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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
(Mark one)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Fiscal Year Ended July 31, 2002
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File Number 000-26763
NET2PHONE, INC.
(Exact name of registrant as specified in its charter)
Delaware 22-3559037
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
520 Broad Street 07102
Newark, New Jersey (Zip Code)
(Address of principal executive offices)
Registrant's telephone number, including area code: (973) 438-3111
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $0.01 per share
(Title of Class)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. |_|
The aggregate market value of registrant's common stock held by non-
affiliates of the registrant on October 17, 2002, was approximately
$74.1 million. On such date, the last sale price of registrant's common stock
was $2.22 per share. The number of shares outstanding of each of the
registrant's classes of common stock, as of October 17, 2002, was 34,447,213
shares of common stock and 28,986,750 shares of Class A common stock.
DOCUMENTS INCORPORATED BY REFERENCE
Certain sections of the registrant's Proxy Statement to be filed in
connection with the 2002 Annual Meeting of Stockholders are incorporated by
reference into Part III of this Form 10-K where indicated.
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NET2PHONE, INC.
2002 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I.
ITEM 1. BUSINESS ................................................................................... 1
ITEM 2. PROPERTIES ................................................................................. 23
ITEM 3. LEGAL PROCEEDINGS .......................................................................... 23
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ........................................ 24
PART II.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS ...................... 24
ITEM 6. SELECTED FINANCIAL DATA .................................................................... 26
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ...... 27
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ................................. 40
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ................................................ 40
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE ....... 40
PART III.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ......................................... 40
ITEM 11. EXECUTIVE COMPENSATION ..................................................................... 40
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ............................. 40
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ............................................. 40
ITEM 14. CONTROLS AND PROCEDURES .................................................................... 40
PART IV.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K ............................ 41
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS ....................................................................... F-1
SIGNATURES ....................................................................................................... S-1
CERTIFICATIONS ................................................................................................... S-3
PART I
This Form 10-K includes "forward-looking statements." The words "may,"
"will," "should," "continue," "future," "potential," "believe," "expect,"
"anticipate," "project," "plan," "intend," "seek," "estimate" and similar
expressions identify forward-looking statements. We caution you that any
forward-looking statements made by us are not guarantees of future performance
and that a variety of factors, including those discussed below, could cause our
actual results and experience to differ materially from the anticipated results
or other expectations expressed in our forward-looking statements. Please see
"Certain Risk Factors" below for detailed information about the uncertainties
and other factors that may cause actual results to materially differ from the
views stated in such forward-looking statements. All forward-looking statements
and risk factors included in this Form 10-K are made as of the date hereof,
based on information available to us as of the date hereof, and we assume no
obligation to update any forward-looking statement or risk factors.
Item 1. Business
Company Overview
We are a provider of Voice over Internet Protocol, or VoIP, telephony
products and services. We began operations in 1995 as a division of IDT
Corporation, and were incorporated in Delaware as a separate subsidiary of IDT
in October 1997. We utilize our VoIP technology to transmit digital voice
communications over the Internet and other data networks. We introduced our
flagship product, the personal computer to telephone, or PC-to-phone, service,
in 1996, which allows our end users to transmit voice communications over data
networks, such as the Internet, to standard phones on public switched
telephone networks. Since we introduced our PC-to-phone service, we have used
our VoIP technology and our ability to bridge VoIP networks with switched
networks to allow end users to send voice communications over the Internet via
telephone, computer or other calling device virtually anywhere in the world.
Since 1996, we have grown our VoIP services to the extent that, based on our
market share, we believe we are the largest retailer of VoIP services
worldwide.
The majority of our revenue comes from the sale of voice minutes over our
data networks. Currently, we market our products and services through three
units, each focused on a different market for those minutes: (1) International
Communications Services; (2) Domestic Retail Services; and (3) Broadband
Telephony Solutions. The International Communications Services group, or ICS,
is responsible for the sale of international long distance solutions utilizing
VoIP technology. ICS, in turn, is comprised of three divisions: (a) Channel
Sales and Distribution; (b) Carrier Services; and (c) Direct to Consumer
Services. Our Domestic Retail Services group sells VoIP minutes via both
disposable and rechargeable calling cards primarily to U.S. consumers.
Finally, our Broadband Telephony Solutions group is able to provide cable
operators with a fully outsourced end-to-end telecommunications solution
utilizing existing high speed cable data networks and the "last mile" access
into consumers' homes provided by the cable operator via cable modems.
During the past twelve months, we have aggressively consolidated our company
to focus on these three lines of business. In addition, we have de-emphasized
our activities in some markets to focus on what we believe are opportunities
with higher gross margins. The financial impact of these activities is described
in more detail below in our Management's Discussion and Analysis of Financial
Condition and Results of Operations under the heading "Restructing, Severance,
Impairment and Other Items."
VoIP Industry Overview
The international telecommunications industry has continued to grow since our
inception in 1995. This growth has been driven by increased demand and enabled
by technological advances, increased network development, greater bandwidth
capacity and domestic and international deregulation. As the industry has grown,
there has been an increasing drive to reduce the expenses surrounding continuous
network development. VoIP technology is a cost effective and efficient
alternative to traditional circuit switching technology. According to a January
2002 Frost & Sullivan report, VoIP is expected to account for approximately 35%
of world voice services by 2007. This expected growth, if achieved, will result
in additional VoIP minutes and associated revenues for the companies positioned
to take advantage of this market. We believe Net2Phone, which one independent
research company listed as having approximately 50% of the global market share
of retail VoIP service at the end of 2001, is in position to capitalize on these
market changes.
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We believe that there is also an increasing market for voice services
provided over cable broadband technology. According to a 2001 J.P. Morgan
estimate, nearly six million homes in the United States will purchase primary-
line telephony from their cable providers, contributing $4.4 billion in
revenues to these providers by 2006. Additionally, the same J.P. Morgan
estimate indicates that cable operators will capture approximately 65% of the
secondary line market by 2006, accounting for about $900 million in revenue by
2006. Because VoIP services are generally more efficient and require less
capital than traditional voice services, cable operators are beginning to
consider VoIP solutions as they begin to enter this new market. We believe our
broadband solution will be attractive to cable operators because we provide a
complete, end-to-end, fully outsourced alternative, that complies with cable
industry standards. We believe we are the first to provide a fully outsourced,
standards-compliant service, and that we will be able to take advantage of our
first-to-market position to some degree.
Our Business
We market our products and services through three units: (1) International
Communications Services; (2) Domestic Retail Services; and (3) Broadband
Telephony Solutions.
1. International Communications Services
We believe that there is a strong opportunity for growth in our
International Communications Services, or ICS, unit during fiscal year 2003.
To that end, in fiscal 2002, we restructured our organization in part to give
stronger focus to our ICS unit. The ICS group is comprised of three divisions:
(a) Channel Sales and Distribution; (b) Carrier Services; and (c) Direct to
Consumer Services.
(a) Channel Sales and Distribution
The Channel Sales and Distribution division contracts with third parties
around the world, who in turn distribute VoIP minutes and related enabling
devices to retailers, businesses, Internet cafes and others in the countries
where the distributor does business. We derive revenue from both the sale of
the hardware required to run our VoIP services and the sale of minutes of use
on our VoIP networks. By offering these third parties a combination of VoIP-
enabling hardware and minutes, we believe we offer a strong competitive
advantage over other VoIP providers, who primarily provide minutes over
personal computers. Our distributors purchase an integrated solution of both
hardware devices as well as VoIP minutes in bulk, predominantly on a pre-paid
basis, and then sell it through their respective distribution channels.
We initiate and manage relationships with our international distributors
through a global sales force, located in the United States, South America,
Europe, the Middle East and Asia. These distributors are then responsible for
their own sales and marketing efforts ultimately down to the end user. Typical
channel partners include Internet service providers, or ISPs, value added
resellers, Internet cafe owners, systems integrators and telecommunications
providers. These distributors then sell Net2Phone's integrated solutions of
hardware and minutes to businesses, Internet cafes, public call centers,
retail computer stores, hotels or directly to end-users. Many of our
distributors are not limited to purchasing combined offerings of devices and
minutes, but may purchase minutes separately, and then sell Net2Phone account
numbers through their distribution channels. We provide both customer service
and technical support to our distributors, who then provide customer service
and technical support through their distribution channels directly to their
end users.
The hardware and Internet devices, such as IP phones, we sell to these
distributors, allow end users to place a VoIP call without a computer. This is
an important piece to our marketing strategy, as many countries do not have
the widespread personal computer penetration that exists in the United States.
By using an IP phone or other device instead of a computer to place a call,
end users can improve the quality of the call as well as the overall user
experience. An end user may access our VoIP network through the use of other
Internet devices, such as our YAP Jack Plus, in conjunction with a regular
telephone. Thus, a user can plug a regular telephone into a Net2Phone powered
device for narrow-band or broadband services, which then connects the call to
a local data network. The call is then routed to Net2Phone's VoIP network,
which then connects to a gateway. The gateway then transfers the call off the
VoIP network and onto the public switched telephone network, or PSTN, and the
call is then completed locally to the caller's destination. We typically
contract with third parties to build these IP
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phones and other Internet devices, embedding either Net2Phone's calling engine
and protocols or industry standard (e.g., SIP) protocols inside the device.
(b) Carrier Services
Through our VoIP network, we offer carriers a low-cost, high quality,
alternative for the transport and termination of voice and fax communications.
We generate revenue from carriers through the sale of access to our network,
via a VoIP interconnect, and through call termination charges. We sell access
to our network to traditional circuit-switch carriers, and also to other VoIP
carriers via what we call a VoIP interconnect. Through the medium of a VoIP
interconnect, we link our VoIP network with other VoIP carriers' networks, and
then buy and sell minutes to and from these carriers. With little capital
expense, this linking of networks allows us to reduce termination costs,
increases the number of termination destinations available for us to resell
and expands our customer base. It is also easier and less expensive for us to
support VoIP networks than traditional networks.
We previously announced our intention to reduce our carrier services
activities and to seek only higher margin business. We recently reiterated
that decision and our intention to continue to de-emphasize our traditional
carrier services, and to that end, we plan on limiting our carrier activity to
selected carriers. IDT was our largest traditional circuit-switch carrier
customer in fiscal 2002, representing approximately 9% of our revenue for the
fiscal year.
