service offerings. However, the FCC has indicated that it
plans to address the regulatory and compensation issues posed by IP telephony
services in the near future. Any ruling by the FCC on the regulatory
considerations affecting Internet and IP telephony services will affect our
operations and revenues.
If the FCC were to determine that certain services are subject to FCC
regulations as telecommunications services, the FCC might require providers of
Internet and IP telephony services to be subject to traditional common carrier
regulation, make universal service contributions and/or pay access charges. It
is also possible that the FCC may adopt a regulatory framework other than
traditional common carrier regulation, which would apply to Internet and IP
telephony providers.
State regulatory authorities may also retain jurisdiction to regulate the
provision of, and impose charges on, intrastate Internet and IP telephony
services. Several state regulatory authorities have initiated proceedings to
examine the regulation of such. The majority of states that have looked at the
regulation of IP telephony services have deferred consideration of the issue
pending the outcome of the FCC's proceedings. Although, at least one state has
ordered that access charges apply to the termination of IP telephony calls. In
addition, several state commissions have participated in the FCC's proceedings
and have advocated imposing traditional common carrier regulation on Internet
and IP telephony providers.
International. The regulatory treatment of Internet and IP telephony outside
of the United States varies widely from country to country. A number of
countries that currently prohibit competition in the provision of voice
telephony may also prohibit Internet and IP telephony. Other countries permit,
but regulate Internet and IP telephony. Some countries will evaluate proposed
Internet and IP telephony service on a case-by-case basis and determine whether
it should be regulated as a voice service or as another telecommunications
service. Finally, in many countries Internet and IP telephony has not yet been
addressed by legislation or regulatory action.
With respect to the European Union, we believe that our services fall outside
the classification of regulated voice telephony services. The current European
Union regulatory regime distinguishes between voice telephony services and
other telecommunications services. In January 1998 and again in December 2000,
the European Commission concluded that IP telephony did not at that time meet
the definition of "voice telephony" subject to member state's regulation.
However, the Commission noted that some forms of IP telephony could be
considered voice telephony, for example, where an IP telephony service is
marketed as an alternative form of voice telephony service, users can dial out
to any telephone number, and the provider guarantees the quality of the IP
voice service by bandwidth reservation and claims that the quality of the IP
voice service is the same as traditional voice telephony service.
A determination by the European Commission that IP telephony constitutes "voice
telephony" may trigger significant regulatory consequences with respect to,
among other things, licensing requirements and contributions to universal
service funding. In addition, the Commission has adopted directives for a new
framework for electronic communications regulation that, in part, attempt to
harmonize the regulations that apply to services regardless of the technology
used by the provider. We cannot predict what future actions the European
Commission may take regarding IP telephony and related matters, or what impact,
if any, such actions may have on our business.
Based on the Commission's current position, we believe that providers of IP
telephony should be subjected to no more than a general authorization or
declaration requirement by the European Union Member States. The Member States
of the European Union are: Austria, Belgium, Denmark, Finland, France, Germany,
Greece, Ireland, Italy, Luxembourg, The Netherlands, Portugal, Spain, Sweden
and the United Kingdom. However, since the Commission's findings on IP
telephony are not binding on the Member States, we cannot assure you that the
services provided over our network will not be deemed "voice telephony" subject
to heightened regulation by one or more EU Member States.
As we make our services available in foreign countries, and as we facilitate
sales by our network partners to end users located in foreign countries, such
countries may claim that we are required to qualify to do business in the
particular foreign country. Such countries may also claim that we are subject
to regulation, including requirements to obtain authorization for the provision
of voice telephony or other telecommunications services, or for the operation
of telecommunications networks. It is also possible that such countries may
claim that we are prohibited in all cases from providing our services or
conducting our business as conducted in those countries.
Our network partners may also currently be, or in the future may become,
subject to requirements to qualify to do business in a particular foreign
country, comply with regulations, including requirements to obtain
authorizations for the provision of voice telephony or other telecommunications
services or for the operation of telecommunications networks, or to cease
providing services or conducting their business as conducted in that country.
We cannot be certain that our network partners either are currently in
compliance with any such requirements, will be able to comply with any such
requirements, and/or will continue in compliance with any such requirements.
Other Regulation Affecting the Internet
United States. Congress has recently adopted legislation that affects certain
aspects of the Internet, including on-line content, user privacy, national
security and taxation. For example, the extension of the Internet Tax Freedom
Act prohibits certain taxes on Internet uses through November 1, 2003. We
cannot predict whether substantial new taxes will be imposed on our services
after that date. In addition, Congress, the FCC and other federal entities are
considering other legislative and regulatory proposals that would further
affect the Internet, including with regard to broadband networks used to
support high- speed Internet access services. Congress is, for example,
currently considering legislation on a wide range of issues including Internet
spamming, database privacy, gambling, pornography and child protection,
Internet fraud and privacy. Various states have adopted and are considering
Internet-related legislation.
International. The European Union has also enacted several directives relating
to the Internet. The European Union has, for example, adopted a directive on
data protection that imposes restrictions on the processing of personal data.
Under the directive, personal data may not be collected, processed, used for
other purposes or transferred outside the European Union unless certain
specified conditions are met. In addition, persons whose personal data is
processed within the European Union are guaranteed a number of rights. The
directive may affect companies that collect or transmit information over the
Internet from individuals in the European Union Member States. In particular,
companies with establishments in the European Union may not be permitted to
transfer personal data to countries that do not maintain adequate levels of
data protection.
In addition, the European Union has adopted a separate, complementary privacy
directive that pertains to the telecommunications sector. This directive
establishes certain requirements with respect to, among other things, the
confidentiality, processing and retention of subscriber traffic and billing
data, security of services and networks, subscriber rights to non-itemized
bills, and the presentation and restriction of calling and connected line
identification. In addition, a number of European countries outside the
European Union have adopted, or are in the process of adopting, rules similar
to those set forth in the European Union directives. Although we do not engage
in the collection of data for purposes other than routing calls and billing for
our services, the data protection directives are quite broad and the European
Union privacy standards are stringent. Accordingly, the potential effect of
these data protection rules on the development of our business is uncertain.
Competition
We compete primarily in the market for enhanced IP communications services.
This market is highly competitive and has numerous service providers.
The market for enhanced Internet and IP communications services is new and
rapidly evolving. We believe that the primary competitive factors determining
our success, in the Internet and IP communications market are:
- - quality of service;
- - the ability to meet and anticipate customer needs through multiple service
offerings;
- - responsive customer care services;
- - price.
Future competition could come from a variety of companies both in the Internet
and telecommunications industries. These industries include major companies who
have greater resources and larger subscriber bases than we have, and have been
in operation for many years. We also compete in the growing market of discount
telecommunications services including calling cards, prepaid cards, call-back
services, dial-around or 10-10 calling and collect calling services. In
addition, some Internet service providers have begun to aggressively enhance
their real time interactive communications, focusing initially on instant
messaging, although we expect them to begin to provide PC-to- Phone services.
IP Telephony Providers. Many companies provide, or are planning to provide,
certain portions of the complete communications solution we offer, including
Net2Phone, iBasis, Inc. and ITXC Corp.
Traditional Telecommunications Carriers.
