UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO
SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
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ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JULY 31, 2003, OR |
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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- 3449037 |
(State
or other jurisdiction of incorporation or organization) |
(I.R.S.
Employer Identification No.) |
520 Broad Street
Newark, New Jersey 07102
(Address of principal executive offices, including area code)
(973) 438-3111
(Registrant’s telephone number, including area code)
| Securities registered pursuant to Section 12(b) of the Act: | None |
| Securities registered pursuant to Section 12(g) of the Act: | Common Stock, par value $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 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.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes No
The aggregate market value of registrant’s common stock held by non-affiliates of the registrant on January 31, 2003 (the last business day of the registrant’s most recently completed second fiscal quarter), was approximately $118.1 million. On such date, the last sale price of registrant’s common stock was $3.90 per share.
The number of shares outstanding of each of the registrant’s classes of common stock, as of October 16, 2003, was 31,475,449 shares of common stock and 28,913,250 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 2003 Annual Meeting of Stockholders are incorporated by reference into Part III of this Form 10-K where indicated.
NET2PHONE, INC. ANNUAL REPORT ON FORM 10-K TABLE OF CONTENTS
| Page | |||||
| Number | |||||
| PART I | 1 | ||||
Item 1. |
Business | 1 | |||
Item 2. |
Properties | 32 | |||
Item 3. |
Legal Proceedings | 32 | |||
Item 4. |
Submission of Matters to a Vote of Security Holders | 33 | |||
| PART II | 34 | ||||
Item 5. |
Market for Registrant’s Common Equity and Related Stockholder Matters | 34 | |||
Item 6. |
Selected Financial Data | 35 | |||
Item 7. |
Management’s Discussion and Analysis of Financial Condition and Results of Operations | 35 | |||
Item 7A. |
Quantitative and Qualitative Disclosures About Market Risk | 48 | |||
Item 8. |
Financial Statements and Supplementary Data | 48 | |||
Item 9. |
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure | 48 | |||
Item 9A. |
Controls and Procedures | 48 | |||
| PART III | 49 | ||||
Item 10. |
Directors and Executive Officers of the Registrant | 49 | |||
Item 11. |
Executive Compensation | 49 | |||
Item 12. |
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters | 49 | |||
Item 13. |
Certain Relationships and Related Transactions | 50 | |||
Item 14. |
Principal Accounting Fees and Services | 50 | |||
| PART IV | 51 | ||||
Item 15. |
Exhibits, Financial Statement Schedules and Reports on Form 8-K | 51 | |||
| INDEX TO FINANCIAL STATEMENTS | F-1 | ||||
| SIGNATURES | S-1 | ||||
| PART I |
This Annual Report on 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 “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 Annual Report 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 factor.
Our fiscal year ends on July 31 of each calendar year. Each reference to a fiscal year in this Annual Report refers to the fiscal year ending July 31 of the calendar year indicated (for example, fiscal 2003 refers to the fiscal year ended July 31, 2003). Unless the context requires otherwise, references to “we,” “us,” “our,” “Net2Phone” and the “Company” refer to Net2Phone, Inc. and its consolidated subsidiaries.
Item 1. Business |
Company Overview |
We are a leading provider of Voice over Internet Protocol, or VoIP, telephony services. Since we began operations in 1995, we have evolved from a pioneer in developing PC-to-telephone calling services over the Internet to a next generation provider of high quality voice and enhanced telecommunication services throughout the world, including cable telephony services. We utilize our VoIP technology to transmit digital voice communications over managed data networks and the Internet. Since 1996, we have carried over five billion VoIP minutes worldwide. Effective August 1, 2003, we changed our corporate structure, creating two wholly owned subsidiaries:
| • | Net2Phone Global Services delivers VoIP telephone services to businesses and consumers directly and through its global distribution network of over 450 resellers in over 130 countries, capitalizing on the growth, quality, flexibility and cost advantages of VoIP
technologies. |
| • | Net2Phone Cable Telephony offers cable operators a complete suite of services enabling them to deliver to their customers residential phone service having comparable quality, features and functionality to that offered by traditional telephone companies. |
Substantially all of our revenues have been, and are currently, derived from Net2Phone Global Services.
We are actively marketing cable telephony services to a wide array of cable operators in the U.S., Europe and Latin America who we believe may be more likely to buy our services than to build their own cable telephony service. On October 22, 2003, following a successful trial period, Net2Phone Cable Telephony signed its first customer contract with Liberty Cablevision of Puerto Rico, Inc., which is wholly owned by our affiliate Liberty Media Corporation, to exclusively deploy and manage Liberty Cablevision of Puerto Rico’s residential cable telephony offering.