(c) Direct to Consumer Services
We provide our PC-to-phone service to consumers globally through our web site
at www.net2phone.com via our CommCenter(SM) service. Our CommCenter service can
be downloaded from our web site in six different languages (English, Spanish,
French, Italian, German and Portuguese). CommCenter allows users with Internet
access to place telephone calls from their personal computer, or PC, to any
other PC or telephone in the world at rates which are almost universally lower
than the rates charged by traditional network carriers.
In addition, we work with multiple Internet service providers, or ISPs, and
other Internet portals to distribute our PC-to-phone service. For example, our
services are fully embedded in the Instant Messaging programs of AOL, Yahoo!
and Microsoft, so that Instant Messaging users can easily place phone calls
from their PCs using Net2Phone technology.
2. Domestic Retail Services
We sell domestic VoIP minutes through the sale of disposable and rechargeable
prepaid calling cards. Using multiple distributors, we sell disposable calling
cards, marketed primarily to ethnic communities. Recent immigrants and members
of these ethnic communities are heavy users of international long distance,
given their desire to keep in touch with family members and friends back home.
These cards can be purchased throughout the country at local retailers such as
newsstands. Our largest pre-paid disposable calling card distributor,
representing approximately 22% of our revenue for fiscal year 2002, is Union
Telecard Alliance, which is an affiliate of IDT. We are currently de-emphasizing
our domestic disposable calling card business.
Our rechargeable calling cards are linked to a customer's credit card. The
Net2Phone Direct(R) card, which is particularly convenient for use by
travellers, is currently available for originating calls from 25 different
countries and often offers lower rates than other long distance providers. Our
Pennytalk(SM) card caters more to callers who tend to talk for long periods of
time, offering a domestic rate of $0.01 per minute with an initial connection
charge of $0.49.
We market our rechargeable pre-paid calling cards through advertising in
traditional direct-response print in domestic publications. In addition, many
customers enroll for calling card services on the company's web site. We also
market through loyalty programs as well as through e-mail based programs to
existing customers.
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3. Broadband Telephony Solutions
We have leveraged our seven years of experience in VoIP services to develop
the first outsourced VoIP solution for cable operators that complies with cable
industry standards. We intend to target non-U.S. cable operators as well as
small to mid-size cable operators in the U.S. who may be more likely to prefer
to buy rather than build their own cable telephony solutions because of the
significant cost and other resources necessary to build an internal solution. By
offering a broadband telephony solution, we enable cable operators to offer
their subscribers the third leg of the "triple play" of voice, video and data
services and provide them with the opportunity to generate incremental revenue
and reduce churn. By hosting a complete solution, we also enable cable operators
to reduce the significant operating expenses associated with building an
internal solution.
Using the Net2Phone solution, the cable operator maintains ownership of the
customer, service brand, and first level customer and technical support. In
turn, we support the back office platform, switching and transport, ongoing
operations and higher levels of technical support to deliver a fully managed
solution. We track and monitor voice quality and network performance metrics
from start to finish and provide cable operators with a full view of the
status of telephone calls routed over their network. Consumers benefit from
cost savings over their current phone service, in addition to receiving a
unified bill aggregating cable TV, high-speed Internet access and telephone
services.
We initiated our first deployment of our cable broadband solution with
Liberty Cablevision of Puerto Rico in June 2002. This deployment began with a
trial to approximately 100 subscribers without charge. We are currently moving
to a second stage of deployment, during which we will commence billing, acquire
market research and validate the scalability of our technology. Although we are
currently evaluating our business model for supporting such a solution, we do
expect to collect some minimal revenues from monthly maintenance fees, platform
usage fees, and per-minute termination fees beginning in fiscal 2003.
Our Strategic Relationships
We maintain strategic relationships with several investors and customers
that are an important part of our business plans. During fiscal 2002, we
terminated or substantially reduced our reliance on several strategic
relationships that were no longer essential to our business plans. We also
sold our ownership interests in some of these companies, and in other
instances, we have elected not to participate in additional financing requests
from these companies, thereby reducing our equity interest in these companies
to a point where our relationships are no longer material.
Our Relationship with IDT Corporation
We continue to maintain significant business relationships with IDT
Corporation and its affiliates. Our companies' headquarters are located in the
same building in Newark, New Jersey. Our Chairman of the Board, Howard Jonas,
is also Chairman of the Board of IDT, and four other members of our thirteen
member board of directors are employees and/or directors of IDT. We also have
the following material business relationships with IDT:
o IDT is our largest carrier customer, and an affiliate of IDT, Union
Telecard Alliance, is our largest pre-paid disposable calling card
customer;
o We are a customer of IDT, using its network for a portion of our long
distance traffic;
o Our Newark, New Jersey headquarters, as well as our facilities in
Hackensack and Piscataway, New Jersey, are leased from IDT;
o We lease equipment storage space for some of our networking hardware from
IDT locations in New Jersey and London, and occasionally at other IDT
locations around the world;
o On occasion, we have aggregated long distance minutes and other services
purchases with IDT;
o We have entered into, and may continue to enter into, joint ventures and
other investments with IDT that we believe to be mutually beneficial. For
example, in April 2002, we formed Enterprise Communication Solutions,
LLC, a Delaware limited liability company, with an affiliate of IDT to
develop and offer voice
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communications services, data services and software systems based on VoIP
technology to large U.S. corporate customers. The business plan for this
company is still being developed; and
o On occasion, we provide outsourced services to IDT, and IDT provides
outsourced services to us.
For more information relating to our relationship with IDT, please see Note
13 to our financial statements included elsewhere in this Form 10-K.
NTOP Holdings, L.L.C. and Our Relationship with Liberty Media
In October 2001, IDT, Liberty Media Corporation and AT&T formed NTOP
Holdings, L.L.C., a limited liability company, which through a series of
transactions among AT&T, IDT and Liberty Media, now holds an aggregate of
28,896,750 million shares of our Class A common stock representing just over
50 percent of our outstanding capital stock, and controls approximately 64% of
our stockholder vote. IDT controls the right to vote the shares of our Class A
common stock held by the LLC in most matters, and is the managing member of
the LLC.
In June 2001, we entered into a Binding Memorandum of Understanding with
Liberty Media Corporation, which provided Liberty Media with a license for our
VoIP and other proprietary technology. As a result of the new corporate
structure formed in October 2001, and the restructuring of our relationship
with Liberty and IDT with respect to our broadband initiative, the Memorandum
of Understanding no longer reflected our anticipated business relationship
with Liberty. Accordingly, we terminated the Memorandum of Understanding in
May 2002, including the license granted to Liberty and the right to receive
the future payments provided for therein, and instead began working closely
with Liberty Media Corporation to develop the business model for offering a
fully outsourced telephony solution to Liberty Media cable operators. To that
end, we entered into an agreement with Liberty Cablevision of Puerto Rico, an
affiliate of Liberty Media, in June 2002 to begin a pilot of such a service,
which is ongoing.
Other Relationships
During fiscal 2002, we have reduced our reliance on several strategic
partners that were material to us in fiscal 2001. Below is a brief description
of the current status of certain of these relationships below.
Yahoo!
On July 24, 2000, we entered into a three-year exclusive services and
marketing agreement whereby Yahoo! granted us exclusivity on the Yahoo!
network of properties. We also committed to make advertising media buys. The
2000 Yahoo! agreement provided, among other things, that: (1) Yahoo! would
embed our Internet telephony software into its Yahoo! Messenger software
client; (2) Yahoo! would use our network to carry traffic to and from its
voice portal that was not yet available to the public; and (3) we would be
permitted to market our products and services to users of the Yahoo! voice
portal.
At the time, our future obligations under the 2000 Yahoo! agreement were
advertising commitments and placement fees, which were to be paid over the
life of the contract, and an upfront signing fee. The 2000 Yahoo! agreement
also provided for revenue sharing after costs were recovered. It became
apparent during the second quarter of fiscal 2001 that the actual usage for
our telephony services would be significantly less than projected with the
result that we would neither cover the costs of continuing the service, nor be
able to cover the incremental cost of the placement or advertising
commitments.
The 2000 Yahoo! agreement also required us to provide free domestic U.S. PC-
to-phone calling to consumers. The cost for the free minutes was initially
projected to be covered by international calling margins and advertising on
the PC-to-phone platform. This advertising model was not successful.
As a result of these factors, in December 2000, we agreed to pay Yahoo! a
one-time fee of $19 million to terminate the 2000 Yahoo! agreement and wrote
off previously capitalized advance payments of $12 million that were being
amortized over the three-year contract period. The $19 million termination fee
was significantly less than the costs that we would have incurred had the 2000
Yahoo! agreement not been terminated.
We entered into a new agreement with Yahoo! in March 2001, whereby we
provided paid VoIP services to Yahoo! The fees we charged Yahoo! for the
services were at competitive rates reflective of current market
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conditions and demand for these services. The 2000 Yahoo! agreement and the
March 2001 Yahoo! agreement are separate and distinct agreements. Accordingly,
we wrote off the $19 million one-time fee and $12 million of unamortized
advance payments, as we were not receiving any future benefit under the 2000
Yahoo! agreement.
Under the March 2001 Yahoo! agreement, we paid to Yahoo! a percentage of PC-
to-phone gross revenues from Yahoo! subscribers as well as revenues we
received from users of the Yahoo! voice activated dialer after deducting
agreed upon per minute charges made by Net2Phone. Under the March 2001
agreement, Yahoo! paid Net2Phone on a per minute basis for the 1-800 My-Yahoo
services hosted by Net2Phone. The March 2001 agreement expired by its terms on
December 31, 2001.
We entered into a new agreement with Yahoo! on January 29, 2002 replacing
the March 2001 agreement. Under the new 2002 agreement, Yahoo!'s users
continue to use Net2Phone's voice activated dialing and PC-to-Phone services
that were offered under the prior agreement. We receive per minute fees from
Yahoo! for calls using the voice activated dialing service and pay Yahoo! a
percentage of gross revenue derived from users of the PC-to-phone service. The
2002 agreement expires by its terms on November 15, 2002.
Microsoft
On June 2, 2000, we entered into a three-year agreement with Microsoft to
integrate our VoIP products and services into Microsoft's MSN Messenger. Under
this agreement, Net2Phone served as Microsoft's exclusive Internet telephony
service provider. This agreement was terminated in anticipation of Microsoft's
release of its new SIP-based Internet telephony service provider program to be
launched in conjunction with a new release of Microsoft's instant messaging
program.