Several traditional telecommunications companies, including industry leaders
such as AT&T, Sprint, Deutsche Telekom, WorldCom and Qwest Communications
International, have announced their intention to offer enhanced Internet and IP
communications services in both the United States and internationally. All of
these competitors are significantly larger than we are and have:
- - substantially greater financial, technical and marketing resources;
- - larger networks;
- - a broader portfolio of services;
- - stronger name recognition and customer loyalty;
- - well-established relationships with many of our target customers;
- - an existing user base to which they can cross-sell their services.
These and other competitors may be able to bundle services and products that
are not offered by us together with enhanced Internet and IP communications
services, which could place us at a significant competitive disadvantage. Many
of our competitors enjoy economies of scale that can result in lower cost
structure for transmission and related costs, which could cause significant
pricing pressures within the industry.
Employees
As of December 31, 2002, we employed 69 full-time and 27 part-time employees,
of which 77 were located in Israel, and 19 were located in New York. We
consider our relationship with our employees to be good. None of our employees
is covered by collective bargaining agreements.
Generally, all male adult citizens and permanent residents of Israel under the
age of 51 are, unless exempt, obligated to perform up to 31 days of military
reserve duty annually. Additionally, all such residents are subject to being
called to active duty at any time under emergency circumstances. Some of our
officers and employees are currently obligated to perform annual reserve duty.
While we have operated effectively under these requirements since we began
operations, no assessment can be made as to the full impact of such
requirements on our workforce or business if conditions should change, and no
prediction can be made as to the effect on us of any expansion of such
obligations.
ITEM 2. PROPERTIES
We maintain our executive offices at 75 Broad Street, New York, New York under
a lease with an annual rent of approximately $650,000, increasing annually to
$870,000 during the final year of the lease. The lease term extends until July
2010, with an option to extend the lease for an additional five years.
We lease a 1,440 square meter office, which houses our research and development
facilities, at the Jerusalem Technology Park, Jerusalem, Israel at an annual
cost of $ 292,000. The lease term that expired in February 2003 contained an
option to extend the lease for an additional five years. In June 2002 we signed
an extension agreement for additional three years, commencing February 2003, at
an annual cost of $201,600, for 1,056 square meters, with the remaining 384
square meters to be returned to the building owner.
ITEM 3. LEGAL PROCEEDINGS
On October 8, 1999, Aerotel, Ltd. and Aerotel U.S.A. commenced a suit against
us, RSL COM and an RSL COM subsidiary in the United States District Court for
the Southern District of New York. Aerotel alleges that we are infringing on a
patent issued to Aerotel in November 1987 by making, using, selling and
offering for sale prepaid telephone card products in the United States. Aerotel
seeks an injunction to stop us from using the technology covered by this
patent, monetary damages in an unspecified amount and reimbursement of
attorneys' fees. We have answered the complaint, the parties engaged in
pre-trial discovery, and the case remains at a preliminary stage. We believe
that we have meritorious defenses to the claims and we intend to defend the
lawsuit vigorously. However, the outcome of the litigation is inherently
unpredictable and an unfavorable result may have a material adverse effect on
our business, financial condition and results of operations. Regardless of the
ultimate outcome, the litigation could result in substantial expenses to us and
significant diversion of efforts by our managerial and other personnel.
We, as well as certain of our former officers and directors, have been named as
defendants in a number of purported securities class actions in Federal
District Court for the Southern District of New York, arising out of our
initial public offering in November 1999 (the "IPO"). Various underwriters of
the IPO also are named as defendants in the actions. The complaints allege,
among other things, that the registration statement and prospectus filed with
the Securities and Exchange Commission for purposes of the IPO were false and
misleading because they failed to disclose that the underwriters allegedly (i)
solicited and received commissions from certain investors in exchange for
allocating to them shares of our stock in connection with the IPO and (ii)
entered into agreements with their customers to allocate such stock to those
customers in exchange for the customers agreeing to purchase additional shares
in the aftermarket at predetermined prices. On August 8, 2001, the court
ordered that these actions, along with hundreds of IPO allocation cases against
other issuers, be transferred to Judge Scheindlin for coordinated pre-trial
proceedings. In July 2002, omnibus motions to dismiss the complaints based on
common legal issues were filed on behalf of all issuers and underwriters. On
February 19, 2003, the Court issued an opinion granting in part and denying in
part those motions to dismiss. The complaint against the Company was not
dismissed as a matter of law. These cases remain at a preliminary stage and no
discovery proceedings have taken place. We believe that the claims asserted
against us in these cases are without merit and intend to defend ourselves
vigorously against them.
On February 12, 2003 we announced that four lawsuits had been filed against us,
our officers and directors, and our majority stockholder, Atarey Hasharon
Chevra Lepituach Vehashkaot Benadlan (1991) Ltd. ("Atarey"), in connection with
our formation of the special committee to evaluate the proposal by Atarey to
purchase all of our outstanding shares of common stock not held by Atarey and
its affiliates. On February 6, 2003, we issued a press release in connection
with the proposed transaction. The lawsuits purport to be class actions on
behalf of our public stockholders. The plaintiffs in these actions have
asserted a variety of claims, including allegations that Atarey's proposed
tender offer price for our publicly held shares is unfair and grossly
inadequate; and that our officers and directors have breached their fiduciary
duties to the public stockholders. Each of the lawsuits has been filed in the
Delaware Court of Chancery in and for New Castle County. We do not believe
that these lawsuits state valid claims against us or any of our officers or
directors.
We are not a party to any other material litigation and are not aware of any
other pending or threatened litigation that could have a material adverse
effect on us or our business taken as a whole.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
Market Information
Our common stock is currently listed on the Nasdaq SmallCap Market under the
symbol "DDDC". The listing of our common stock was transferred from the Nasdaq
National Market to the Nasdaq SmallCap Market effective on September 17, 2002.
Our common stock had traded on the Nasdaq National Market under the symbol
"DDDC" since November 22, 1999. We currently meet all criteria for continued
inclusion in the Nasdaq SmallCap Market except for the $1.00 minimum bid price
per share requirement. We currently have a grace period until September 1, 2003
to demonstrate a closing bid price of at least $1.00 for a minimum of ten
consecutive trading days, provided we can demonstrate that we remain in
compliance with the Nasdaq SmallCap Market's initial listing standards, based
on Nasdaq's most recent rules. Nasdaq regulations allow for the transfer back
to the Nasdaq National Market should we maintain a minimum bid price of $1.00
for at least 30 consecutive trading days by September 1, 2003, and comply at
all times with other applicable continued listing requirements for the Nasdaq
National Market.
The following table sets forth the per share range of high and low closing
sales prices of our common stock for the periods indicated:
High Low
------ -----
Year ended December 31, 2000
First quarter $62.38 $18.00
Second quarter 21.38 5.75
Third quarter 15.00 3.56
Fourth quarter 5.44 1.19
Year ended December 31, 2001
First quarter 3.50 1.03
Second quarter 1.61 0.60
Third quarter 0.98 0.26
Fourth quarter 0.93 0.52
Year ended December 31, 2002
First quarter 1.25 0.75
Second quarter 1.08 0.60
Third quarter 0.63 0.34
Fourth quarter 0.90 0.37
Year ended December 31, 2003
First quarter (through March 27th, 2003) 0.68 0.48
On March 27, 2003, the last reported sale price for our common stock on the
Nasdaq SmallCap Market was $0.55 per share. The market price for our stock is
highly volatile and fluctuates in response to a wide variety of factors.
Holders
As of March 27, 2003, we had approximately 129 holders of record of our common
stock. This does not reflect persons or entities who hold their stock in
nominee or "street" name through various brokerage firms.