During the past eighteen months, we have focused the units now in Net2Phone Global Services on opportunities in emerging markets where we believe our services can command higher margins. Additionally, we have de-emphasized relatively low-margin services, such as disposable calling cards in the U.S. and wholesale carrier services, and we have significantly reduced our workforce. Although these measures have resulted in a decline in our revenues since fiscal 2001 and we have never generated income from operations (other than as a result of a litigation settlement in fiscal 2003), our gross margins have increased and we have substantially reduced cash used in operating activities. Below are some of our key results:
| • | revenue of $91.8 million in fiscal 2003, $137.9 million in fiscal 2002 and $150.2 million in fiscal 2001; |
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| • | gross margins of 42.4 percent in fiscal 2003, 43.1 percent in fiscal 2002 and 27.8 percent in fiscal 2001; |
| • | cash used in operating activities of $7.1 million in fiscal 2003 (which included $19.5 million of proceeds from a litigation settlement), $90.6 million in fiscal 2002 and $115.1 million in fiscal 2001; and |
| • | cash, cash equivalents and marketable securities of $94.1 million as of July 31, 2003, including $24.2 million in restricted cash. |
Our strategic investors are IDT Corporation, a leading global telecommunications provider, and Liberty Media Corporation, a global media company with interests in cable properties in 20 countries, representing more than 12 million subscribers. IDT and Liberty Media together own NTOP Holdings, L.L.C., which currently holds an aggregate of approximately 47.9 percent of our outstanding capital stock and 64.7 percent of the aggregate voting power. IDT is the controlling member of NTOP Holdings through which it effectively controls us.
Industry Overview |
The VoIP industry has grown dramatically from the early days of calls made through personal computers. According to a research study from Insight Research, VoIP-based services will grow from $13.0 billion in 2002 to nearly $197.0 billion in 2007, representing a significant opportunity for VoIP providers such as Net2Phone.
VoIP is an alternative technology that can replace services provided by the traditional telephone network. VoIP technology translates voice into data packets, transmits the packets over data networks and reconverts them into voice at the destination. Unlike traditional telephone networks, VoIP does not use dedicated circuits for each telephone call; instead, the same VoIP network can be shared by multiple users for voice, data and video simultaneously. This type of data network is more efficient than a dedicated circuit network because the data network is not restricted by the one-call, one-line limitation of a traditional telephone network. This improved efficiency creates cost savings that can be passed on to the consumer in the form of lower rates or retained by the VoIP provider.
The growth of VoIP has been and continues to be driven primarily by:
| • | increasing consumer demand for lower cost phone service; |
| • | improved quality and reliability of VoIP calls fueled by technological advances, increased network development and greater bandwidth capacity; |
| • | continuing domestic and international deregulation, opening new market opportunities for VoIP services; |
| • | new product innovations that allow VoIP providers to offer services not currently offered by traditional phone service companies; and |
| • | growing demand for long distance communication services driven by the increased mobility of the global workforce. |
As a result of these developments, consumers, enterprises and telecommunications providers are continuing to embrace offerings from VoIP providers, such as those offered by us. Consumers, particularly in emerging markets, are increasingly using VoIP-enabled services, such as calling cards and Internet Protocol, or IP, telephones, to realize significant cost savings on long distance calls. Enterprises are significantly reducing telephony expenses by using VoIP to link users within offices and around the world. VoIP enables telecommunications providers to reduce their network costs and to deliver new products and services that cannot be supported by traditional networks.
According to the World Trade Organization, 69 governments around the world have committed to telecommunications deregulation, opening new markets and fostering competition with incumbent telecommunications providers. To remain competitive in this environment, both incumbent and newly
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licensed telecommunications providers are seeking to lower costs, improve functionality and introduce new services.
Cable Telephony Market |
Telephony represents a significant revenue growth opportunity for cable operators. In-Stat/MDR projects that the number of cable telephony subscribers worldwide will grow from 8.6 million at the end of 2002 to over 22 million by 2006. In-Stat/MDR further projects that worldwide cable telephony services revenue will increase from $3.0 billion in 2002 to over $7.5 billion by 2006. The following table provides an estimate of worldwide cable telephony subscribers through 2006 (subscribers in thousands):
| 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | Compound Annual Growth Rate |
||||||||||||||||
North America |
1,745 | 2,430 | 3,185 | 4,260 | 5,475 | 7,890 | ||||||||||||||||
Europe |
3,710 | 5,370 | 6,250 | 7,110 | 8,250 | 9,820 | ||||||||||||||||
Rest of World |
550 | 840 | 1,215 | 1,760 | 2,890 | 4,415 | ||||||||||||||||
Total Subscribers |
6,005 | 8,640 | 10,650 | 13,130 | 16,615 | 22,125 | 29.8% | |||||||||||||||
Source: In-Stat/MDR, September 2002; subscribers include those receiving cable telephony through traditional circuit-switched and VoIP services.
With the addition of cable telephony, cable operators can offer their subscribers a bundle of telephone, television and high speed Internet service, referred to as the “triple play” of voice, video and data services. We believe cable operators will accelerate the bundling of telephone service into their existing video and data offerings in order to:
| • | generate a new source of revenue; |
| • | improve customer retention; |
| • | compete with local residential telephone providers that bundle high speed DSL Internet access with telephone service; and |
| • | compete with satellite television services, some of which are partnering with residential telephone providers to provide a bundled voice, video and data offering. |
Cable operators currently have two distinct technologies that they can employ to offer cable telephony services: constant bit rate technology and VoIP technology. Constant bit rate technology utilizes the circuit-switched network currently used in traditional phone service. VoIP technology permits cable operators to implement and offer telephony services comparable to those offered by traditional telephone service providers, at costs below those associated with constant bit rate technology. VoIP cable telephony services can use the public Internet to carry voice traffic or can employ a fully managed network. VoIP cable telephony services that use the public Internet tend to suffer from the data loss and transmission delays associated with the Internet. In contrast, by using a fully managed VoIP network that does not rely on the public Internet, VoIP operators, such as Net2Phone Cable Telephony, can give voice calls priority over data and video traffic and significantly improve call quality. Several cable operators including Cablevision, Time Warner Cable, Comcast and Cox Communications have announced limited deployment of VoIP-based cable telephony as a new product offering.