On October 10, 2001, we signed a one-year integration and marketing
agreement with Microsoft pursuant to which Microsoft includes Net2Phone, for a
fee, as one of its approved Internet telephony service providers in its new
version of Microsoft's Instant Messaging Service software. Users of the new
Internet Messaging Service are able to choose us as their Internet telephony
service provider for the purpose of making PC-to-phone calls and to access
other telephony related services from us. We are solely responsible for
establishing the pricing plans and promotions relating to its services. This
agreement by its terms expired on October 10, 2002, and we are currently
negotiating an extension with Microsoft.
ADIR Technologies
We formed ADIR Technologies, Inc., along with several minority stockholders,
including IDT, in 2000 to develop and market network management software for
VoIP and other packet-based multimedia networks. In June 2001, ADIR entered
into a sales coordination agreement with Cisco Systems, Inc., a minority
investor in ADIR, and we believed this agreement would lead to Cisco working
with ADIR to jointly market ADIR's network management platform. In August
2001, ADIR acquired all of the issued and outstanding capital stock of
NetSpeak Corporation, a Florida corporation.
In March 2002, Net2Phone and ADIR filed suit against Cisco and a Cisco
executive in the United States District Court for the District of New Jersey.
The suit arose out of the relationships that had been created in connection with
Cisco's and Net2Phone's original investments in ADIR and out of ADIR's
subsequent acquisition of Netspeak. We consummated a settlement agreement in
August 2002. For a description of this litigation, see Legal Proceedings below
and Note 21 of our financial statements included elsewhere in this Form 10-K.
As the result of the litigation between the parties and the ultimate
settlement of that litigation, the relationship between ADIR and Cisco has
ended. Therefore, we intend to stop pursuing ADIR's original business plan,
which was largely dependent on marketing arrangements with CISCO. We are
currently examining alternative approaches, including pursuing possible
business development opportunities or merger and acquisition transactions with
third parties. We expect to continue to use Cisco products and maintain our
business relationships with Cisco that are not related to ADIR.
Customer and Technical Support
We provide customer service on various levels to different customers. Within
the ICS unit, customer service and technical support is provided directly to
channel sales distributors. The distributors provide their own support
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directly to their sub-distributors and end users. Our Network Operations
Center, or NOC, provides support to carriers and monitors our telephony
network 24 hours a day, seven days a week. Consumers who access our services
directly through CommCenter, Net2Phone Direct or Pennytalk receive customer
service and technical support through multilingual telephone communication,
web-based customer service as well as e-mail support. Over the past year, we
scaled back our internal customer support and migrated to an outsourced
solution, allowing us to utilize multiple call centers globally to provide
better support to our worldwide customer base. Additionally, we upgraded our
web-based customer management system, allowing customer service agents around
the world to access customer information and provide improved support.
Technology
All of our services rely on similar technology to transmit calls over data
networks, such as the Internet. We compress and digitize voice into packets
and send the packets over data networks around the world. All calls are routed
to our managed softswitch, which is a software-based product that provides
call control functionality and rates; manages and enrolls customers; and bills
calls and routes them to the closest gateway to the recipient. Unless the
recipient is an on-line device, the packets are then reassembled and the calls
are transferred to the public switched telephone network (PSTN) and directed
to a regular telephone anywhere in the world.
We believe that reliable and flexible billing, information management,
monitoring and control systems are critical to our success, and support all of
our products and services. Accordingly, we have invested substantial resources
to develop and implement our sophisticated real-time call management
information system. Key elements of this system include:
o customer provisioning;
o customer access;
o fraud control;
o network security;
o call routing;
o call monitoring;
o call reliability; and
o detailed call records.
Our Network Operations Center, or NOC, located at our headquarters in
Newark, New Jersey, employs a staff of approximately 15 people, and
incorporates a Data NOC and a Voice NOC to provide 24/7 support to our
operations around the world. We use network management tools to manage call
quality and view all gateways and traffic in real-time from the NOC. We have
hubs in the United States, United Kingdom and Hong Kong to route voice traffic
within particular regions, thereby enhancing the quality of the calls. The
Voice and Data NOCs manage the entire Net2Phone network.
Additionally, our NOC group provides technical support to troubleshoot
equipment and network issues at all times, to ensure that issues are remedied
through multiple engineering groups. Our out sourced customer service centers
also rely on our customer service group for the resolution of outstanding
technical issues.
Our goal is to comply with standards set forth by telecommunications
operators, Internet telephony consortiums and broadband providers in order to
further expand the reach of our network. Currently, our technology complies
with the following standards:
o Voice Codecs: Lucent SX9600, SX7300 ; G.729 ; G.711 ; G.723
o Broadband : DOCSIS 1.1
o Fax : FRF11.1 Annex D ; T.30 and T.4 via PCM pass through
o Packetization: Real Time Protocol (RTP)
o VoIP Signaling: SIP; H.323; MGCP
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o DTMF: RFC2833; SIP INFO with MGCP body attachment
o PSTN Signaling: SS7/ANSI SS7
Our customers may access our VoIP telephony services via multiple points,
varying slightly by product and/or service. Our services are organized around
these various access points.
International Communications Services
(a) Channel Partners. Many of our users who become customers through our
channel partners access our network through Internet devices that incorporate
our VoIP technology. A user can plug a regular telephone into one of these
devices that compresses voice into packets that are then routed appropriately
in the same manner as our other VoIP calls.
In order to improve efficient management of product offerings, we have added
new reporting tools that now provide all groups with a direct view into the
network's performance. We have also created a multi-level technical support
interface, allowing channel partners to view both their account activity as
well as the activities of their sub-distributors and end users. We also
support the user interface for foreign currency, allowing channel partners to
charge their users in their currencies while partners pay us in U.S. currency.
(b) Carrier Services. Our carrier partners gain access to our network
through a carrier network interconnect. We maintain core interconnect
locations, or hubs, in Newark and Piscataway, NJ, London and Hong Kong for
both our traditional carrier interconnects and our VoIP interconnects. With
regard to our traditional carrier interconnects, we can use an ISDN
(integrated services digital network) interconnect for a PSTN (public switched
telephone network) customer, or we can utilize other telephony signaling
standards, such as SS7 in the U.S. or C7 in Europe. With regard to our VoIP
interconnects, we can interconnect either via SIP or H323, two of the primary
VoIP interconnect standards in use today. Once the networks are
interconnected, we work with each partner to buy or sell minutes to each other
through a unilateral or bilateral carrier agreement.
(c) Direct to Consumer Services. Our PC-to-phone application is simple to
install and to use and has won various industry awards. The software is
organized into two elements: an application interface engine and an internet
telephony calling engine. The software is flexible and customizable and the
newest version of the domestic software supports buddy lists for building
online calling communities. Through presence management, callers can identify
which of their friends, family or coworkers are online and then choose to
initiate either a voice or text conversation via the Internet. Consumers can
initiate calls from their Internet-connected PCs which then dispatch the call
to a telephone or a multimedia Internet-connected PC.
Domestic Retail Services
Our calling card customers access our services by dialing an access number
that reaches one of our gateways. These gateways convert calls into packets
and then the calls are sent over an IP network to another gateway. The calls
are then taken off the IP network and transmitted locally over the public
switched telephone network, or PSTN. We are currently in the process of
installing new standards-compliant higher-density gateways with lower
"latency," which means less of a delay between the moment a caller speaks and
the moment the listener hears what was said. Early tests have indicated
improved quality of calls as a result of this upgrade.
Broadband Telephony Solutions
End users can access our VoIP services by plugging a regular telephone into
a cable modem equipped with Net2Phone's protocols. Calls are then routed and
managed over the cable operator's network to our IP network, where the calls
are then routed to the closest terminating gateway. The calls are then taken
off the network and completed locally over the PSTN. From the moment a
subscriber picks up the handset and a call is initiated across the local cable
network to Net2Phone's global IP network and then terminates to the PSTN, our
sophisticated management system provides both Net2Phone and the cable operator
with a real-time view of each network segment enabling them to monitor,
diagnose and troubleshoot any issues.
8
Competition
International Communications Services
Internationally, the competitive marketplace varies from region to region.
In markets where the telecommunications marketplace has been fully
deregulated, the competition continues to increase. Even a newly deregulated
market, such as India, allows for new entrants to establish a foothold and
offer competitive services more easily. Competitors include both government-
owned phone companies as well as emerging competitive carriers. As consumers
and telecommunications providers have come to understand the benefits that may
be realized from transmitting voice over the Internet, a substantial number of
companies have emerged to provide VoIP services. The principal competitive
factors in the market include: price, quality of service, breadth of
geographic presence, customer service, reliability, network capacity, the
availability of enhanced communications services and brand recognition.
Some providers, such as Go2Call, DeltaThree, Inc. MediaRing and Innomedia,
offer similar services to ours, including international communications
services and direct-to-consumer product offerings. Wholesale Internet
Telephony Service Providers (ITSPs), such as ITXC Corp. and iBasis, Inc.
compete with our carrier services, and could become meaningful competitors to
our international communications services group.
Domestic Retail Services
The long distance market in the United States is highly competitive. There
are several much larger and numerous similar-sized and smaller competitors,
and we expect to face continuing competition based on price and service
offerings from existing competitors. The principal competitive factors in the
market include: price, quality of service, breadth of geographic presence,
customer service, reliability, network capacity and the availability of
enhanced communications services. Competitors include AT&T, Sprint, IDT and
Regional Bell Operating Companies (RBOC), all of whom offer services and
products competitive with ours on the above factors, including offering their
own pre-paid calling cards.
Broadband Solutions
Net2Phone believes that it presently provides the only fully outsourced IP
telephony solution for cable operators that complies with cable industry
standards. Other providers, such as Vonage, DeltaThree, Inc. and Gemini Voice
Solutions, offer telephony services over cable networks, but, unlike Net2Phone,
we believe that they can neither offer cable standards-compliant solutions nor
can they deliver a fully managed solution that enables the cable operator to
transform all phone jacks in a residence from the local phone company to the
cable operator. Our ability to sell our broadband product may be further limited
by the fact that major cable operators may elect to build their own internal
cable telephony solutions.
Research and Development
At our research and development centers, we employ approximately 30
engineers, whose technical expertise covers software, hardware, switching,
security, voice compression, protocols, web applications, PC development,
interactive voice response systems, VoiceXML, speech applications, next-
generation signaling, firewalls and NATs (network address translations),
engineering real-time online transactions, billing and network and call
management. This staff is devoted to the improvement and enhancement of our
existing product and service offerings, as well as to the development of new
products and services.