Dividend Policy
We have never declared or paid any cash dividends on our capital stock. We do
not anticipate paying any cash dividends on our capital stock in the
foreseeable future. We currently intend to retain future earnings, if any, to
finance our operations and to expand our business. Any future determination to
pay cash dividends will be at the discretion of our board of directors and will
be dependent upon our financial condition, operating results, capital
requirements and other factors that our board of directors considers
appropriate.
Equity Compensation Plan Information
The following table provides certain aggregate information with respect to all
of our equity compensation plans in effect as of December 31, 2002:
Plan Category Number of Weighted Number of
Securities to Average Securities
be Issued Upon Exercise Price Remaining
Exercise of of Outstanding Available for
Outstanding Options, Future Issuance
Options, Warrants and Under Equity
Warrants and Rights Compensation
Rights Plans
(excluding
securities
reflected in
first column)
-------------- -------------- --------------- ----------------
Equity 3,449,520 $2.87 550,480
Compensation
Plans Approved
by Security
Holders (1)
-------------- -------------- --------------- ----------------
Equity N/A N/A N/A
Compensation
Plans not
Approved by
Security
Holders
-------------- -------------- --------------- ----------------
Total 3,449,520 $2.87 550,480
-------------- -------------- --------------- ----------------
(1) These plans consist of our 1999 Stock Incentive Plan, 1999 Directors'
Plan, and 1999 Employee Stock Purchase Plan.
Recent Sales of Unregistered Securities
None.
Use of Proceeds
On November 22, 1999, we offered 6,000,000 shares of our common stock in an
initial public offering. These shares were registered with the Securities and
Exchange Commission on a registration statement on Form S-1 (file no.
333-86503), which became effective on November 22, 1999. We received net
proceeds of approximately $96,255,000 from the sale of 6,900,000 shares at the
initial public offering price of $15.00 per share after deducting underwriting
commissions and discounts and expenses of approximately $6,300,000. The
managing underwriters for our initial public offering were Lehman Brothers
Inc., Merrill Lynch & Co., U.S. Bancorp Piper Jaffray, Lazard Freres & Co. LLC
and Fidelity Capital Markets.
Through December 31, 2002, we used approximately $33 million of the net
proceeds for sales, marketing and promotional activities, $20 million for
capital expenditures and $13 million for general corporate purposes. Pending
use of the remaining net proceeds, we have invested the remaining net proceeds
in interest-bearing, investment-grade instruments, certificates of deposit, or
direct or guaranteed obligations of the United States.
ITEM 6. SELECTED FINANCIAL DATA
We derived the selected consolidated financial data presented below from our
consolidated financial statements and related notes included in this annual
report. You should read the selected consolidated financial data together with
our consolidated financial statements and related notes and the section of this
annual report entitled "Management's Discussion and Analysis of Financial
Condition and Results of Operations." Brightman Almagor & Co., a member firm of
Deloitte Touche, independent certified public accountants, audited our
historical financial statements since inception and as of and for the years
ended December 31, 1998, 1999, 2000, 2001 and 2002. Their report appears
elsewhere in this annual
report.
Year Ended December 31,
-----------------------------------------------
1998 1999 2000 2001 2002
(In thousands, except share data)
Statement of Operations Data:
Revenues:
Affiliates $3,896 $7,431 $13,977 $1,669 $ -
Non-affiliates 1,742 3,621 16,399 13,991 12,929
Total revenues 5,638 11,052 30,376 15,660 12,929
Costs and operating expenses:
Cost of revenues, net (4,459) (9,723) (24,932) (13,486) (8,934)
Research and development expenses, net (650) (1,233) ( 6,625) ( 5,648) (3,435)
Selling and marketing expenses (2,431) (7,403) (20,548) ( 7,800) (3,910)
General and administrative (1,842) (2,754) ( 6,694) ( 6,982) (2,158)
expenses (exclusive of non-cash
compensation expense)
Non-cash compensation expense ( 743) (19,116) ( 6,331) (825) (270)
Depreciation and amortization (2,671) ( 3,721) ( 7,919) ( 8,996) (6,606)
Write-down of fixed assets - - - ( 1,003) -
Expenses due to cancellation of - - - ( 3,628) -
supplier agreement
Impairment of goodwill - - ( 8,905) ( 4,151) -
Total costs and operating expenses (12,796) (43,950) (81,954) (52,519) (25,313)
Loss from operations ( 7,158) (32,898) (51,578) (36,859) (12,384)
Interest income (expense), net ( 186) (873) 3,632 1,677 448
Minority interest 223 - - - -
Income taxes - - (311) (552) (141)
Net loss $( 7,121)$(33,771) $(48,257) $(35,734) $(12,077)
Net loss per share - basic and $ (0.37) $(1.65) $ (1.67) $ (1.23) $ (0.42)
diluted
Weighted average shares outstanding 19,254 20,418 28,833 29,035 28,886
- - basic and diluted
Year Ended December 31,
---------------------------------------------
1998 1999 2000 2001 2002
(In thousands)
Balance Sheet Data:
Cash and cash equivalents $ 1,357 $89,957 $20,857 $13,583 $5,681
Short-term investments - 11,276 30,542 14,192 15,552
Working capital (deficiency) (3,232) 82,942 43,538 23,374 17,675
Total assets 25,676 126,832 86,169 45,869 32,197
Long-term debt due to affiliates 5,107 - - - -
Total stockholder's equity 12,370 102,580 72,479 38,921 27,114
(deficiency)
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion of our financial condition and results of operations
should be read together with our consolidated financial statements and the
related notes thereto included in another part of this annual report. This
discussion contains certain forward-looking statements that involve substantial
risks and uncertainties. When used in this report the words "anticipate,"
"believe," "estimate," "expect" and similar expressions as they relate to our
management or us are intended to identify such forward-looking statements. Our
actual results, performance or achievements could differ materially from those
expressed in, or implied by, these forward-looking statements. Historical
operating results are not necessarily indicative of the trends in operating
results for any future period.
Overview
We are a provider of integrated Voice over Internet Protocol (VoIP) telephony
services. We were founded in 1996 to capitalize on the growth of the Internet
as a communications tool by commercially offering Internet Protocol (IP)
telephony services. IP telephony is the real time transmission of voice
communications in the form of digitized "packets" of information over the
Internet or a private network, similar to the way in which e-mail and other
data is transmitted. Our business currently includes the provision of enhanced
Web-based and other communications services to individual consumers, under our
iConnectHere brand name, the provision of a total "Hosted Communications
Solution" that enables corporate customers and service providers to offer
private label telecommunications to their customer bases, and the transmission
of voice and data traffic for communications carriers.
Prior to 1999, our focus was to build a privately-managed, global network
utilizing IP technology. Our business primarily consisted of carrying and
transmitting traffic for communications carriers over our network. Beginning in
1999, we began to diversify our offerings by layering enhanced IP telephony
services over our network. These enhanced services were targeted at consumers
and were primarily accessible through our consumer Web site. During 2000, we
began offering services on a co-branded or private-label basis to service
providers and other businesses to assist them in diversifying their product
offerings to their customer bases. In early 2001, we deployed our Broadband
Phone offering - a complete phone replacement solution available to business
and consumer customers over the "last mile" through broadband connections via
cable modem, DSL or fixed wireless. In 2001, we also announced the launch of
our state-of-the-art SIP (Session Initiation Protocol) infrastructure, and we
became one of the first service providers to have built an end-to-end SIP
network. During 2002, our continuing SIP efforts resulted in our launch of our
SIP-based dialer. These efforts are designed to position us as a leading
provider of VoIP services.