VoIP technology enables cable operators to provide a comprehensive residential telephony solution, which we believe has several key benefits relative to traditional circuit-switched networks, including:
| • | comparable reliability, enhanced services and functionality; |
| • | simpler and faster deployment; |
| • | lower initial deployment costs; and |
| • | lower cost structure providing an ability to offer competitive pricing to customers. |
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Cable operators seeking to offer cable telephony by developing an in-house service must integrate several additional components with their existing systems, which requires substantial capital expense. Cable operators developing an in-house service must also engage in hiring, retraining and process reengineering to support telephony services. Full service VoIP telephony companies, such as Net2Phone, can provide cable operators the ability to outsource their cable telephony services, thereby reducing cable operators’ costs, time to market and risks associated with developing and maintaining an in-house cable telephony service.
Our Products and Services |
Net2Phone Global Services |
We offer a variety of VoIP-based telecommunications products and services to consumers, enterprises and telecommunications providers around the world, primarily through local resellers. Our centrally managed platform supports a full range of consumer and corporate hardware products and services that enhance quality, lower costs and improve ease of use and management. The devices and calling cards we offer allow users to access our VoIP platform to make low cost calls to anywhere in the world. Below are the key products and services offered by Net2Phone Global Services:
| • | Enterprise Solutions. We provide a suite of VoIP products and services targeting small and medium-sized enterprises. Our recently introduced Max Private Voice NetworkSM, or Max PVN, allows business customers to utilize their existing broadband connections to place
free calls among their corporate offices and their primary business contacts, such as customers and suppliers. Our Max PVN and several of our other products also allow enterprises to access our VoIP platform to make low cost VoIP calls to anywhere in the world. |
| • | Calling Cards and Prefix Dialing. We sell rechargeable and disposable calling cards in the U.S. and internationally directly and through our resellers. We offer calling cards in over 130 countries that can be used to access our VoIP platform to make low cost local, long
distance or international calls. We also offer a calling card that enables users to access our VoIP platform from 25 countries to make low cost calls. Additionally, we offer dial-around numbers, called “prefix codes,” similar to the “10-10” service prevalent in the U.S. |
| • | Public Call Centers and Internet Cafes. We offer public call centers and Internet cafes the ability to sell VoIP services. Public call centers and Internet cafes are popular in emerging markets where telecommunications infrastructure is limited and consumers rarely have
freely available access to a telephone or the Internet. Our product and service offerings to public call centers and Internet cafes include devices to support end users and a billing software platform that allows call centers and Internet cafes to create their own rate tables, bill
in their local currencies and print out customized bills with their company’s information. |
| • | Broadband Telephony. We sell devices that can be plugged into a high speed connection anywhere in the world and allows users to be reached at the telephone number assigned to such devices. The devices also allow users to access our VoIP platform to make high speed
connections to anywhere in the world. |
| • | Satellite VoIP. We offer VoIP products and services to satellite broadband providers that allow them to offer voice service in conjunction with their high speed data offerings. We have improved voice quality over satellite by implementing voice packet prioritization and
working with third party device manufacturers, including LG Electronics and Hughes Network Systems, to deliver a device that can be easily installed on existing equipment. |
| • | Carrier Services. We sell excess capacity on our retail VoIP routes to other telecommunications carriers. Through our VoIP network, we offer carriers what we believe is a low cost, high quality alternative for the transport and termination of voice and fax
communications. |
We are also evaluating and developing new products and service offerings to serve our target markets including: VoIP over wireless fidelity, or WiFi, integration and interoperability between our VoIP services
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and mobile devices, consumer broadband telephony, expanding our suite of enterprise services and operator code dialing services.
Net2Phone Cable Telephony |
Taking advantage of our experience and leadership in VoIP services, we have developed a fully outsourced VoIP service offering that enables cable operators to provide VoIP-based residential telephone services. We believe our offering provides comparable quality, features and functionality to that provided by traditional phone companies. Our platform utilizes a fully managed network and does not need to carry voice traffic over the public Internet, which may suffer from data loss and transmission delays, allowing us and our customers to provide voice quality equivalent to that provided by traditional phone companies.
We offer cable operators the ability to provide cable telephony services to their customers faster and with less expense than if they were to develop their own cable telephony service. Our service offerings allow cable operators to bundle telephony services with their video and data offerings. The cable operator can use its own brand, deliver a single bill and provide direct customer support to its customers. We support the back office platform, switching and transport of voice traffic, ongoing operations and secondary technical support to deliver a fully managed VoIP service.
We work with cable operators to deploy an integrated, tested and operational telephony service, including customized operations support systems, network interfaces, carrier interconnects, telecommunications methods and procedures and real-time service assurance, including 24 x 7 network operations center support. Our service offering includes:
Planning and Deployment Services |
We customize our service offering to capitalize on cable operators’ existing systems and processes. Our team works with cable operators’ engineers to design an optimal VoIP framework that interfaces with the public switched telephone network, or PSTN. We project traffic volume and capacity requirements on the cable operators’ facilities, the PSTN and IP networks to develop a system that can handle peak demands across each segment. We also develop and document business processes and provide training and support to cable operators during the cable telephony service launch and on an ongoing basis.