Current research and development activities include the following:
o enhancements to our PC-to-phone software to increase functionality;
o porting of our PC-to-phone software to other operating system platforms;
o enhancements to our call processing platform to increase scalability and
performance;
o enhancements to our billing platforms to increase scalability and
performance;
o enhancements to our enhanced services platform to host interactive voice
response and VoiceXML applications;
o development of speech enabled calling applications;
9
o interactions between voice over IP protocols, NATs and firewalls;
o multiprotocol VoIP support to embrace multiple VoIP calling devices and
platforms;
o protocol support for IP calling software and devices; and
o enhancements to end-to-end cable telephony solutions and related
applications.
Our future success will depend, in part, on our ability to improve existing
technology, retaining services of talented employees and developing new
products and services that incorporate leading technology.
Costs for the internal development of new software products and substantial
enhancements to existing software products are expensed as incurred until
technological feasibility has been established, at which time any additional
costs would be capitalized. Software development costs are our only research
and development expenditures. For the years ended July 31, 2002, 2001 and
2000, research and development costs totaled approximately $11,185,000,
$10,360,000, and $4,692,000, respectively. We anticipate that our research and
development costs will decrease in the short term as we consolidate our two
research development centers, resulting in a reduction in payroll and other
operating expenses.
Regulation
The use of the Internet and private IP networks to provide voice
communications services, is a relatively recent market development. Although
the provision of such services is currently permitted by United States law and
largely unregulated within the United States, several foreign governments have
adopted laws and/or regulations that could restrict or prohibit the provision
of voice communications services over the Internet or private IP networks.
More aggressive regulation of the Internet in general, and Internet telephony
providers and services specifically, may adversely affect our business,
financial condition, operating results and future prospects, particularly if
increased numbers of governments impose regulations restricting the use and
sale of IP telephony services.
United States. In an April 10, 1998 Report to Congress, the Federal
Communications Commission (FCC) declined to conclude that IP telephony
services constitute telecommunications services and instead indicated that it
would undertake a subsequent examination of the question whether certain forms
of phone-to-phone Internet telephony are information services or
telecommunications services. The FCC indicated that in the future it would
consider the extent to which phone-to-phone-Internet telephony providers could
be considered "telecommunications carriers" such that they could be subject to
the regulations governing traditional telephone companies such as the
imposition of access charges. The FCC stated that although it did not have a
sufficient record upon which to make a definitive ruling, the record suggested
that, to the extent that certain forms of phone-to-phone IP telephony appear
to possess the same functionality as traditional telecommunications services
and to the extent the providers of those services obtain the same circuit-
switched access as obtained by interexchange carriers, the FCC may find it
reasonable that they pay similar access charges. The FCC also recognized,
however, that it would consider whether it should forbear from imposing any of
the rules that would apply to phone-to-phone Internet telephony providers as
"telecommunications carriers." Thus, the FCC currently does not impose
regulatory surcharges or traditional common carrier regulation upon providers
of Internet communications services, although it could determine to do so in
the future.
To date the FCC has determined that providers of Internet telephony services
should not be required to pay interstate access charges, this decision may be
reconsidered in the future. For instance, on April 19, 2001 in Docket No. CC
01-92, the FCC adopted a proposal to begin a fundamental examination of all
forms of intercarrier compensation -- the payments among telecommunications
carriers resulting from their interconnecting networks. The FCC could adopt an
intercarrier compensation mechanism and other regulations that could result in
an increase in the cost of the local transmission facilities necessary to
complete our calls or a decrease in the costs of such facilities to
traditional long distance telephone companies. If we were required to increase
our rates as a result of new FCC regulations, this could have a significant
impact on our ability to compete with long distance carriers.
Additionally, on October 18, 2002, AT&T filed a petition with the FCC
seeking a declaratory ruling that would prevent incumbent local exchange
carriers, or ILECs, from imposing traditional circuit-switched access
10
charges on phone-to-phone IP services. This petition and subsequent ILEC
reactions may exert pressure on the FCC to render a decision regarding the
regulation of phone-to-phone IP services. The FCC could determine, for
instance, that certain types of Internet telephony should be regulated like
basic interstate telecommunications services. Thus, Internet telephony would
no longer be exempt from the access charge regime that permits local telephone
companies to charge long distance carriers for the use of the local telephone
network to originate and terminate long-distance calls, generally on a per
minute basis. Similarly, the FCC could conclude that Internet telephony
providers should contribute to the Universal Service Fund, which provides
support to ensure universal access to telephone service. The imposition of
interstate access charges or universal service contributions would
substantially increase our costs of serving our customers. The imposition of
regulation and contribution requirements might also negatively affect the
incentives for companies to continue to develop IP technologies. It is also
possible that the FCC might adopt a regulatory framework that is unique to IP
telephony providers or one where IP telephony providers are subject to reduced
regulatory requirements. We cannot predict what regulations, if any the FCC
will impose.
In addition, other aspects of our operations may be subject to state or
federal regulation, such as regulations relating to the confidentiality of
data and communications, copyright issues, taxation of services, universal
service funding, and licensing. Similarly, changes in the legal and regulatory
environment relating to the Internet connectivity market, including regulatory
changes that affect telecommunications costs or that may increase the
likelihood of competition from the regional Bell operating companies, or
RBOCs, or other telecommunications companies, could increase our costs of
providing service.
Moreover, state governments and their regulatory authorities may assert
jurisdiction over the provision of intrastate IP communications services where
they believe that their telecommunications regulations are broad enough to
cover regulation of IP services. Various state regulatory authorities have
initiated proceedings to examine the regulatory status of Internet telephony
services, and a state court in Colorado has ruled that the use of the Internet
to provide certain intrastate services does not exempt an entity from paying
intrastate access charges. Similarly, the State Public Service Commission
(PSC) of New York has ruled (with respect to another company providing IP
telecommunications,) that certain IP services may be considered
telecommunications services subject to access charges depending on how much of
the service is provided over IP networks.
As state governments, courts, and regulatory authorities continue to examine
the regulatory status of Internet telephony services, they could render
decisions or adopt regulations affecting providers of Internet telephony
services or requiring such providers to pay intrastate access charges or to
make contributions to universal service funding. Should the FCC determine to
regulate IP services, states may decide to follow the FCC's lead and impose
additional obligations as well.
International. The regulatory treatment of IP communications outside the
United States varies significantly from country to country. Net2Phone operates
on a global scale. The regulations we are subject to in many jurisdictions
change from time to time, they may be difficult to obtain or it may be
difficult to obtain accurate legal translations where official legal
translations are unavailable. Additionally, in our experience, the enforcement
of these regulations does not always track the letter of the law. Accordingly,
although we devote what we believe to be sufficient resources to maintaining
compliance with these regulations, we cannot be certain that we are in
compliance with all of the relevant regulations at any given point in time.
While some countries prohibit IP telecommunications, others have determined
that IP services offer a viable alternative to traditional telecommunications
services. As the Internet telephony market has expanded, regulators have begun
to reconsider whether to regulate Internet telephony services. Some countries
currently impose little or no regulation on Internet telephony services, as in
the United States. Other countries, including those in which the governments
prohibit or limit competition for traditional voice telephony services,
generally do not permit Internet telephony services or strictly limit the
terms under which those services may be provided. Still other countries
regulate Internet telephony services like traditional voice telephony
services, requiring Internet telephony companies to make universal service
contributions and pay other taxes. While some countries subject IP telephony
providers to reduced regulations, others have moved towards liberalization of
the IP communications sector and have lifted bans on provision of IP
telecommunications services. We cannot predict how a regulatory or policy
change of a particular country might affect the provision of our services. We
11
believe that while increased regulations and restrictions could pose a threat
to our ability to provide services, the lifting of regulations in a country
generally will enable us to expand our services and presence in that country.
In some cases where access to some of our services has been blocked by
government-controlled telecommunications companies, we have tried to negotiate
agreements with those governments to provide our services. We intend to
continue to do the same where similar situations may arise. No assurances can
be given, however, that we will be successful in such negotiations or that we
will be able to provide alternative means of accessing our services that will
not be blocked by foreign governments or government-controlled
telecommunications companies. The varying and continually changing regulatory
landscape of Internet telephony in the countries in which we currently provide
or may provide services may adversely and materially affect our business,
financial condition and results of operations.
In addition, as we expand into additional foreign countries, some countries
may conclude that we are required to qualify to do business in their country,
that we are otherwise subject to regulation, or that we are prohibited from
conducting our business in such countries. Our failure to qualify as a foreign
corporation in certain jurisdictions, or to comply with foreign laws and
regulations, may adversely affect our business.
Moreover, our distributors in various foreign countries may be or may become
subject to various regulatory requirements. We cannot be certain that our
partners are currently in compliance with every regulatory or other legal
requirement in their respective countries, that they will be able to comply
with existing or future requirements, and/or that they will remain in
compliance with all requirements. Failure of our distributors to comply with
these requirements could adversely affect our business.
Regulation of the Internet. In addition to regulations addressing Internet
telephony specifically, other regulatory issues relating to the Internet in
general could affect our ability to provide our services. Congress has adopted
legislation that regulates certain aspects of the Internet, including online
content, user privacy, taxation, liability for third-party activities, and
jurisdiction. In addition, a number of initiatives pending in Congress and
state legislatures would prohibit or restrict advertising or sale of certain
products and services on the Internet, which may have the effect of raising
the cost of doing business on the Internet generally. The European Union has
also enacted several directives relating to the Internet, one of which
addresses online commerce. Recently, the European Union adopted a privacy
directive that establishes certain requirements with respect to, among other
things, the confidentiality, processing and retention of personally
identifiable subscriber information and usage patterns. The potential effect,
if any, of these data protection rules on the development of our business
remains uncertain.
Federal, state, local and foreign governmental organizations are considering
other legislative and regulatory proposals that would regulate the Internet.
For instance, the extension of the Internet Tax Freedom Act prohibits the
taxing of certain Internet uses through November 1, 2003. We cannot predict
whether new taxes will be imposed on our services or, depending on the type of
taxes imposed, whether and how our services would be affected thereafter.
Increased regulation of the Internet may decrease its growth and hinder
technological development, which may negatively impact the cost of doing
business via the Internet or otherwise materially adversely affect our
business, financial condition, and results of operations.