Factors Affecting Future Results
Industry and Economic Factors: Our operations and earnings are affected by
local, regional and global events or conditions that affect supply and demand
for telecommunications products and services. These events or conditions are
generally not predictable and include, among other things, general economic
growth rates and the occurrence of economic recessions; the development of new
supply sources; supply disruptions; technological advances, including advances
in telecommunications technology and advances in technology relating to
telecommunications usage; changes in demographics, including population growth
rates and consumer preferences; and the competitiveness of alternative
telecommunications sources or product substitutes. Currently, the economy in
general and the telecommunications industry in particular are suffering. A
number of the leading telecommunications companies have seen their market
capitalizations decrease dramatically and some have filed for bankruptcy
protection. As a result, raising capital has become extremely difficult, there
is extreme pressure on the pricing of telecommunications services and potential
customers and partners have sharply cut back on expenditures, all of which
impact us.
Competitive Factors: The telecommunications industry is highly competitive.
There is competition within the traditional telecommunications marketplaces
(landline and wireless) and also with other emergent "next generation"
telecommunications providers, including IP telecommunications providers in
supplying the overall telecommunications needs of businesses and individual
consumers. We compete with other telecommunications firms in the sale and
purchase of various products and services in many national and international
markets and employ all methods of competition which are lawful and appropriate
for such purposes. A key component of our competitive position, particularly
given the commodity-based nature of many of our products, is our ability to
manage operating expenses successfully, which requires continuous management
focus on reducing unit costs and improving efficiency.
Political Factors: Our operations and earnings have been, and may in the future
be, affected from time to time in varying degree by political instability and
by other political developments and laws and regulations, such as forced
divestiture of assets; restrictions on production, imports and exports; war or
other international conflicts; civil unrest and local security concerns that
threaten the safe operation of company facilities; price controls; tax
increases and retroactive tax claims; expropriation of property; cancellation
of contract rights; and telecommunications regulations. Both the likelihood of
such occurrences and their overall effect upon us vary greatly from country to
country and are not predictable.
Project Factors: In addition to the factors cited above, the advancement, cost
and results of particular projects depend on the outcome of negotiations with
potential partners, governments, suppliers, customers or others; changes in
operating conditions or costs; and the occurrence of unforeseen technical
difficulties.
Risk Factors: See "-Risk Factors" below for discussion of the impact of market
risks, financial risks and other uncertainties.
Revenues
Prior to June 28, 2001, our majority shareholder was RSL COM, a large
telecommunications provider, who was also our largest customer. As such, for
financial reporting purposes for fiscal year 2001 and prior years, revenues
were derived from affiliates and non-affiliates. Revenues from affiliates
consist of revenues received from RSL COM for the carrier transmission and
calling card services we provided to RSL COM, prior to Atarey's acquisition of
RSL COM's holdings of our stock. The majority of the services we provided to
RSL COM were resold by RSL COM to other communications companies, and the
remainder were used directly by RSL COM's customers. Carrier transmission
services to RSL COM accounted for 0% of our total revenues in 2002 and 10.7% of
our total revenues in 2001.
Revenues from non-affiliates consist of revenues from end- users of our
enhanced IP communications services, including PC-to- Phone and Phone-to-Phone,
which are generated by our both our consumer offering, iConnectHere, and our
Hosted Communications Solution, and revenues from carriers other than RSL COM
for carrier transmission services. All revenues are recognized as the services
are performed. The provision of enhanced IP communications services (primarily
PC-to-Phone) through iConnectHere accounted for 43.3% and 32.7% of our total
revenues in 2002 and 2001, respectively, while the provision of enhanced IP
communications services through our Hosted Communications Solution sales
efforts accounted for 16.9% and 22.1% of our total revenues in 2002 and 2001,
respectively. Carrier transmission services to non-affiliates accounted for
10.9% and 11.2% of our total revenues in 2002 and 2001, respectively.
Costs and Operating Expenses
Costs and operating expenses consist of cost of revenues, research and
development expenses, selling and marketing expenses, general and
administrative expense, depreciation and amortization of goodwill, non-cash
stock compensation, write-down of fixed assets, expenses due to cancellation of
agreement with a supplier and impairment of goodwill related expenses.
- - Cost of revenues consist primarily of access, termination and transmission
costs paid to carriers that we incur when providing services and fixed costs
associated with leased transmission lines. The term of our contracts for leased
transmission lines is generally one year, or less, and either party can
terminate with prior notice.
- - Research and development expenses consist primarily of costs
associated with establishing our network and the initial testing of our
services and compensation expenses of software developers involved in new
product development and software maintenance. In the future, these expenses may
fluctuate as a percentage of revenue depending on the project undertaken during
the reporting period. Since our inception, we have expensed all research and
development costs in each of the periods in which they were incurred.
- - Selling and marketing expenses consist primarily of advertising and
promotional expenses incurred to attract potential consumer users of
iConnectHere and expenses associated with our direct sales force incurred to
attract potential business customers and service providers for our Hosted
Communications Solution. We expect to decrease our overall selling and
marketing expenses as we focus our attention on growing the percentage of sales
related to our Hosted Communications Solution. We anticipate that as we add new
paid users we will be able to spread these costs over a larger revenue
base and accordingly improve our operating margins.
- - General and administrative expenses consist primarily of
compensation and benefits for management, finance and administrative personnel,
occupancy costs and legal and accounting fees, as well as the expenses
associated with being a public company, including the costs of directors' and
officers' insurance.
We have not recorded any income tax benefit for net losses and credits incurred
for any period from inception to December 31, 2002. The utilization of these
losses and credits depends on our ability to generate taxable income in the
future. Because of the uncertainty of our generating taxable income, we have
recorded a full valuation allowance with respect to these deferred assets.
We recognized $6.3 million in non-cash compensation expense in 2000, $825,000
in 2001, and $270,000 in 2002.
Critical Accounting Policies
Our established policies are outlined in the footnotes to the Consolidated
Financial Statements (contained in Part IV, Item 15 of this Form 10-K) entitled
"Note 2 - Summary of significant accounting policies". As part of its oversight
responsibilities, our management evaluates the propriety of its accounting
methods as new events occur. We believe that our policies are applied in a
manner which provides the reader of our financial statements a current,
accurate and complete presentation of information in accordance with U.S.
Generally Accepted Accounting Principles. Principal accounting practices that
require the use of assumptions and judgments are outlined below:
Revenue recognition and deferred revenue: We record revenue from Internet
telephony services based on minutes (or fractions thereof) of customer usage.
We record payments received in advance for prepaid services and services to be
supplied under contractual agreements as deferred revenue until such related
services are provided. We estimate the allowance for doubtful accounts by
reviewing the status of significant past due receivables and analyzing
historical bad debt trends and we then reduce accounts receivables by such
allowance for doubtful accounts to expected net realizable value.
Expenses: Cost of revenues is comprised primarily of access, transmission and
termination costs based on actual minutes in addition to monthly circuit lease
costs and is net of reimbursements from vendors. Research and development
expenses, net of reimbursements from vendors, are expensed as incurred.
Advertising expenses are expensed as incurred.