Switching and Service Assurance Platform |
The switching and service assurance platform provides the infrastructure required to support VoIP cable telephony and consists of the following elements:
| • | Call Management Server Platform. Our call management server platform provides the features and functions typically delivered by a hardware-based switch, known as a CLASS 5 switch, but at a significantly lower cost. The software-based solution allows us to process
a call and deliver it through the most efficient, cost effective and high quality route, provide CLASS 5 feature support (for example, caller ID, call waiting, distinctive ring and three-way calling), interface to the PSTN for termination and origination and provide network
generated announcements. |
| • | Record Keeping Server. The record keeping server is a real-time event messaging, collection, correlation and distribution database developed by us. The database stores the information generated by the call management server platform and the real-time assurance
platform described below. The record keeping server can be accessed by cable operator and Net2Phone operations personnel through a Web-based or software interface to analyze call information, which can then be employed to improve network functions and prevent
possible future network problems. The record keeping server also stores all the usage information required for customer support, billing, back office and management functions. |
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| • | Real-time Service Assurance Platform. The real-time assurance platform continually monitors the call management server platform and originates and terminates test calls across each cable, PSTN and IP entry and exit point to sample call quality and network
availability. This information is collected and programmed by the cable operator and Net2Phone personnel to generate real-time alarms if actual |
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performance metrics exceed predetermined thresholds. The result is that cable operators and Net2Phone can monitor call traffic and diagnose and resolve network problems in real-time,
often before the telephone user notices any problem. |
| • | Cable Voice Operations Support System. The cable voice operations support system, which we have developed, consists of a web-based portal and a software client interface to access, control, monitor and manage the cable telephony service. Once the proper
administrative controls have been established in the cable voice operations support system, customer service and back office personnel use this system to access data required to provide customer support and track billing and accounts payable. Additionally, we and cable
operator management can use the system interfaces to access management reports such as overall network quality, end-user customer service response times, billing history and calling patterns and destinations. |
Telecommunications Administration |
We order, provision and administer circuits for each phone line, and we establish agreements with both local and long distance telecommunications providers to terminate calls. We also acquire and manage a database of telephone numbers to assign to users in every geographic region of our customers. IDT will be a significant supplier of telecommunications services to our cable telephony business. For more information see “—Telecommunications Services Agreement with IDT” elsewhere in this Annual Report.
Liberty Cablevision of Puerto Rico Pilot Test and Agreement |
During the past eighteen months, we successfully executed a pilot test of our cable telephony offering with Liberty Cablevision of Puerto Rico, which led to the signing, on October 22, 2003, of a full scale, six-year agreement under which we will provide Liberty Cablevision of Puerto Rico with our cable telephony services. Liberty Cablevision of Puerto Rico passes, or could potentially serve, a total of approximately 310,000 homes and serves approximately 120,000 customers in 37 municipalities principally located in the Eastern, Central and Northern regions of the island of Puerto Rico.
The pilot test demonstrated the viability of our cable telephony service and platform in an actual market setting. The pilot test resulted in average subscriber usage exceeding 1,100 minutes of calls per month, which we believe is comparable to the Puerto Rico incumbent telephone provider level, with more than 35 percent of the minutes being in-bound. Quality-of-service scored amongst the highest rating, as compared to standards set by the International Telecommunications Union.
Under the terms of the agreement, Liberty Cablevision of Puerto Rico will maintain ownership of the customer, service brand and first level customer and technical support, while we will support the back office platform, switching and transport of voice traffic, ongoing operations and secondary technical support to deliver a fully managed VoIP service. We will track and monitor voice quality and network performance metrics from start to finish and will provide Liberty Cablevision of Puerto Rico with a full view into telephone calls routed over its network.
Liberty Cablevision of Puerto Rico will pay us an up-front license fee and an on-going monthly maintenance fee for each cable telephony subscriber line ordered by it. In addition, Liberty Cablevision of Puerto Rico will reimburse us for equipment, as well as the telecommunications costs we incur, such as long distance and call termination fees, to provide the telephony service, plus a margin. Under the agreement, we commit to maintain defined quality levels. If we fail to do so, Liberty Cablevision of Puerto Rico will be entitled to service credits. The agreement has a six year term. Liberty Cablevision of Puerto Rico has a one-time right to terminate the agreement at will during April 2004.
Our Competitive Advantages |
We believe we have several core competitive advantages that will allow us to maintain and expand our position as a leading provider of VoIP services.
Leadership and Experience in VoIP. We pioneered the development and commercial introduction of VoIP services and have a globally recognized brand name in the VoIP industry. We have a proven track
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record of quickly deploying and successfully managing our VoIP services around the world, across a variety of networks and technologies. Currently, our top sixteen engineering personnel responsible for integrating and deploying our services have an aggregate of over 240 years of telecommunications engineering experience, much of it gained at Bell Labs and IBM research laboratories. Over our eight-year history, our research and development team has created innovative new products, feature enhancements and applications to improve the performance and quality of our services. Our cable telephony service capitalizes on the call management and monitoring platform developed for Net2Phone Global Services and the lessons learned in developing VoIP services around the world.