Intellectual Property
We rely on a combination of patents, trademarks, domain name registrations
and trade secret laws and contractual restrictions to enforce our rights in
our intellectual property against others.
Patents
We currently own two VoIP related patents issued in the United States and
have over thirty other applications pending in both the U.S. and abroad. The
two U.S. patents are patent number 6,137,792, or Patent `792, and patent
number 6,389,038, or Patent `038. Patent `792 relates to a method and system
for enabling data transmission over a bypass circuit-switched network between
two computers connected to a public packet-switched network, such as the
Internet. Patent `038 relates to a method and system for combining plural
independently addressable packets into a larger packet, called a SuperPacket,
which improves the utilization of a telecommunications channel, and helps
reduce latency. Because these patents relate to our core business, we
12
believe these patents have value. Patent `792 was issued on October 24, 2000
and expires October 24, 2020. Patent `038 was issued May 14, 2002 and expires
May 14, 2022.
In addition to the above referenced patents, we own a majority interest in
ADIR Technologies, Inc., which wholly owns NetSpeak, Inc., a Florida
corporation. NetSpeak owns a portfolio of ten patents. We are currently
conducting an investigation into the scope and value of these patents, some of
which relate to our core VoIP technology.
The ability to make, use, sell or offer for sale our products and services
is important to our business. We are aware that patents have been granted to
others based on fundamental technologies in the Internet telephony area. It is
possible that certain patent infringement claims might be asserted
successfully against us in the future. A party making an infringement claim
could secure a substantial monetary award or obtain injunctive relief that
could effectively block our ability to provide services or products in the
United States or abroad. If any of these risks materialize, we could be forced
to suspend operations, to pay significant amounts to defend our rights, and/or
secure an expensive license. A substantial amount of the attention of our
management may be diverted from our ongoing business. Moreover, because patent
applications in the United States are not publicly disclosed when filed, third
parties may have filed applications that, if issued as patents, could result
in claims against us in the future. These claims could materially adversely
affect our ability to operate and our financial condition and results of
operations. We may be able to use our own patents against such claims, for
example, if cross-licenses are warranted.
Although we have no knowledge that we infringe the patent rights of any
third party, on February 15, 2000, Multi-Tech Systems, Inc. filed suit against
us and several other companies in the United States Federal District Court in
Minneapolis, Minnesota, asserting patent infringement. For a discussion of the
Multi-Tech proceeding, see Legal Proceedings below.
Trademarks
We own twenty-seven registered trademarks in the United States and more than
fifty foreign registered trademarks. Our most important mark is NET2PHONE. We
have made a significant investment in protecting this mark, and we believe it
has achieved recognition in the U.S. and abroad. We are currently engaged in
an international filing program to file trademark applications for trademark
registrations of the mark NET2PHONE in a number of foreign countries. There
can be no assurance that we will be able to secure registration and maintain
protection for NET2PHONE in all the countries where we deem it important to do
so. Competitors of ours or other third parties may adopt marks similar to our
mark NET2PHONE, thereby interfering with our efforts to build brand identity
and possibly leading to customer confusion.
We have encountered trademark oppositions challenging our registration and
use of the NET2PHONE mark in several countries. We have also encountered
refusals to registration from local trademark offices in several foreign
countries, typically based on the asserted grounds that the mark is
descriptive/non-distinctive or that it conflicts with a prior registered mark.
In addition, in a limited number of situations, third parties have challenged
our marks. Our practice is to oppose vigorously such challenges, and we have
generally been successful.
Unlike patents, which have a limited duration, our trademarks will continue
to be registered so long as we pay the required fees and the company does
nothing to lose its rights, such as permit others to use the same mark.
Domain Names
We have registered many Internet domain names that contain the term
NET2PHONE. We cannot assure you that we will be successful in obtaining all of
the domain names that we would like to have, either because of unwarranted
expense, inability to register the domain due to registrar requirements that
we cannot meet, or because of third parties who previously registered the
relevant domain name. We have encountered several instances of third parties
who have registered the term NET2PHONE within a domain name. We have generally
had success in obtaining the transfer of those domains that we deemed
important to our business from such third parties by agreement, institution of
accepted domain name dispute resolution proceedings, or other means, but we
cannot assure you that we will be successful in the future in obtaining all
domains that we deem important. Finally, there are many variations of the word
NET2PHONE, and it is difficult, if not impossible, to register each variation,
or to pursue all pirates who register such variations. Because we are in large
part an Internet business,
13
we may be negatively impacted by the unauthorized use of the word NET2PHONE,
or of a substantially similar word, in a domain name owned by a third party.
Confidentiality Agreements
All key employees have signed confidentiality agreements, and it is our
standard practice to require newly hired employees to execute confidentiality
agreements. These agreements provide that the employee or consultant may not
use or disclose confidential company information except in the performance of
their duties for the company, or in other limited circumstances. These
agreements also state that, to the extent rights in any invention conceived of
by the employee or consultant while they were employed by us do not vest in
the company automatically by operation of law, the employee or consultant is
required to assign their rights to us. The steps taken by us may not, however,
be adequate to prevent the misappropriation of our proprietary rights or
technology.
Employees
As of July 31, 2002, we employ 290 individuals full-time, 4 individuals
part-time, and 3 individuals on a temporary basis. These employees include
approximately 109 in technical support and customer service, 56 in marketing
and sales, 41 in management and finance, 61 in operations and 30 in research
and development. We anticipate that by December 2002, as a result of
consolidations primarily related to our research and development and network
operations areas, we will reduce the number of full-time employees by
approximately 63. Our employees are not represented by a union, and we
consider our employee relations to be good. We have never experienced a work
stoppage.
Revenues and Assets by Geographic Area
For the year ended July 31, 2002, 45% of our revenue was derived from
international customers, and 55% from customers in the United States.
Substantially all our long-lived assets are located in the United States. For
more detailed information concerning our geographic segments, see Note 20 to
our financial statements included elsewhere in this Form 10-K.
Executive Officers
The following are the executive officers of Net2Phone as of October 29,
2002:
Executive
Name Age Officer Since Present Office
- ---- --- ------------- --------------
Stephen M. Greenberg.................................................... 58 2000 Chief Executive Officer and
Vice Chairman of the Board
Norman Klugman.......................................................... 52 2002 Chief Financial Officer and
Chief Operating Officer
Jonathan Reich.......................................................... 36 1999 President, Worldwide Sales and
Marketing
Bruce Shoulson.......................................................... 62 2001 General Counsel and President of
Broadband Division
Jeffrey Skelton......................................................... 36 2000 Chief Technology Officer
Glenn J. Williams....................................................... 39 1999 Corporate Secretary and
Executive Vice President of
Legal and Business Affairs
Stephen M. Greenberg is presently our Chief Executive Officer and Vice
Chairman of our Board of Directors. Mr. Greenberg practiced law for 32 years
prior to joining us. His legal career began in Newark, New Jersey in 1968. He
served as Executive Assistant to the United States Attorney for the District
of New Jersey from 1969 to 1971. Before joining Net2Phone, Mr. Greenberg was a
founder of and senior partner in the New Jersey law firm of Stern & Greenberg.
Mr. Greenberg has received many honors including one for Outstanding
14
Personal Achievement from the New Jersey Bar Association. He is also a
Commissioner of the New Jersey Public Broadcasting Authority and a member of
the New Jersey Israel Commission.
Norman Klugman has been our Chief Financial Officer since March 2002 and
also our Chief Operating Officer since August 2002. From 1993 to 1994,
Mr. Klugman was Chief Operating Officer of Worldcom/LDDS. From January 1994 to
December 1995, Mr. Klugman was founder and Chief Executive Officer of Trescom
International, a facilities-based international long distance company. From
1995 to March 2002, Mr. Klugman was a consultant for various companies in the
telecommunications and other industries. From March 2001 to July 2001,
Mr. Klugman served as interim Chief Financial Officer for Teligent, a
telecommunications company that provided local, long distance, and high-speed
Internet access to businesses.
Jonathan Reich has been our President, Worldwide Sales and Marketing since
July 2002 and our Executive Vice President--Marketing and Corporate
Development from January 1999 to July 2002. Prior to his employment with us,
Mr. Reich was IDT Corporation's Senior Vice President of Advertising,
Marketing and Business Development in charge of strategic relationships for
both us and IDT Corporation from June 1997 to December 1998 and IDT
Corporation's director of advertising from January 1995 to November 1997. From
1992 to 1993, Mr. Reich worked for Sanford Bernstein & Co. as an associate
analyst. Prior to this, Mr. Reich was an internal consultant for Morgan
Stanley & Co.
Bruce Shoulson has been our General Counsel since February 2001 and the
President of our Broadband Division since July 2002. Mr. Shoulson practiced
law for 36 years with the law firm of Lowenstein Sandler P.C. prior to joining
Net2Phone. Mr. Shoulson was a partner at Lowenstein Sandler from 1970 until he
joined us in February 2001.
Jeffrey Skelton has been our Chief Technology Officer since September 2000
and a senior engineer since December 1997. Prior to his employment with us,
Mr. Skelton was a principal technical staff member and a software engineer at
AT&T from 1988 to December 1997.
Glenn J. Williams has been our Executive Vice President of Legal and
Business Affairs and Corporate Secretary since February 2001. From October
1999 to February, 2001, Mr. Williams served as our General Counsel and
Corporate Secretary. Prior to joining us, Mr. Williams served as Associate
General Counsel to IDT Corporation from December 1998 to September 1999. From
August 1997 to December 1998, Mr. Williams served as Associate General Counsel
to a privately held company and from 1994 to 1997 worked as an attorney in
private practice, including representing the New Jersey Sports and Exposition
Authority.
Risk Factors
In addition to other information in this Form 10-K and any documents
incorporated by reference to this Form 10-K, the following risk factors should
be carefully considered when evaluating our company and our business.
Investing in our common stock involves a high degree of risk, and you should
be able to bear the complete loss of your investment. We also caution you that
this Form 10-K includes forward-looking statements that are based on
management's beliefs and assumptions and on information currently available to
management. Future events and circumstances and our actual results could
differ materially from those projected in any forward-looking statements. The
risk and uncertainties described below are not the only ones we face.
Additional risks and uncertainties not presently known to us or that we
currently deem immaterial also may impair our business operations. If any of
the following risk and uncertainties actually occur, our future operating
results and financial condition could be harmed, and the market price of our
common stock could decline.