Long-lived Assets: Property and equipment are stated at cost. Depreciation is
calculated using the straight-line method over the estimated useful lives of
the depreciable assets, which range from two to five years. Improvements are
capitalized, while repair and maintenance costs are charged to operations as
incurred. In accordance with SFAS 121, our long-lived assets are reviewed for
impairment on a quarterly basis and whenever events or changes in
circumstances occur indicating that the net carrying amount may not be
recoverable. We review for impairment by comparing the carrying value of the
long-lived asset to the estimated undiscounted future cash flows expected to
result from the use of the long-lived assets (and their eventual disposition).
If the sum of the expected undiscounted future cash flows is less than the
carrying amount of assets, we would recognize an impairment loss. The
impairment loss, if determined to be necessary, would be measured as the
amount by which the carrying amount of the long-lived asset exceeds the fair
value of the long-lived asset based on estimated future discounted cash flows.
Effective December 1, 2001, we adopted SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets," (SFAS 144) which addresses
financial accounting and reporting for the recognition and measurement of
impairment and disposal of long-lived assets. SFAS 144 supersedes SFAS No.
121. The adoption of SFAS 144 did not have a material effect on our
consolidated financial position or results of operations.
Results of Operations
The following table sets forth the statement of operations data presented as a
percentage of revenues for the periods indicated:
2000 2001 2002
-------- ------- -------
Year Ended December 31,
--------------------------
Revenues:
Affiliates 46.0% 10.7% 0.0%
Non-affiliates
54.0 89.3 100.0
Total revenues ----- ------ -------
100.0 100.0 00.0
Costs and operating expenses:
Cost of revenues, net 82.1 86.0 69.1
Research and development expenses, net 21.8 36.0 26.6
Selling and marketing expenses 67.6 49.8 30.2
General and administrative expenses
(exclusive of non-cash 22.0 44.6 16.7
compensation expense)
Non-cash compensation expense 20.8 5.3 2.1
Depreciation and amortization 26.1 57.4 51.1
Write down of fixed assets - 6.4 0.0
Expenses due to cancellation of supplier agreement - 23.2 0.0
Impairment of goodwill 29.3 26.5 0.0
Total revenues ----- ------ ------
Total costs and operating expenses 269.8 335.3 95.8
Total revenues ------ ------- ------
Loss from operations (169.8) (235.3) (95.8)
Interest income (expense), net 12.0 10.7 3.5
Income taxes 1.0 ( 3.5) ( 1.1)
------ ------- ------
(158.9)% (228.2)% (93.4)%
======== ======== =======
Comparison of 2002 and 2001
Revenues
Affiliates. There were no revenues from affiliates in 2002, compared to $1.7
million in 2001.The decrease in revenues from affiliates was due to the sale of
all of our Class B Common Stock, representing majority ownership of us, on June
29, 2001 by RSL Communications, Ltd. ("RSL COM") and our disconnection from the
RSL COM network.After June 29, 2001, there were no further revenues from
affiliates, and we do not anticipate receiving revenues from affiliates in the
future.
Non-affiliates. Revenues from non-affiliates decreased approximately $1.1
million or 7.9% to approximately $12.9 million in 2002 from approximately $14.0
million in 2001. Revenues from enhanced IP communications services (including
our Hosted Communications Solution) decreased by approximately $0.7 million or
5.7% to approximately $11.5 million in 2002 from approximately $12.2 million in
2001, due to a lesser number of new Hosted Communications Solution partners,
yielding lower up-front integration fees, and partially offset by a greater
number of PC- to-Phone and Phone-to-Phone calls being placed by an increasing
user base.
Revenues from carrier transmission services, for telecommunications carriers
other than RSL COM, decreased by approximately $0.4 million or 22.2% to
approximately $1.4 million in 2002 from approximately $1.8 million in 2001, due
primarily to decreased demand from a smaller customer base. No customer (other
than RSL COM in 2001) accounted for greater than 10% of our revenues during
these periods.
Costs and Operating Expenses
Cost of revenues. Cost of revenues decreased by $4.6 millionor34.1% to $8.9
million in 2002 from $13.5 million in 2001,due primarily to a decrease in the
amount of traffic being terminated.
Research and development expenses. Research and development expenses decreased
by $2.2 million or 39.3% to $3.4 million in 2002 from $5.6 million in 2001, due
to lower personnel costs associated with the development of new services and
enhancements to our existing services.
Selling and marketing expenses. Selling and marketing expenses decreased by
$3.9 million or 50.0% to $3.9 million in 2002 from $7.8 million in 2001, due to
a significant decrease in branding and promotional activities.
General and administrative expenses. General and administrative expenses
decreased by $4.8 millionor68.6%to $2.2 million in 2002 from $7.0 million in
2001, primarily due to decreased personnel and occupancy costs.
Non-cash compensation expenses. Non-cash compensation expenses decreased by
$0.5 million or 62.5% to $0.3 million in 2002 from $0.8 million in 2001, due to
our impairment of goodwill during 2001. Consequently, there were no goodwill
related expenses during 2002.
Depreciation and amortization of goodwill. Depreciation and amortization of
goodwill increased by $2.4 million or 26.7% to $6.6 million in 2002 from $9.0
million in 2001, due to our on- going purchase, and subsequent depreciation of
fixed assets.
Loss from Operations
Loss from operations decreased by $24.5 million or 66.4% to $12.4 million in
2002 from $36.8 million in 2001, due primarily to the decrease in costs and
operating expenses, including non- cash compensation expenses and selling and
marketing expenses. We expect to continue to incur losses for the foreseeable
future.
Interest (Expense) Income, Net
Interest income decreased by $1.3million or 76.5% to $0.4 million in 2002 from
$1.7 million in 2001, due primarily to lower interest rates earned on a reduced
balance of remaining proceeds from our initial public offering.
Income Taxes, Net
We paid net income taxes of $0.1 million in 2002 compared to $0.6 million in
2001.
Net Loss
Net loss decreased $23.6 million or 66.1% to $12.1 million in 2002 from $35.7
million in 2001, due to the foregoing factors.
Comparison of 2001 and 2000
Revenues
Affiliates. Revenues from affiliates decreased by $12.3 million or 87.9% to
$1.7 million in 2001 from $14.0 million in 2000, due to the sale of all of our
Class B Common Stock on June 29, 2001 by RSL COM to Atarey and our
disconnection from the RSL COM network. After June 29, 2001, there were no
further revenues from affiliates, and we do not anticipate receiving revenues
from affiliates in the future.
Non-affiliates. Revenues from non-affiliates decreased by $2.4 million or 14.6%
to $14.0 million in 2001 from $16.4 million in 2000. Revenues from enhanced IP
communications services (including our Hosted Communications Solution)
decreased by $1.4 million or 10.3% to $12.2 million in 2001 from $13.6 million
in 2000, due to a lesser number of new Hosted Communications Solution partners,
yielding lower up-front integration fees, partially offset by a greater number
of PC-to-Phone and Phone-to- Phone calls being placed by an increasing user
base. Revenues from carrier transmission services for telecommunications
carriers other than RSL COM decreased by $1.0 million or 35.7% to $1.8 million
in 2001 from $2.8 million in 2000, due primarily to decreased demand from a
smaller customer base.
Revenues from carrier transmission services to RSL COM and other
telecommunications carriers accounted for 19.5% and 25.3% of revenues in 2001
and 2000, respectively. As revenues from our enhanced IP communication services
continue to grow as a percentage of total revenue, we expect that our revenues
from carrier transmission services will continue to account for a declining
percentage of our revenues. Other than RSL COM, no other customer accounted for
greater than 10% of our revenues
during these periods.