Platform to Deliver Centrally Managed, High Quality and Low Cost Voice Services. We provide our services through our centrally managed platform, which aggregates, provisions, rates, routes, monitors and bills phone calls in real-time. Our platform allows us to offer a comprehensive array of services meeting the varied needs of consumer, enterprise, cable and carrier customers. Through our platform, we track and manage calls to optimize voice quality. Furthermore, using a fully managed network that does not use the public Internet, Net2Phone Cable Telephony can process calls to deliver them through the most efficient, cost effective and high quality routes, resulting in voice quality equivalent to that offered by traditional telephone companies. Our centrally managed platform allows us to increase the number of end users of our services, without significant additional capital expenses generally associated with network build-outs.
Strategic Relationships. We have established and expect to expand our strategic relationships with cable operators, equipment suppliers and telecommunications companies. Liberty Media has introduced us to cable operators seeking to deploy cable telephony. Liberty Media has ownership interests in cable systems with an aggregate of 12 million subscribers in 20 countries and relationships with leading cable equipment suppliers. Through our relationship with IDT, we are able to obtain access to high quality telecommunications services and networks at competitive prices. We believe our cable telephony platform, combined with our telecommunications services agreement with IDT, creates a compelling and highly competitive cable telephony service offering.
Global Distribution Channels. Net2Phone Global Services has developed and continues to expand and improve its global distribution channel that delivers low cost, high quality VoIP services to resellers around the globe. We deliver VoIP telephone services to businesses and consumers in over 130 countries through our global distribution network of over 450 resellers and other distribution channels. As countries continue to deregulate their telecommunications services, we can employ our distribution network and capitalize on our existing reseller relationships to partner with incumbent telecommunications providers, well capitalized new entrants, large systems integrators or significant sales and marketing organizations.
Financial Strength. We have a strong balance sheet, with $94.1 million in cash, cash equivalents, marketable securities and restricted cash as of July 31, 2003. Our financial strength allows us to aggressively pursue new VoIP opportunities, such as the cable telephony market, while at the same time growing our existing core business lines in targeted areas. In addition, our financial strength allows us to offer cable operators flexible strategic, operational and economic alternatives for deploying cable telephony in their territories.
Our Strategy |
Our strategy is to become the leading provider of VoIP telephony products and services in the markets we serve. The following are key elements of our strategy:
Capitalize on the Growth of VoIP Services and the Cable Telephony Market. We believe Net2Phone Global Services and Net2Phone Cable Telephony are well positioned to take advantage of the expected growth of the VoIP services and cable telephony markets. According to a research study from Insight Research, VoIP-based services will grow from $13 billion in 2002 to nearly $197 billion in 2007, representing a significant opportunity for us. In-Stat/MDR projects that the number of cable telephony subscribers worldwide will grow from 8.6 million at the end of 2002 to over 22 million by 2006.
Target Small to Mid-sized Cable Operators in the U.S. and International Cable Operators. Net2Phone Cable Telephony targets small to mid-sized cable operators in the U.S. and operators of all sizes in Europe
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and Latin America, who we believe may be more likely to buy our services than to build their own cable telephony service. These cable operators may not have the significant technical and financial resources required to develop an internal cable telephony solution, such as the personnel to support network operations, engineering, support and project management. We believe our service and our expertise in VoIP reduces cable operators’ costs, time to market and risks associated with developing and maintaining an in-house cable telephony service.
Offer Flexible Deployment and Economic Alternatives. Net2Phone Cable Telephony offers cable operators a choice of strategic deployment and economic alternatives for our cable telephony offering. Depending on the particular market and financial position of each operator, we tailor our offer to fit within the business objectives and the available resources of each cable telephony opportunity. We can develop and integrate specific features and applications into our service, such as voice-mail, voice-activated dialing and Internet-based account management, which the operator can then offer to its subscribers to meet the operator’s strategic objectives. For resource and capital constrained operators, we offer an alternative that requires a lower amount of human resources and financial investment by the operator.
Focus Net2Phone Global Services on High Margin Opportunities in Emerging Markets and New Service Offerings. Net2Phone Global Services targets international markets undergoing telecommunications deregulation, which we believe will provide high margin opportunities. We plan to continue to enhance our global distribution chain by securing new resellers with strong local sales and marketing channels. Our plan is to develop and integrate new services into our existing managed platform, such as our recently introduced Max Private Voice NetworkSM service.
Sales and Marketing |
Net2Phone Global Services |
Net2Phone Global Services sells and markets our services through three divisions, each designed to focus on a specific market. The International Communication Services Division sells all of our services to resellers across the globe that have access to consumers and small to mid-sized businesses. Our Consumer Division sells our direct-to-consumer calling cards in the U.S. and PC-to-phone services. The Carrier Services Division sells excess capacity on our VoIP network to other telecommunications carriers.
International Communications Services. Our International Communications Services Division primarily contracts with resellers around the world, who in turn sell our services to retailers, businesses, Internet cafés and others in their local markets. Our experience in building a global distribution chain and integrating our services in the emerging international telecommunications environment assists us in effectively entering markets as they open to competition.