15
Risks Related to Our Financial Condition and Our Business
We have never been profitable. If we continue to incur losses, we may not be
able to finance the commercial deployment of our products and services.
We have never been profitable on an annual basis. Our aggregate revenues
from inception to July 31, 2002 were approximately $408.4, and our accumulated
deficit was approximately $773.7 million as of that date. We will need to
generate significant revenue to achieve profitability. We may not be able to
do so. Even if we do achieve profitability, we cannot assure you that we will
be able to sustain or increase profitability on a quarterly or annual basis in
the future.
Our limited operating history makes evaluating our business difficult.
IDT formed us as a subsidiary in October 1997. Prior to that, we conducted
business as a division of IDT. Therefore, we have only a limited operating
history with which you may evaluate our business. You must consider the
numerous risks and uncertainties an early stage company like ours faces in the
new and rapidly evolving market for Internet-related services. These risks
include our ability to:
o increase awareness of our brand and continue to keep and build our
customer base;
o develop and implement effective marketing and business plans;
o maintain our current, and develop new, strategic relationships;
o respond effectively to competitive pressures; and
o continue to develop and upgrade our network and technology.
If we are unsuccessful in addressing these risks, sales of our products and
services, as well as our ability to maintain or increase our customer base,
will be substantially diminished.
We intend to pursue new streams of revenue, which we have not attempted to
generate before and which may not be profitable.
In addition to our current minutes-based revenue, we are beginning to pursue
new revenue opportunities, such as from our broadband telephony business. We
intend to devote significant capital and resources to create these new revenue
streams and we cannot ensure that these investments will be profitable. For
example, in fiscal 2002, we pursued new Web-based revenue opportunities from
banner advertising, and then elected to exit those lines of business and focus
on our core business units. In fiscal 2003, we intend to devote significant
resources to implement our broadband telephony business initiative. Our
business model for our broadband telephony business has not been tested, and
may not be attractive to potential cable operator customers. Also, we have not
tested our broadband telephony solution on a large scale, and therefore, we
cannot be sure our solution will be scalable to the extent necessary to serve
a large customer base.
We may have difficulties managing our operations, which may reduce our chances
of achieving profitability.
Our future performance will depend, in part, on our ability to manage our
business growth effectively. To that end, we will have to undertake the
following tasks, among others:
o continue to develop our operating, administrative, financial and
accounting systems and controls;
o continue to improve coordination among our engineering, accounting,
finance, marketing and operations personnel;
16
o continue to enhance our management information systems capabilities; and
If we cannot accomplish these tasks, our chances of achieving profitability
may be diminished.
If we fail to establish and maintain strategic relationships, our sales would
suffer.
We currently have significant strategic relationships with IDT Corporation
and Liberty Media. For a complete description of these strategic
relationships, see Strategic Relationships above. We depend on these
relationships to help us:
o expand our customer base;
o distribute our products to potential customers; and
o increase usage of our services.
We believe that our success in the ICS and broadband areas depends, in part,
on our ability to develop and maintain relationships with leading hardware and
software companies, as well as our many distribution partners.
In addition to these strategic relationships, we rely on one of our vendors,
LG Electronics, to manufacture approximately fifty percent of the hardware
devices sold by our channel sales and distribution group. We do not have a
contract with LG Electronics, and therefore, LG Electronics could stop
providing us with these products with little or no prior notice. While we
believe our relationship with LG Electronics is stable, we can provide no
assurance that this relationship will continue to be good, or continue at all.
While we believe we could replace LG Electronics if necessary, this could take
a period of time during which our channel sales and distribution group's
hardware sales could be materially impacted, and this could impact our ability
to service some of our customers for this period of time. We are currently
devising a plan that can be implemented quickly to avoid or significantly
reduce this period of time if LG Electronics were not continue to provide us
with these devices in a timely maner.
We have and plan to increasingly depend on our international operations, which
subject us to unpredictable regulatory, economic and political situations.
Our customers based outside of the United States generated approximately 45%
percent of our revenue during fiscal 2002. A significant component of our
strategy is to continue to expand internationally. We cannot assure you that
we will be successful in expanding into additional international markets. In
addition to the uncertainty regarding our ability to generate revenue from
foreign operations and expand our international presence, there are certain
risks inherent in doing business on an international basis, including:
o changing regulatory requirements, which vary widely from country to
country;
o action by foreign governments or foreign telecommunications companies to
limit access to our services;
o increased bad debt and subscription fraud;
o legal uncertainty regarding liability, tariffs and other trade barriers;
o economic and political instability; and
o potentially adverse tax consequences.
For example, several of our largest customers are based in the Middle East,
and other areas of the world, such as Argentina, where there is currently
significant political and economic instability. We have experienced power
supply problems, difficulty maintaining local customer support and
difficulties dealing with local companies and governments in some of these
regions. Moreover, developments in the Middle East, such as the commencement
of hostilities by the United States or others, could result in the disruption
of our business in the regions affected by the hostilities. These events could
also reduce travel to these regions, which could further adversely affect our
calling card business, which relies in large part on the use of calling cards
by travelers. We cannot assure you that these political and economic
difficulties will not continue or that they will not expand into other
geographic areas experiencing political and economic instability.
17
Competition could reduce our market share and decrease our revenue.
The market for VoIP services is extremely competitive. Many companies offer
products and services like ours, and many of these companies have a
substantial presence in the markets we serve. In addition, many of these
companies are larger than we are and have substantially greater financial,
distribution and marketing resources than we do. We therefore may not be able
to compete successfully with these companies. If we do not succeed in
competing with these companies, we will lose customers and our revenue will be
substantially reduced. Our competitors include the following:
International Communications Services. Competitors include both government-
owned phone companies as well as emerging competitive carriers such as
Go2Call, DeltaThree, MediaRing and Innomedia. Wholesale Internet Telephony
Service Providers, or ITSPs, such as ITXC and iBasis, compete with our carrier
services business.
Domestic Retail Services. There are several large and numerous small
competitors, and we expect to face continuing competition based on price and
service offerings from existing competitors. Competitors include AT&T, Sprint,
IDT and Regional Bell Operating Companies (RBOC), all of whom offer their own
pre-paid calling cards.
Broadband. Other companies, such as Vonage and Gemini Voice Solutions,
offer telephony services over cable networks, but, unlike Net2Phone, we
believe that they can neither offer cable standards-compliant solutions nor
can they transform all phone jacks in a residence from the local phone company
to the cable operator. Our ability to sell our broadband telephony solution
product may be further limited by the fact that major cable operators may
elect to build their own internal cable telephony solutions.
Our business may be affected by the proliferation and increased usage of
cellular telephones.
A significant number of our calling card customers use calling cards while
traveling, both domestically and abroad. As more and more people obtain
cellular telephones, and as cellular telephone users increase their usage, and
begin to use their phones in broader geographic regions, including
internationally, the need for these customers to purchase our calling cards
may be reduced. We cannot predict how this development will impact our
business, as our calling card rates could be attractive enough for cellular
telephone users to continue to purchase our cards when traveling.
Pricing pressures may lessen our competitive pricing advantage.
Our success is based partly on our ability to provide discounted domestic
and international long distance services by taking advantage of cost savings
achieved by carrying voice traffic over the Internet, as compared to carrying
calls over long distance networks, such as those owned by AT&T, Sprint and MCI
WorldCom. In recent years, the price of long distance calls has fallen. In
response, we may lower the price of our service offerings. AT&T, Sprint and
MCI WorldCom have adopted pricing plans in which the rates that they charge
for U.S. domestic long distance calls are not always substantially higher than
the rates that we charge for our U.S. domestic service. The price of long
distance calls may decline to a point where we no longer have a price
advantage over these traditional long distance services. Alternatively, other
providers of long distance services may begin to offer unlimited or nearly
unlimited use of some of their services for an attractive monthly rate. We
would then have to rely on factors other than price to differentiate our
product and service offerings, which we may not be able to do.
We may not be able to compete with providers that can bundle long distance
services with other offerings.
Our competitors may be able to bundle services and products that we do not
offer together with long distance or Internet telephony services. These
services could include wireless communications, voice and data services,
Internet access and cable television. This form of bundling would put us at a
competitive disadvantage if these providers can combine a variety of service
offerings at a single attractive price. In addition, some of the
telecommunications and other companies that compete with us may be able to
provide customers with lower communications costs or other incentives with
their services, reducing the overall cost of their communications packages,
and significantly increasing pricing pressures on our services. This form of
competition could significantly reduce our revenues.
18
If our customers do not perceive our services to be effective or of high
quality, our brand and name recognition would suffer.
We believe that establishing and maintaining brand and name recognition is
critical for attracting and expanding our targeted client base. We also
believe that the importance of reputation and name recognition will increase
as competition in our market increases. Promotion and enhancement of our name
will depend on the effectiveness of our marketing and advertising efforts and
on our success in continuing to provide high-quality products and services,
neither of which can be assured. Our International Communications Services
business requires us to rely on third party distributors to promote and market
our products and services. We cannot be assured that these third parties
provide the same level of effort as we do to protect the high-quality
reputation we believe our services and products maintain. If they do not, our
reputation may be diminished in these markets.
All of the IP telephony calls made by our customers are connected through
local telephone companies and, at least in part, through leased networks that
may become unavailable.
We are not a local telephone company or a local exchange carrier. Our
network covers only portions of the United States. Accordingly, we must route
parts of some domestic and all international calls made by our customers over
leased transmission facilities. In addition, because our network does not
extend to homes or businesses, we must generally route calls through a local
telephone company to reach our network and, ultimately, to reach their final
destinations.
In many of the foreign jurisdictions in which we conduct or plan to conduct
business, the primary provider of significant in-country transmission
facilities is the national telephone company, which may be the only provider
in that country. Accordingly, we may have to lease transmission capacity at
artificially high rates from such a monopolistic provider, and consequently,
we may not be able to generate a profit on those calls. In addition, national
telephone companies may not be required by law to lease necessary transmission
lines to us or, if applicable law requires national telephone companies to
lease transmission facilities to us, we may encounter delays in negotiating
leases and interconnection agreements and commencing operations. Additionally,
disputes may result with respect to pricing, billing or other terms of these
agreements, and these disputes could affect our ability to continue to operate
in these countries.
Our success depends on our ability to handle a large number of simultaneous
calls, which our systems may not be able to accommodate.