Costs and Operating Expenses
Cost of revenues. Cost of revenues decreased by$11.4 million or 45.8% to $13.5
million in 2001 from $24.9 million in 2000,due primarily to a decrease in the
amount of traffic being terminated.
Research and development expenses. Research and development expenses decreased
by $1.0 million or 15.2% to $5.6 million in 2001 from $6.6 million in 2000, due
to lower personnel costs associated with the development of new services and
enhancements to our existing services.
Selling and marketing expenses. Selling and marketing expenses decreased by
$12.8 million or 62.1% to $7.8 million in 2001 from $20.6 million in 2000, due
to a significant decrease in branding and promotional activities.
General and administrative expenses. General and administrative expenses
increased by $0.3millionor4.5%to $7.0 million in 2001 from $6.7 million in
2000, primarily due to increased personnel and occupancy costs.
Non-cash compensation expenses. Non-cash compensation expenses decreased by
$5.5 million or 87.3% to $0.8 million in 2001 from $6.3 million in 2000, due to
the completed amortization of costs incurred during 1998. Remaining
amortization of costs related to the 1999 grants of options and warrants below
the then fair market value will continue to be reflected in future financial
statements.
Depreciation and amortization of goodwill. Depreciation and amortization of
goodwill increased by $1.1 million or 13.9% to $9.0 million in 2001 from $7.9
million in 2000, due to our on- going purchase, and subsequent depreciation of
fixed assets.
Impairment of goodwill. We incurred a one-time expense of $4.2 million for the
year ended December 31, 2001 related to the impairment of goodwill. This
one-time charge was due to the write- off of `pushed-down' goodwill associated
with the acquisition of us by RSL COM, the valuation of which was impacted by
the sale of majority ownership by RSL COM to Atarey. We incurred a one-time
expense of $8.9 million for the year ended December 31, 2000 related to the
impairment of goodwill. This one-time charge was due to the write-off of
goodwill associated with the technology acquired through our acquisition of
Yourday.com, which was not incorporated into iConnectHere as originally
planned.
Write down of fixed assets from RSL sale. We incurred a one- time expense of
approximately $7.0 million from the write down of equipment that was purchased
in previous periods to support contracts and inter-company agreements between
us and RSL COM that were cancelled at the time of RSL COM's sale of its
majority ownership interest to Atarey. See Note 12 to the accompanying
financial statements for further details.
Expenses due to the cancellation of a supplier agreement . We incurred a
one-time expense of approximately $3.6 million that resulted from the
cancellation of a development and promotion agreement between CNET and us.
Expenses included a payment to terminate the contract and the acceleration of
the amortization of compensation charges deferred in previous years.
Loss from Operations
Loss from operations decreased by $14.7 million or 28.5% to $36.8 million in
2001 from $51.5 million in 2000, due primarily to the decrease in costs and
operating expenses, including non- cash compensation expenses and selling and
marketing expenses. We expect to continue to incur losses for the foreseeable
future.
Interest (Expense) Income, Net
Interest income decreased by $1.9 million or 52.8% to $1.7 million in 2001 from
$3.6 million in 2000, due primarily to lower interest rates earned on a reduced
balance of remaining proceeds from our initial public offering.
Income Taxes, Net
We paid net income taxes of $0.6 million in 2001 compared to $0.3 million in
2000.
Net Loss
Net loss decreased $12.5 million or 25.9% to $35.7 million in2001from$48.2
million in 2000,duetotheforegoing factors.
Liquidity and Capital Resources
Since our inception in June 1996, we have incurred significant operating and
net losses due in large part to the start-up and development of our operations.
As of December 31, 2002, we had an accumulated deficit of approximately $139.5
million. We anticipate that we will continue to incur operating and net losses
for the foreseeable future.
As of December 31, 2002, we had cash and cash equivalents of approximately $5.7
million, marketable securities and other short-term investments of
approximately $15.6 million and working capital of approximately $17.7 million.
We generated negative cash flow from operating activities of approximately $6.2
million during 2002 compared with negative cash flow from operating activities
of $22.7 million during 2001. Accounts receivable were approximately $0.7
million and $1.1 million at December 31, 2002 and December 31, 2001,
respectively.
Our capital expenditures decreased from approximately $1.6 million in the year
ended December 31, 2001 compared to approximately $0.4 million in the year
ended December 30, 2002, as we better utilize our existing domestic and
international network infrastructure.
Short-term, we obtain our funding from our utilization of the remaining
proceeds from our initial public offering offset by positive or negative cash
flow from our operations. These proceeds are maintained as cash and cash
equivalents with an original maturity of three months or less. Based on current
trends in our operations, these funds will be sufficient to meet our working
capital requirements, including operating losses, and capital expenditure
requirements for at least the next fiscal year, assuming that our business plan
is implemented successfully, and that:
- - our recent revenue trends, which reflected an increase in our higher-margin
(primarily PC-to-Phone) products and services continues to increase;
- - our expense trends remain at or near the rates of our fourth quarter 2002
rates, which were significantly reduced during the year through reductions in
personnel, curtailment of discretionary expenditures, and reduced network
rent and termination rates from our carriers; and
- - our net cash-burn rate, which was significantly reduced during the year due
to the foregoing factors to approximately $0.8 million in the fourth quarter
of 2002, continues to improve throughout 2003 and beyond.
To the extent that these trends do not remain steady, or if in the longer-term
we are not able to successfully implement our business strategy we may be
required to raise additional funds for our ongoing operations. Additional
financing may not be available when needed or, if available, such financing may
not be on terms favorable to us, especially in light of current economic
conditions and the unfavorable market for telecommunications companies in
particular. If additional funds are raised through the issuance of equity
securities, our existing stockholders may experience significant dilution. In
addition, while the indentures governing outstanding indebtedness of RSL COM
were cancelled and no longer restrict our ability to incur indebtedness, we
cannot assure you that any third party will be willing or able to provide
additional capital on favorable terms or at all.
Contractual Obligations and Commercial Commitments
With the exception of the real estate in ITEM 2. PROPERTIES, and Operating
Lease commitments (including automobile leases) of approximately $190,000 in
2003 and $140,000 in 2004, we have no other material contractual or commercial
commitments for 2003 and thereafter.
Risk Factors
In addition to the other information included in this annual report, you should
consider the following risk factors. This annual report contains
forward-looking statements covered by the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995. These forward-looking statements
involve risks and uncertainties that may affect our business and prospects.
Our results may differ significantly from the results discussed in the
forward-looking statements as a result of certain factors that are listed below
or discussed elsewhere in this annual report and our other filings with the
Securities and Exchange Commission. Risks Related to Our Company
We Have a History of Losses and Negative Cash Flow and We Anticipate They Will
Continue
We have incurred significant losses since inception, and we expect to continue
to incur significant losses for the foreseeable future. We reported net losses
of approximately $12.1 million in 2002, approximately $35.7 million in 2001,
and approximately $48.3 million in 2000. As of December 31, 2002, our
accumulated deficit was approximately $139.5 million. We generated negative
cash flow of approximately $7.9 million during 2002 and $7.3 million during
2001. As a percentage of revenues, our net loss was 93.4% in 2002, 228.2% in
2001 and 158.9% in 2000. Our revenues may not grow or even continue at their
current level. As a result, while we believe we have sufficient funds to meet
our working capital requirements for at least the next fiscal year (see -
Liquidity and Capital Resources), we will need to increase our revenues
significantly to become profitable. In order to increase our revenues, we need
to attract and maintain customers to increase the fees we collect for our
services. If our revenues do not increase as much as we expect or if our
expenses increase at a greater pace than revenues, we may never be profitable
or, if we become profitable, we may not be able to sustain or increase
profitability on a quarterly or annual basis.