We initiate and manage relationships with our international resellers through a global marketing and sales force of 39 employees and additional consultants and sales representatives located in the U.S., South America, Europe, the Middle East and Asia. Although our resellers are generally responsible for all sales and marketing expenses, we assist in managing their marketing efforts. We are focusing our marketing efforts towards selecting resellers in markets undergoing telecommunications deregulation over the next three years.
Using our platform, resellers can quickly and easily sell our products in their own countries. We enable our resellers to generate calling card accounts, create rate tables to support different markets, provide customized billing in multiple currencies and languages and offer customer support tools.
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Consumer Division. Our Consumer Division is comprised of both calling card services in the U.S. as well as our PC-to-phone service.
| • | Calling Cards: We market our rechargeable pre-paid calling cards in the U.S. through traditional direct-response advertising in domestic publications. In addition, many customers enroll for calling card services on our web site. We also market through loyalty programs as
well as through e-mail-based programs to existing customers. |
We sell disposable calling cards domestically through Union Telecard Alliance, which is an affiliate of IDT. UTA represented approximately 9.7 percent of our revenue for fiscal 2003. We are currently de-emphasizing our domestic disposable calling card business.
| • | PC-to-Phone Service: We provide our PC-to-phone service to consumers globally through our web site. |
Carrier Services Division. We sell excess capacity on our retail VoIP routes to other carriers through our internal sales force. We have de-emphasized our traditional carrier services, and to that end, we have limited our activity to selected carriers, particularly those who work with us to market some of our other international products and services. IDT was our largest traditional carrier customer in fiscal 2003, representing approximately 8.6 percent of our total revenue.
Net2Phone Cable Telephony |
Net2Phone Cable Telephony targets small to mid-sized cable operators in the U.S. and operators of all sizes in Europe and Latin America, who we believe may not have the significant technical and financial resources required to develop and maintain an internal cable telephony service. Our offering can be deployed over all or part of a cable operator’s two-way digital cable systems.
Our sales process combines business case development with a proposed technical architectural design. The timing of this process is variable and driven principally by the cable operator’s own strategic priorities.
We offer cable operators a range of strategic deployment and economic alternatives. We expect our cable telephony agreements to have terms of approximately seven years. Our two basic deployment options are described below, although our agreements could include aspects of each of these options:
| • | Hosted Service. In a hosted service arrangement, the operator outsources the planning, development and aspects of the ongoing operation of cable telephony. The cable operator collects revenue from its customers and pays us a fee on a per subscriber basis for providing
our integrated services as well as ongoing maintenance and support fees. In addition, the cable operator reimburses us for our telecommunications costs plus a margin. These costs include the set up and ongoing management of local and long distance interconnection and
termination, the costs of any dedicated circuits and the recurring cost of maintaining phone numbers and other support services, such as 911 and operator assisted calling. Our fees on a particular contract will depend on a number of variables, including the size of the cable
operator’s telephony footprint, its ability to sell cable telephony services to its customers, the complexity of the deployment and the amount of local versus long distance termination. In a hosted service arrangement, the cable operator is responsible for sales and marketing, customer activation, customer support, billing and collection, plant engineering and service technicians and any regulatory costs associated with offering cable telephony. The cable operator is also responsible for the capital expense associated with the cost of new service installation, the cost of equipment deployed at the subscriber’s premises and the upgrade to its existing cable modem termination server. We bear the capital and operating expenses for the planning, design, procurement, deployment and operation of the VoIP cable telephony infrastructure. Our capital expenses include the hardware and software costs of integrating our services and systems with the operator’s systems. |
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| • | Franchise Service. In the franchise service arrangement, Net2Phone Cable Telephony initially acquires the exclusive rights to offer cable telephony services in the cable operator’s territory, subject to the cable operator’s right to buy back the cable telephony rights and
subscribers at pre-negotiated periods and valuations. Under this arrangement, Net2Phone manages all aspects of the cable telephony |
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offering in the franchise area. In a franchise services arrangement, cable operators collect the revenues from cable telephony subscribers and pass them through to us. We pay the cable
operators an up front franchise fee based on the number of two-way homes passed, a monthly royalty fee based on a percentage of revenues and the costs associated with the deployment
of cable telephony. We may continue to offer services to the cable operator if the operator elects to exercise its buy-back option. |
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| Our costs include reimbursing the cable operator for the sales and marketing of the cable telephony service and all other direct operational expenses such as customer activation, customer service, billing and collection, plant engineering and service technicians and any other legal and regulatory expenses associated with offering cable telephony. We will also bear the cost for the set up and ongoing management of local and long distance termination and any other telecommunications administration activities required to interconnect seamlessly with the public switched network. We are also responsible for the capital expense associated with the cost of new service installation, the cost of equipment deployed at the subscriber’s premises and the upgrade to the cable operator’s existing cable modem termination server. Our capital expenses include the hardware and software costs of integrating our services and systems with the operator’s systems. |
Telecommunications Services Agreement with IDT |
On October 29, 2003, we entered into a binding memorandum of understanding with IDT for the provision of telecommunications services to Net2Phone Cable Telephony. The memorandum of understanding contemplates that IDT, directly or through its subsidiaries, will provide us with local and inter-exchange network access, termination, origination and other related services, drawing on its resources as a licensed local, long distance and international telecommunications provider. IDT is a competitive local exchange carrier and an inter-exchange carrier and its network includes switching facilities in over 20 U.S. cities and additional points of presence in more than ten countries, allowing us to co-locate our equipment and interconnect to IDT’s network at those points. We believe that this agreement will enable us to improve the time-to-market, stability, scalability and security of our cable telephony services and will allow us to more quickly attract and add customers.