We expect the volume of simultaneous calls to increase significantly as we
expand our operations. Our network hardware and software may not be able to
accommodate this additional volume. If we fail to maintain an appropriate
level of operating performance, or if our service is disrupted, our reputation
could be hurt and we could lose customers.
Because we are unable to predict definitely the volume of usage and our
capacity needs, we may be forced to enter into disadvantageous contracts that
would reduce our operating margins.
We may have to enter into additional long-term agreements for leased
capacity. To the extent that we overestimate our call volume, we may be
obligated to pay for more transmission capacity than we actually use,
resulting in costs without corresponding revenue. Conversely, if we
underestimate our capacity needs, we may be required to obtain additional
transmission capacity through more expensive means or such capacity may not be
available.
We may not be able to obtain sufficient funds to grow our business.
Due to our limited operating history and the nature of our industry, our
future capital needs are difficult to predict. Therefore, we may require
additional capital to fund some or all of the following:
o unanticipated opportunities;
o strategic alliances;
o potential acquisitions;
o changing business conditions; and
o unanticipated competitive pressures.
19
While we believe we have enough cash and short-term investments to
adequately fund our business for the foreseeable future, we may need to forego
business opportunities relating to the above listed events if we do not obtain
additional financing. Obtaining additional financing will be subject to a
number of factors, including market conditions, our operating performance and
investor sentiment. These factors may make the timing, amount, terms and
conditions of additional financings unattractive to us. If we are unable to
raise additional capital, our growth could be impeded.
Any damage to or failure of our systems or operations could result in
reductions in, or terminations of, our services.
Our success depends on our ability to provide efficient and uninterrupted,
high-quality services. Our systems and operations are vulnerable to damage or
interruption from natural disasters, power loss, telecommunication failures,
physical or electronic break-ins, sabotage, intentional acts of vandalism and
similar events that may be or may not be beyond our control. Our systems and
operations could also be interrupted by internet service providers or
government owned telecommunications companies that implement network changes
or blocks, which may also be out of our control. While we have built in system
redundancies to reduce this risk, the occurrence of any or all of these events
could still hurt our reputation and cause us to lose customers.
Unauthorized use of our intellectual property by third parties may damage our
brand.
We regard our patents, service marks, trademarks, trade secrets and other
intellectual property as important to our success. We rely on trademark and
copyright law, trade secret protection and confidentiality agreements with our
employees, customers, partners and others to protect our intellectual property
rights. Despite our precautions, it may be possible for third parties to
obtain and use our intellectual property without authorization. Furthermore,
the laws of some foreign countries may not protect intellectual property
rights to the same extent as do the laws of the United States. It may be
difficult for us to enforce certain of our intellectual property rights
against third parties who may have acquired intellectual property rights by
filing unauthorized applications in foreign countries to register the marks
that we use because of their familiarity with our worldwide operations. Since
Internet related industries such as ours are exposed to the intellectual
property laws of numerous foreign countries and trademark rights are
territorial, there is uncertainty in the enforceability and scope of
protection of our intellectual property. The unauthorized use of our
intellectual property by third parties may damage our brand.
Defending against intellectual property infringement claims could be expensive
and could disrupt our business.
We cannot be certain that our products and services do not or will not
infringe upon valid patents, trademarks, copyrights or other intellectual
property rights held or claimed by third parties. Multi-Tech, Inc. has filed a
lawsuit against us alleging that we infringe upon its patents. While we have
received a successful preliminary ruling in this case, there can be no assurance
that this ruling will not be appealed and possibly overturned. While this case
is being resolved, we are incurring substantial expenses defending this claim.
If Multi-Tech is successful appealing this ruling, we may be subject to
significant monetary liability and our business may be materially disrupted. For
a complete discussion of the Multi-Tech case, please see Legal Proceedings
below.
We may also be subject to other legal proceedings and claims from time to
time relating to the intellectual property of others in the ordinary course of
our business. We may incur substantial expenses in defending against those
third-party infringement claims, regardless of their merit. Successful
infringement claims against us may result in substantial monetary liability or
may materially disrupt the conduct of our business.
Our common stock price is likely to be highly volatile.
The market price of our common stock has been and will likely continue to be
highly volatile, as is the stock market in general, and the market for VoIP
services and telecommunications related companies in particular. Some of the
factors that may materially affect the market price of our common stock are
beyond our control, such as changes in financial estimates by securities
analysts, conditions or trends in the VoIP services and other Internet and
telecommunications related industries, announcements made by our competitors,
or sales of our common stock. These factors may materially adversely affect
the market price of our common stock, regardless of our performance.
20
Risks Related to Our Relationship with AT&T/IDT/Liberty Media
In October 2001, AT&T, IDT Corporation and Liberty Media Corporation formed
NTOP Holdings, LLC, a new Delaware limited liability company which through a
series of transactions among AT&T, IDT and Liberty Media now holds an
aggregate of approximately 50 percent of our outstanding capital stock and 64
percent of the aggregate voting power of our capital stock. IDT controls the
right to vote the shares of Class A common stock held by the LLC in most
matters. This relationship contains certain risks associated with it including
the following:
We may experience conflicts of interest resulting from the LLC's power to
elect the members of our board of directors.
The LLC, currently controls 64 percent of the aggregate voting power of our
capital stock, and has the power to nominate and elect the members of our board
of directors when such members become eligible for re- election, so long as at
least five members are not affiliated with us, IDT or AT&T, as required by our
bylaws. This power may give rise to significant influence and/or conflicts of
interest with respect to certain decisions involving business opportunities and
similar matters that may arise in the ordinary course of our business or the
business of any of the owners of the LLC.
The holdings of the LLC may limit your ability to influence the outcome of
matters subject to a stockholder vote.
The LLC is able to exert considerable influence over us, including in
the election of our directors, the appointment of management and the approval
of any other action requiring the approval of our stockholders, including any
amendments to our certificate of incorporation and mergers or sales of our
company or of all of our assets. In addition, we could be prevented from
entering into certain transactions that could be beneficial to us and our
stockholders. Third parties will likely be discouraged from making a tender
offer or bid to acquire us because of the LLC's stock ownership and voting
power.
We have contracted with IDT for various services and for the use of its
telecommunications network, which contracts we may not be able to renew when
they expire.
In May 1999, we entered into agreements with IDT under which IDT provided
administrative and telecommunication services to us. Since some of these
agreements have expired, we will need to extend them, engage other entities to
perform these services or perform these services ourselves. We cannot assure
you that IDT will continue to provide these services. As a result, we may have
to purchase these services from third parties or devote resources to handle
these functions internally, which may cost us more than we paid IDT for the
same services.
Some of our business relationships with IDT and its affiliates are not covered
by written agreements, and, therefore, IDT could stop them at any time.
One of IDT's affiliates, Union Telecard Alliance, is our largest customer,
representing approximately 22% of our revenue for fiscal 2002. IDT is our
largest carrier customer, representing approximately 9% of our revenue for
fiscal 2002. While we have understandings in place with both UTA and IDT
relating to the services we provide to them, these understandings have not
been reduced to writing, and therefore may be terminated at any time by either
party, or the terms could change without notice to us. Our relationship with
both UTA and IDT is in good standing, and we do not expect the terms to change
in any material respect while we negotiate and finalize written agreements
with these two parties.
Risks Related to Our Industry
Federal, state and international regulations may be passed that could impede
our business.
The legal and regulatory environment that pertains to our business is
uncertain and changing rapidly. For example, in the United States, the Federal
Communications Commission (FCC) could undertake an examination of whether to
impose surcharges or additional regulations upon certain providers of Internet
telephony. The imposition of regulations on IP communications services may
negatively impact our business.
In addition, regulatory treatment of Internet telephony outside the United
States varies from country to country. For example, access to certain services
may be negatively impacted by government regulation. We
21
cannot predict whether these regulations will restrict or prohibit our ability
to provide products and services in the future. These actions and other
similar actions in foreign countries may cause us to lose customers and
revenue.
New regulations could increase our costs of doing business and prevent us
from delivering our products and services over the Internet, which could
adversely affect our customer base and our revenue. The growth of the Internet
may also be significantly slowed. This could delay growth in demand for our
products and services and limit the growth of our revenue. In addition to new
regulations being adopted, existing laws may be applied to the Internet. We
cannot predict how the laws will develop with regard to IP communications and
the extent of any negative impact that such regulations could have on our
business. New and existing laws may cover issues that include:
o sales and other taxes;
o interstate access charges;
o user privacy;
o pricing controls;
o characteristics and quality of products and services;
o consumer protection;
o contributions to the Universal Service Fund, which is funded by
telecommunications carriers for the purpose of supporting local telephone
service in rural and high cost areas;
o cross-border commerce;
o copyright, trademark and patent infringement; and
o other claims based on the nature and content of Internet materials.
For a more complete description of regulations affecting our business, see
Regulation above.
If the Internet does not continue to grow as a medium for voice
communications, our business will suffer.
The technology that allows voice communications over the Internet is still
in its early stages of development. Historically, the sound quality of
Internet calls was poor. As the industry has grown, sound quality has
improved, but the technology requires additional refinement. Additionally, the
Internet's capacity constraints may impede the acceptance of Internet
telephony. Callers could experience delays, errors in transmissions or other
interruptions in service that are beyond our control. Making telephone calls
over the Internet must also be accepted as an alternative to traditional
telephone service. Because the Internet telephony market is new and evolving,
predicting the size of this market and its growth rate is difficult. If our
market fails to develop, then we will be unable to grow our customer base and
our opportunity for profitability will be harmed.
Our business will not grow without increased use of the Internet.
The use of the Internet as a commercial marketplace is at an early stage of
development. Demand and market acceptance for recently introduced products and
services over the Internet are still uncertain. We cannot predict whether
customers will be willing to shift their traditional activities online. The
Internet may not prove to be a viable commercial marketplace for a number of
reasons, including:
o concerns about security;
o Internet congestion;
o inconsistent service; and
o lack of cost-effective, high-speed access.
If the use of the Internet as a commercial marketplace does not continue to
grow, we may not be able to grow our customer base, which may prevent us from
achieving profitability.
22
Our risk management practices may not be sufficient to protect us from
unauthorized transactions or thefts of services.