We Will Need Additional Capital to Finance Our Operations in the Future
We intend to continue to enhance and expand our network in order to maintain
our competitive position and meet the increasing demands for service quality,
capacity and competitive pricing. Also, the introduction of new products and/or
service will require significant marketing and promotional expenses that we
often incur before we begin to receive the related revenue. While we believe we
have sufficient funds to meet our working capital requirements for at least the
next fiscal year (see - Liquidity and Capital Resources), if our cash flow from
operations is not sufficient to meet our capital expenditure and working
capital requirements, we will need to raise additional capital to continue our
operations. Especially in light of current economic conditions and the
unfavorable market for telecommunications companies in particular, we may not
be able to raise additional capital, and if we are able to raise additional
capital through the issuance of additional equity, our current investors could
experience dilution. If we are unable to obtain additional capital, we may be
required to reduce the scope of our business or our anticipated growth, which
would reduce our revenues.
We Have a Limited Operating History Upon Which You Can Evaluate Us
We have only a limited operating history upon which you can evaluate our
business and prospects. We commenced operations in June 1996. You should
consider our prospects in light of the risks, expenses and difficulties we may
encounter as an early stage company in the new and rapidly evolving market for
IP communications services. These risks include our ability:
- - to increase acceptance of our enhanced IP communications services (including
our Hosted Communications Solution), thereby increasing the number of users
of our IP telephony services;
- - to compete effectively;
- - to develop new products and keep pace with developing technology.
In addition, because we expect an increasing percentage of our revenues to be
derived from our enhanced IP communications services (including our Hosted
Communications Solution), our past operating results may not be indicative of
our future results.
We May Not be Able to Expand Our Revenue and Achieve Profitability
Our business strategy is to expand our revenue sources to include the provision
of enhanced IP communications services to several different customer groups. We
can neither assure you that we will be able to accomplish this nor that this
strategy will be profitable. Currently, our revenues are primarily generated by
sales of enhanced IP communications services through our direct consumer
offering, iConnectHere. Enhanced IP communications services generated 60.2%,
54.8%, and 44.8% of our total revenues in 2002, 2001 and 2000, respectively.
The provision of enhanced IP communications services has not been profitable to
date and may not be profitable in the future.
In the future, we intend to generate increased revenues from multiple sources,
many of which are unproven, including the commercial sale of our Hosted
Communications Solution and enhanced IP communications services. We expect that
our revenues for the foreseeable future will be dependent on, among other
factors:
- - sales of enhanced IP communications services and our Hosted Communications
Solution;
- - acceptance and use of IP telephony;
- - expansion of service offerings;
- - traffic levels on our network;
- - the effect of competition, regulatory environment, international long
distance rates and access and transmission costs on our prices;
- - continued improvement of our global network quality.
We may not be able to sustain our current revenues or successfully generate
additional revenues from the sale of enhanced IP communications services,
Hosted Communications Solutions or carrier transmission services.
We Cannot Assure You That a Market for Our Services Will Develop
We are uncertain whether a market will develop for our enhanced IP
communications services or our Hosted Communications Solutions. Our market is
new and rapidly evolving. Our ability to sell our services may be inhibited by,
among other factors, the reluctance of some end users to switch from
traditional communications carriers to IP communications carriers and by
concerns with the quality of IP telephony and the adequacy of security in the
exchange of information over the Internet. End users in markets serviced by
recently deregulated telecommunications providers are not familiar with
obtaining services from competitors of these providers and may be reluctant to
use new providers, such as us. Our ability to increase revenues depends on the
migration of traditional telephone network traffic to our IP network. We will
need to devote substantial resources to educate customers and end users about
the benefits of IP communications solutions in general and our services in
particular. If enterprises and their customers do not accept our enhanced IP
communications services and our Hosted Communications Solutions as a means of
sending and receiving communications, we will not be able to increase our
number of paid users or successfully generate revenues in the future.
Our Future Success Depends on the Growth in the Use of the Internet as a Means
of Communications
If the market for IP communications, in general, and our services in
particular, does not grow at the rate we anticipate or at all, we will not be
able to increase our number of users or generate revenues we anticipate. To be
successful, IP communications requires validation as an effective, quality
means of communication and as a viable alternative to traditional telephone
service. Demand and market acceptance for recently introduced services are
subject to a high level of uncertainty. The Internet may not prove to be a
viable alternative to traditional telephone service for reasons including:
- - inconsistent quality or speed of service;
- - traffic congestion on the Internet;
- - potentially inadequate development of the necessary infrastructure;
- - lack of acceptable security technologies;
- - lack of timely development and commercialization performance improvements;
- - unavailability of cost-effective, high-speed access to the Internet.
If Internet usage grows, the Internet infrastructure may not be able to support
the demands placed on it by such growth, or its performance or reliability may
decline. In addition, Web sites may from time to time experience interruptions
in their service as a result of outages and other delays occurring throughout
the Internet network infrastructure. If these outages or delays frequently
occur in the future, Internet usage, as well as usage of our communications
portal and our services, could be adversely affected.
Potential Fluctuations in Our Quarterly Financial Results Make it Difficult for
Investors to Predict Our Future Performance
Our quarterly operating results may fluctuate significantly in the future as a
result of a variety of factors, many of which are outside our control. The
factors generally within our control include:
- - the rate at which we are able to attract users to purchase our enhanced IP
communications services and our Communications Solutions;
- - the amount and timing of expenses to enhance marketing promotion efforts and
to expand our infrastructure;
- - the timing of announcements or introductions of new or enhanced services by
us.
The factors outside our control include:
- - the timing of announcements or introductions of new enhanced services by our
competitors;
- - technical difficulties or network interruptions in Internet or our
privately-managed network;
- - general economic and competitive conditions specific to our industry.
The foregoing factors also may create other risks affecting our long-term
success, as discussed in the other risk factors.
We believe that quarter-to-quarter comparisons of our historical operating
results may not be a good indication of our future performance, nor would our
operating results for any particular quarter be indicative of our future
operating results.
Our Network May Not Be Able to Accommodate Our Capacity Needs
We expect the volume of traffic we carry over our network to increase
significantly as we expand our operations and service offerings. Our network
may not be able to accommodate this additional volume. In order to ensure that
we are able to handle additional traffic, we may have to enter into long-term
agreements for leased capacity. To the extent that we overestimate our capacity
needs, we may be obligated to pay for more transmission capacity than we
actually use, resulting in costs without corresponding revenues. Conversely, if
we underestimate our capacity needs, we may be required to obtain additional
transmission capacity from more expensive sources. If we are unable to maintain
sufficient capacity to meet the needs of our users, our reputation could be
damaged and we could lose users.
We Face a Risk of Failure of Computer and Communications Systems Used in Our
Business
Our business depends on the efficient and uninterrupted operation of our
computer and communications systems as well as those that connect to our
network. We maintain communications systems in four facilities in New York, Los
Angeles, London and Jerusalem. Our systems and those that connect to our
network are subject to disruption from natural disasters or other sources of
power loss, communications failure, hardware or software malfunction, network
failures and other events both within and beyond our control. Any system
interruptions that cause our services to be unavailable, including significant
or lengthy telephone network failures or difficulties for users in
communicating through our network or portal, could damage our reputation and
result in a loss of users.