IDT will provide us with these services at its incremental cost for providing the services plus a five percent margin. We believe the pricing we will receive from IDT will be more favorable than what we would be able to receive from third parties. In exchange for such attractive pricing, access to IDT’s facilities and other benefits, we have agreed to issue to IDT 6.9 million shares of our Class A common stock at the time we enter into the definitive agreement. The stock will be held in escrow and released to IDT in equal installments over five years. The stock held in escrow will secure IDT’s performance of its obligations under the agreement.
The memorandum of understanding requires us and IDT to use good faith efforts to enter into a definitive agreement relating to these services. We believe we will enter into a definitive agreement within 90 days. The definitive agreement will have an indefinite term, however, either party may terminate the agreement upon 180 days notice, beginning 180 days prior to the fifth anniversary of the agreement. The memorandum of understanding was approved by an independent committee of our board of directors.
For more information relating to our relationship with IDT, please see Note 13 to our financial statements included elsewhere in this Annual Report.
Although we intend to use IDT as our primary provider for telecommunications services related to offering cable telephony, we have sole discretion to use other telecommunications services providers. We may choose to use other providers in cases where they offer more competitive rates, in situations where IDT is not able to deliver the services we require or for other reasons as we deem strategically, operationally or financially appropriate.
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Our Infrastructure |
Our Centrally Managed Platform |
We have a centrally managed platform consisting of reliable and flexible data management, monitoring, control and billing systems, which support all of our products and services. We have invested substantial resources to develop and implement our sophisticated real- time call management information system. Key elements of this system include: customer provisioning, customer access, fraud control, network security, call routing, call monitoring, media processing and normalization, call reliability and detailed call records.
Our platform monitors our process of digitizing and compressing voice into packets and transmitting these packets over data networks around the world. All call signaling is routed to a managed softswitch, which is a software-based product that manages call admission, call control, call rating and event recording and routes calls to an appropriate endpoint. Unless the recipient is using an internet telephony an on-line device, the packets are sent to a gateway where they are reassembled and the call is transferred to the PSTN and directed to a regular telephone anywhere in the world. We have hubs in the U.S., United Kingdom and Hong Kong which terminate voice traffic within particular regions. Our billing and back office systems manage and enroll customers and bill calls as they originate and terminate on the system.
Network Operations Center |
Our Network Operations Center is located at our headquarters in Newark, New Jersey, and employs a staff of 18 people with experience in both voice and data operations to provide twenty four hour support to our operations and customers around the world. We use various tools to monitor and manage all elements of telephone calls in real-time. Additionally, our Network Operations Center provides technical support to troubleshoot equipment and network problems.
Customer and Technical Support |
We provide customer service on various levels to different customers. Within the International Communications Services division of our Net2Phone Global Services business, we provide customer service and technical support directly to our resellers. The resellers provide their own support directly to their sub-resellers and end users. U.S. consumers who access our services directly through the web site receive customer service and technical support through multilingual telephone communication, web-based customer service as well as e- mail support. We utilize multiple call centers globally to provide better support to our worldwide customer base.
Net2Phone Cable Telephony provides cable operators with the tools, documentation and software to deliver first level customer and technical support to their subscribers. We do not interface directly with cable operator’s subscribers. We provide advanced technical support to the cable operators directly.
Back Office Systems |
In order to improve efficient management of product offerings, we have added new reporting tools that provide a direct view into the network’s performance. We have also created a multi-level technical support interface, allowing resellers to view both their account activity as well as the activities of their sub-resellers and end users. We also support the user interface for foreign currency, allowing resellers to charge their users in their currencies while the partners pay us in U.S. currency.
Interconnection Agreements |
We are party to telecommunications interconnect and service agreements with several telecommunications providers, including regional bell operating companies, competitive local exchange carriers, foreign post, telephone and telegraph companies, Internet backbone providers and others. Pursuant to these agreements, we can transport VoIP packets to our hubs and terminate calls throughout the world.
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Key Suppliers |
IDT will be a significant supplier of telecommunications services to our cable telephony business. For a more complete discussion of this agreement, see “—Telecommunications Services Agreement with IDT.”
We rely on one of our vendors, LG Electronics, to manufacture approximately fifty percent of the hardware devices sold by Net2Phone Global Services’ 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 hardware sales could be materially impacted, and this could impact our ability to service some of our customers for this period of time.
The services provided by our Net2Phone Cable Telephony business depend on a softswitch product. We currently have one softswitch vendor and one softswitch in operation. We understand that our softswitch vendor may be experiencing financial difficulties. We are currently testing softswitch products from other vendors to determine whether they comply with our quality and service standards. One vendor, other than our current vendor, has satisfied our testing standards. However, we have not agreed on terms of supply with that vendor.