As have many others in our industry whose customers use credit cards to
purchase services, we have been the victim of consumer fraud and theft of
service. From time to time, callers have obtained our services without
rendering payment by unlawfully using our access numbers and personal
identification numbers. We attempt to manage these theft and fraud risks
through our internal controls and our monitoring and blocking systems. If
these efforts are not successful, the theft of our services may cause our
revenue to decline significantly. To date, costs related to consumer fraud and
theft have not materially impacted our business or revenues. In addition, the
company has introduced new consumer fraud controls, including pre-purchase
credit card verification, daily tracking of usage patterns, alignment of IP
addresses with customer registration data, as well as post-purchase credit
card verifications.
Item 2. Properties
Our primary facility is our headquarters and executive offices located on all
or portions of four floors at 520 Broad Street, Newark, New Jersey. We also
locate equipment around the world. Our principal equipment locations are in
Newark, NJ, London, England, Hong Kong, China and Piscataway, NJ. Since the
equipment is portable, the lease arrangements for the equipment locations are
generally short term or at-will. We believe that our facilities are suitable and
adequate for our business for the foreseeable future. A summary of the
materially important leased facilities where we conduct business operations is
as follows:
Total Lease
Domestic Office Locations(1) Sq. Ft. Occupant Expiration Date
---------------------------- ------- -------- ---------------
Newark, New Jersey ....................................................... 69,525 Net2Phone, 05/31/10
Headquarters
Hackensack, New Jersey ................................................... 8,150(2) Net2Phone 06/30/04
Customer
Service
(now vacant)
Brick, New Jersey ........................................................ 14,663 Net2Phone and 03/31/06
Adir Laboratories
Boca Raton, Florida ...................................................... 51,740(2) Adir/Netspeak 08/9/10
West Long Branch, New Jersey ............................................. 31,485 Net2Phone 09/30/07
Laboratories
Foreign Office Locations
------------------------
Jerusalem, Israel ........................................................ 1,800 Net2Phone MEA 07/14/03
Warsaw, Poland ........................................................... 2,153 Net2Phone Month
Global to month
- ---------------
(1) We lease approximately 20,000 additional square feet of office space in New
York, New York, and Boston, Massachusetts that is currently vacant, or
close to vacant. We have either subleased or are currently attempting to
sublease this space.
(2) As a result of our restructuring in early 2002, and the reduction of work
force that was part of this restructuring, we are not utilizing all of the
square footage at these facilities and we are attempting to sublease parts
of this space.
Item 3. Legal Proceedings
Multi-Tech
On February 15, 2000, Multi-Tech Systems, Inc. filed suit against Net2Phone
and other companies in the United States Federal District Court in
Minneapolis, Minnesota. Multi-Tech alleged that "the defendant
23
companies are infringing because they are providing the end users with the
software necessary to simultaneously transmit voice and data on their computers
in the form of making a phone call over the Internet." We continue to defend the
lawsuit vigorously. On August 16, 2002, following an initial hearing, called a
Markman hearing, the Court issued an order construing the claims of all of the
patents subject to the lawsuit that Net2Phone considers favorable to its
non-infringement defenses. In light of the order, Net2Phone expects Multi-Tech
to agree to a stipulation of non-infringement and joint motion for entry of
final judgment dismissing all of Multi-Tech's infringement claims. Multi-Tech is
likely to appeal the Markman order to the Circuit Court of Appeals contesting
the Court's construction of the patent claims.
Class-Actions
Four substantially similar class-action lawsuits were filed in the United
States District Court for the Southern District of New York on behalf of all
persons who acquired our stock between July 29, 1999 and December 6, 2000.
Net2Phone, certain of our executive officers and underwriters involved in our
initial public offering were named as defendants in these complaints. The
complaints allege, in part, that certain underwriters of our initial public
offering violated federal securities laws by failing to disclose that they had
solicited and received undisclosed commissions and allocated shares in our
initial public offering to those investors in exchange for their agreement to
purchase our shares in the after-market at pre-determined prices. The complaints
also allege that, whether or not Net2Phone and the named executives were aware
of the underwriters' arrangements, Net2Phone and the named executives have
statutory liability under the federal securities laws for issuing a registration
statement in connection with our initial public offering that failed to disclose
that these allegedly undisclosed arrangements existed. The suits against us are
substantially the same as suits making the same allegations that have been filed
against more than 100 other companies that had their initial public offerings at
or about the same time. The deadline for all defendants to respond to the
complaints has been extended by the court to which the various cases have been
assigned. We recently have been able to secure the voluntary dismissal of our
executive officers from the lawsuits. In addition, our underwriting agreement
with our underwriters provides for indemnification of Net2Phone and its
executives and directors for liabilities arising out of misstatements in our
registration statement attributable to material non-disclosures by the
underwriters. We intend to pursue our indemnification claims against the
underwriters. In addition, we maintain directors and officers liability
insurance coverage which should substantially cover the costs of defending the
various suits. However an unfavorable decision in one or more of these cases
could have a material adverse effect on our business operations, financial
condition, results of operations and cash flows.
Cisco Systems
In August 2002, Net2Phone and its subsidiary, ADIR Technologies, consummated
the settlement of their lawsuit filed in the United States District Court for
the District of New Jersey against Cisco Systems, Inc. and a Cisco employee who
had served as a director of Adir. The complaint sought compensatory and punitive
damages based upon claims for misappropriation of trade secrets, fraud, unfair
competition, breach of contract and breach of fiduciary duties. The suit arose
out of the relationships that had been created in connection with Cisco's and
Net2Phone's original investments in Adir in 2000 for purposes of developing
Adir's VoIP software and out of Adir's subsequent purchase of NetSpeak, Inc. in
August 2001. The parties agreed to settle the suit on July 31, 2002. Under the
terms of the settlement, during the first quarter of fiscal 2003, Net2Phone
received the shares representing 18.5% of Adir owned by Cisco and SoftBank Asia
Infrastructure Fund and Cisco paid Net2Phone and Adir the sum of $19,500,000.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to our stockholders during the fourth quarter of
the fiscal year ended July 31, 2002.
24
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Market Information
Our stock is quoted on the Nasdaq National Market under the ticker symbol
"NTOP." There is no public market for our Class A common stock. The following
table sets forth for the periods indicated the high and low sale prices per
share for our common stock as reported on the Nasdaq National Market.
Year Ended July 31, 2002 High Low
------------------------ ---- ---
First Quarter..................................... $6.11 $2.65
Second Quarter ................................... $6.80 $4.48
Third Quarter..................................... $5.87 $4.48
Fourth Quarter ................................... $5.50 $3.00
Year Ended July 31, 2001 High Low
------------------------ ---- ---
First Quarter..................................... $33.81 $16.70
Second Quarter ................................... $20.25 $6.84
Third Quarter..................................... $13.44 $7.38
Fourth Quarter ................................... $9.46 $4.10
On October 17, 2002, the last reported sale price of our common stock on the
Nasdaq National Market was $2.22 per share.
Holders
As of October 17, 2002, there were approximately 379 stockholders of record
of our common stock and 11 stockholders of record of our Class A common stock,
par value $.01 per share.
Dividend Policy
We have not paid any cash dividends in the past and do not intend to pay
cash dividends on our capital stock for the foreseeable future. Instead, we
intend to retain all earnings, if any, for use in the operation and expansion
of our business.
Equity Compensation Plan Information
The following table provides, as of July 31, 2002, information with respect
to compensation plans (including individual compensation arrangements) under
which our equity securities are authorized for issuance.
(a) (b) (c)
- ---------------------------------------------------------------------------------------------------------------------------------
Plan Category Number of securities to be Number of securities
issued upon exercise of Weighted-average exercise remaining available for
outstanding options, warrants price of outstanding options, future issuance under equity
and rights warrants and rights compensation plans (excluding
securities reflected in
column (a))
- ---------------------------------------------------------------------------------------------------------------------------------
Equity compensation plans
approved by security holders 10,623,023(1) $5.59 6,316,977
- ---------------------------------------------------------------------------------------------------------------------------------
Equity compensation plans not
approved by security holders 150,000(2) $4.36 0
- ---------------------------------------------------------------------------------------------------------------------------------
Total 10,773,023 $5.59 6,316,977
25
- ---------------
(1) Represents stock options issued pursuant to 1999 Net2Phone Stock Option
Plan.
(2) On August 6, 2001, we granted options to purchase 50,000 shares of our
common stock to each of three employees of Aplio, S.A., a subsidiary of
Net2Phone. The exercise price per share of these options was $4.36, subject
to certain adjustments. The options were fully vested upon the execution of
the stock option agreements, and may be exercised through January 3, 2005.
Unregistered Sale of Common Stock
In connection with the termination of Ilan Slasky's employment, Mr. Slasky
sold 500 shares of the common stock of Adir Technologies, Inc., our
majority-owned subsidiary, to IDT Corporation. On or about January 24, 2002, IDT
transferred the shares of Adir to us in exchange for 273,798 shares of our
common stock valued at $1.4 million or $5.20 per share, the closing price of our
common stock on January 24, 2002. Under certain circumstances, we are required
to guarantee to IDT that the shares still owned by it on January 31, 2007 will
have a market value of at least $5.20 per share on that date.
The issuance of the shares of our common stock to IDT was exempt from the
registration provisions of the Securities Act of 1933, pursuant to Section 4(2)
of the Securities Act for transactions not involving a public offering, based on
the fact that the common stock was offered and sold to an accredited investor
who had access to financial and other relevant data concerning Net2Phone, its
financial condition, business and assets.
26
Item 6. Selected Financial Data
The following selected financial data should be read in conjunction with our
financial statements and related notes thereto and "Management's Discussion
and Analysis of Financial Condition and Results of Operations" included in
Item 7. The statement of operations data for fiscal 1998, fiscal 1999, fiscal
2000, fiscal 2001 and fiscal 2002 and the balance sheet data as of July 31,
1998, 1999, 2000, 2001 and 2002 are derived from our financial statements.
Fiscal Year Ended July 31,
-----------------------------------------------------------------------------
Statement of Operations Data: 1998 1999 2000 2001 2002
------------ ------------ ------------- ------------- -------------
Revenue:
Service......................................... $ 10,490,972 $ 32,648,305 $ 61,253,096 $ 143,309,997 $ 133,143,796
Product......................................... 1,515,000 608,152 11,148,094 6,888,491 4,711,369
------------ ------------ ------------- ------------- -------------
Total revenue................................... 12,005,972 33,256,457 72,401,190 150,198,488 137,855,165
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Costs and expenses:
Services cost of revenue........................ 6,576,523 17,554,074 34,700,401 102,805,831 72,235,412
Products cost of revenue........................ 272,236 263,936 6,286,392