Our Computer Systems and Operations May Be Vulnerable to Security Breaches
Our computer infrastructure is potentially vulnerable to
physical or electronic computer viruses, break-ins and similar disruptive
problems and security breaches that could cause interruptions, delays or loss
of services to our users. We believe that the secure transmission of
confidential information over the Internet, such as credit card numbers, is
essential in maintaining user confidence in our services. We rely on licensed
encryption and authentication technology to effect secure transmission of
confidential information, including credit card numbers. It is possible that
advances in computer capabilities, new technologies or other developments could
result in a compromise or breach of the technology we use to protect user
transaction data. A party that is able to circumvent our security systems could
misappropriate proprietary information or cause interruptions in our
operations. Security breaches also could damage our reputation and expose us to
a risk of loss or litigation and possible liability. Although we have
experienced no security breaches to date of which we are aware, we cannot
guarantee you that our security measures will prevent security breaches.
Third Parties Might Infringe Upon Our Proprietary Technology
We cannot assure you that the steps we have taken to protect our intellectual
property rights will prevent misappropriation of our proprietary technology. To
protect our rights to our intellectual property, we rely on a combination of
trademark and patent law, trade secret protection, confidentiality agreements
and other contractual arrangements with our employees, affiliates, strategic
partners and others. We may be unable to detect the unauthorized use of, or
take appropriate steps to enforce, our intellectual property rights. Effective
copyright and trade secret protection may not be available in every country in
which we offer or intend to offer our services. Failure to adequately protect
our intellectual property could harm our brand, devalue our proprietary content
and affect our ability to compete effectively. Further, defending our
intellectual property rights could result in the expenditure of significant
financial and managerial resources.
Our Services May Infringe on the Intellectual Property Rights of Others
Third parties may assert claims that we have violated a patent or infringed a
copyright, trademark or other proprietary right belonging to them. We
incorporate licensed third-party technology in some of our services. In these
license agreements, the licensors have agreed to indemnify us with respect to
any claim by a third party that the licensed software infringes any patent or
other proprietary right so long as we have not made changes to the licensed
software. We cannot assure you that these provisions will be adequate to
protect us from infringement claims. Any infringement claims, even if not
meritorious, could result in the expenditure of significant financial and
managerial resources.
On October 8, 1999, we were named as a defendant in a lawsuit alleging that we
are infringing on a patent by making, using, selling and offering for sale
prepaid telephone card products in the United States. The plaintiffs are
seeking an injunction to stop us from using the technology covered by this
patent, monetary damages in an unspecified amount and reimbursement of
attorneys' fees. We have answered the complaint, the parties engaged in
pre-trial discovery, and the case remains at a preliminary stage. We believe
that we have meritorious defenses to the claim and we intend to defend the
lawsuit vigorously. However, the outcome of the litigation is inherently
unpredictable and an unfavorable result may have a material adverse effect on
our business, financial condition and results of operations. Regardless of the
ultimate outcome, the litigation could result in substantial expenses to us and
significant diversion of efforts by our managerial and other personnel.
Operating Internationally Exposes Us to Additional and Unpredictable Risks
We intend to continue to enter additional markets in Eastern Europe, Latin
America, Africa and Asia and to expand our existing operations outside the
United States. International operations are subject to inherent risks,
including:
- - potentially weaker protection of intellectual property rights;
- - political instability;
- - unexpected changes in regulations and tariffs;
- - fluctuations in exchange rates;
- - varying tax consequences;
- - uncertain market acceptance and difficulties in marketing efforts due to
language and cultural differences.
We Have Experienced Losses as a Result of Fraud
We have experienced losses due to fraud. In 2002, we experienced losses from
fraud of less than 2% of our revenues. Callers have obtained our services
without rendering payment by unlawfully using our access numbers and personal
identification numbers. Although we have implemented anti-fraud measures in
order to control losses relating to these practices, these measures may not be
sufficient to effectively limit all of our exposure in the future from fraud
and we continue to experience losses from fraud. While we have established
reserves for bad debts in accordance with historical levels of uncollectible
receivables resulting primarily from these fraudulent practices, our losses may
exceed our reserves and could rise significantly above anticipated levels.
Intense Competition Could Reduce Our Market Share and Harm Our Financial
Performance
Competition in the market for enhanced IP communications services is becoming
increasingly intense and is expected to increase significantly in the future.
The market for enhanced Internet and IP communications is new and rapidly
evolving. We expect that competition from companies both in the Internet and
telecommunications industries will increase in the future. Our competitors
include both start-up IP telephony service providers and established
traditional communications providers. Many of our existing competitors and
potential competitors have broader portfolios of services, greater financial,
management and operational resources, greater brand-name recognition, larger
subscriber bases and more experience than we have. In addition, many of our IP
telephony competitors use the Internet instead of a private network to transmit
traffic. Operating and capital costs of these providers may be less than ours,
potentially giving them a competitive advantage over us in terms of pricing.
We also compete in the growing market of discount telecommunications services
including calling cards, prepaid cards, call-back services, dial-around or
10-10 calling and collect calling services. In addition, some Internet service
providers have begun to aggressively enhance their real time interactive
communications, focusing initially on instant messaging, although we expect
them to begin to provide PC-to- phone services.
If we are unable to provide competitive service offerings, we may lose existing
users and be unable to attract additional users. In addition, many of our
competitors, especially traditional carriers, enjoy economies of scale that
result in a lower cost structure for transmission and related costs, which
cause significant pricing pressures within the industry. Although the minutes
of use we sell are increasing, revenues are not increasing at the same rate due
primarily to a decrease in revenue per minute for our carrier transmission
services. In order to remain competitive we intend to increase our efforts to
promote our services, and we cannot be sure that we will be successful in doing
this.
In addition to these competitive factors, recent and pending deregulation in
some of our markets may encourage new entrants. We cannot assure you that
additional competitors will not enter markets that we plan to serve or that we
will be able to compete effectively.
Decreasing Telecommunications Rates May Diminish or Eliminate Our Competitive
Pricing Advantage
Decreasing telecommunications rates may diminish or eliminate the competitive
pricing advantage of our services. International and domestic
telecommunications rates have decreased significantly over the last few years
in most of the markets in which we operate, and we anticipate that rates will
continue to be reduced in all of the markets in which we do business or expect
to do business. Users who select our services to take advantage of the current
pricing differential between traditional telecommunications rates and our rates
may switch to traditional telecommunications carriers as such pricing
differentials diminish or disappear, and we will be unable to use such pricing
differentials to attract new customers in the future. In addition, our ability
to market our carrier transmission services to telecommunications carriers
depends upon the existence of spreads between the rates offered by us and the
rates offered by traditional telecommunications carriers, as well as a spread
between the retail and wholesale rates charged by the carriers from which we
obtain wholesale service. Continued rate decreases will require us to lower our
rates to remain competitive and will reduce or possibly eliminate our gross
profit from our carrier transmission services. If telecommunications rates
continue to decline, we may lose users for our services.
Government Regulation and Legal Uncertainties Relating to IP
Telephony Could Harm Our Business
Historically, voice communications services have been provided by regulated
telecommunications common carriers. We offer voice communications to the public
for international and domestic calls using IP telephony, and we do not operate
as a licensed telecommunications common carrier in any jurisdiction. Based on
speci