We believe that we have adequate alternative arrangements to receive an alternative supply of softswitches and service and support for our softswitches if our existing supplier is unable to continue to supply or service or support softswitches, including providing some of the service and support functions ourselves. However, we may not be able to obtain alternative service or supply on favorable terms, which may have a material adverse effect on our ability to provide cable telephony services.
Competition |
Net2Phone Global Services |
International Communication 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 allows new entrants to establish a foothold and offer competitive services relatively easily. Our competitors include both government-owned and incumbent phone companies and 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, distribution, customer service, reliability, network capacity, the availability of enhanced communications services and brand recognition.
Consumer Division |
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, distribution, customer service, reliability, network capacity and the availability of enhanced communications services. Some of our competitors include AT&T, MCI, Sprint, IDT and Regional Bell Operating Companies, all of whom offer services and products competitive with ours on the above factors, including offering their own pre-paid calling cards.
Some providers, such as Go2Call and DeltaThree, Inc., offer similar PC-to-phone services to ours.
Carrier Services Division |
Wholesale Internet telephony service providers, such as ITXC Corp. and iBasis, Inc. compete with our carrier services, and could become meaningful competitors to our international communications services
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group. We also compete with other wholesale telecommunications providers, such as MCI, Global Crossing, IDT and Level 3.
Net2Phone Cable Telephony |
Our ability to sell our cable telephony services may be limited by the fact that cable operators may elect to develop and maintain their own internal cable telephony services instead of buying services from us.
We compete with other providers who currently market cable telephony services directly to consumers and cable operators. These companies may be able to offer services similar to ours, or features that we may be unable to provide, and may offer services at prices lower than we intend to charge.
Other companies aggregate a series of elements to deploy cable telephony systems that could be competitive to ours. These systems include combinations of softswitches, announcement servers and gateways, but these vendors do not offer telecommunications administration, record keeping servers or interconnections with the public switched telephone network. We can and may partner with some of these vendors to incorporate some of their elements into our offering as we use available components to complete our solution.
We and cable operators seeking to provide our telephony services directly to customers will face competition for subscribers for telephone services from incumbent local exchange carriers, such as Verizon, Qwest, SBC Communications and competitive local exchange carriers. We expect that competition for telephony services will be primarily on the basis of price, quality, customer service and the ability to offer a bundled service offering of voice, data and video. Some local exchange carriers, alone or together with partners such as satellite television providers, are or may become capable of providing bundled service offerings of voice, high speed internet and video similar to those which cable operators may provide. For example, Echostar has announced its intention to bundle its satellite television offering with Qwest’s and SBC’s voice and data services. These providers may be able to provide this bundled service offering at lower prices or with greater reliability than cable operators, which in turn may adversely affect demand for our product.
Research and Development |
We employ approximately 81 employees involved in research and development and related activities, whose technical expertise covers software, hardware, switching, security, voice compression, protocols, web applications, PC development, interactive voice response systems, next-generation signaling, firewalls and network address translations, engineering real-time online transactions, billing, network and call management and conferencing network monitoring and cable systems. 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. 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.
Software development costs are our primary research and development expenditures. Such costs, which totaled $5.4 million in fiscal 2003, $11.2 million in fiscal 2002 and $10.4 million in fiscal 2001, are included in selling, general and administrative 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 materially and 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. This additional regulation could have a material adverse effect on both our Net2Phone Global Services and Net2Phone Cable Telephony subsidiaries.
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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 characteristics 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.” To date, the FCC has not imposed regulatory surcharges or traditional common carrier regulation upon providers of Internet communications services.
Although the FCC treats providers of Internet telephony services no differently from providers of other information and enhanced services that are exempt from payment of 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. An increase in our rates as a result of new FCC regulations could have a material adverse effect on our ability to compete with long distance carriers.
There are several proceedings pending before the FCC that may affect the regulatory status of Internet telephony. 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 charges on phone-to-phone IP services. On February 5, 2003, pulver.com filed a petition with the FCC seeking a declaratory ruling that its “Free World Dialup,” which facilitates point-to-point broadband Internet protocol voice communications, is neither telecommunications nor a telecommunications service as these terms are defined in section 153 of the Telecommunications Act of 1996. More recently, Vonage filed a petition for declaratory ruling requesting that the FCC find an Order of the Minnesota Public Utilities Commission (MNPUC) requiring Vonage to comply with state laws governing providers of traditional telephone service to be preempted because Vonage’s broadband Internet telephony service is an information service. These petitions and subsequent industry 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 networks to originate and terminate long-distance calls, generally on a per minute basis, which in turn could have a material adverse effect on the ability of Net2Phone Cable Telephony to become a viable company in the cable telephony market.
The FCC could also 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 in the U.S. The imposition of regulation and contribution requirements might also negatively affect the incentives for companies to continue to develop IP technologies to offer VoIP services. 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.
Other aspects of our services may be subject to state or federal regulation, such as regulations relating to the confidentiality of data and communications, copyright issues, taxation of services, licensing, and 911
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emergency access. For instance, in a Further Notice of Proposed Rulemaking released February 20, 2002, the FCC has undertaken an examination of whether emergency 911 requirements should be extended to packet-based networks and services. Although Net2Phone Global Services does not currently offer 911 service, Net2Phone Cable Telephony is currently providing it to Liberty Cablevision of Puerto Rico. We expect to continue to develop technologies that may be able to su