NET2PHONE INC - 10-Q Quarterly Report

United States
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark one)

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended October 31, 2004

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 of Incorporation or Organization)	(I.R.S. Employer Identification No.)


520 Broad Street, Newark, New Jersey	07102
(Address of Principal Executive Offices)	(Zip Code)

(973) 438-3111
(Registrant’s Telephone Number, Including Area Code)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act) Yes No

As of December 3, 2004, the registrant had outstanding 47,384,766 shares of common stock, $.01 par value, and 28,911,750 shares of Class A common stock, $.01 par value. (The number of outstanding shares of Class A common stock does not include 6.9 million shares we expect to issue as of the date definitive agreements are executed between Net2Phone, Inc. and IDT Corporation as described in more detail in Note 4 to the Consolidated Financial Statements included herein.)

NET2PHONE, INC.

TABLE OF CONTENTS


PART I. FINANCIAL INFORMATION

Item 1. Financial Statements:		Page No.

	Condensed Consolidated Balance Sheets as of October 31, 2004 and July 31, 2004	3

	Condensed Consolidated Statements of Operations for the three months ended October 31, 2004 and 2003	4

	Condensed Consolidated Statement of Stockholders’ Equity for the three months ended October 31, 2004	5

	Condensed Consolidated Statements of Cash Flows for the three months ended October 31, 2004 and 2003	6

	Notes to Condensed Consolidated Financial Statements	7

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		17

Item 3. Quantitative and Qualitative Disclosures About Market Risk		22

Item 4. Controls and Procedures		22

PART II. OTHER INFORMATION

Item 1. Legal Proceedings		23

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		23

Item 3. Defaults Upon Senior Securities		23

Item 4. Submission of Matters to a Vote of Security Holders		23

Item 5. Other Information		23

Item 6. Exhibits		23

Signatures		24

PART I—FINANCIAL INFORMATION

Item 1. Financial Statements

NET2PHONE, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

			October 31, 2004 (unaudited)			July 31, 2004 (note 1)
(In thousands, except per share data)
ASSETS:
Current assets:
	Cash and cash equivalents	$	859		$	12,408
	Restricted cash		1,229			919
	Marketable securities		103,706			99,125
	Notes receivable from employees		625			925

	Other current assets		10,477			8,505

	Total current assets		116,896			121,882
Property and equipment, net			19,626			18,929
Restricted cash, cash equivalents and marketable securities–long term			20,052			20,362
Notes receivable from employees – long term			94			125
Other assets			3,866			3,959

	Total assets	$	160,534		$	165,257


LIABILITIES AND STOCKHOLDERS' EQUITY:
Current liabilities:
	Accounts payable	$	3,056		$	838
	Accrued expenses		8,575			9,629
	Capital lease obligations		—			127
	Due to IDT		346			971
	Other current liabilities		6,586			6,629

	Total current liabilities		18,563			18,194
Other liabilities			1,031			1,109

Long-term obligations			17,182			17,329

	Total liabilities		36,776			36,632

Stockholders’ equity:
	Common stock, $.01 par value; 200,000 shares authorized including redeemable shares; 51,504 and 50,083 shares issued and outstanding		515			501
	Class A common stock, $.01 par value; 37,924 shares authorized; 30,303 and 29,958 shares issued and outstanding		303			299
	Additional paid-in capital		943,835			938,361
	Accumulated deficit		(781,989	)		(773,699	)
	Accumulated other comprehensive income (loss)		(600	)		(962	)
	Deferred compensation		(3,770	)		(1,159	)
	Loans to stockholders		(1,049	)		(1,171	)
	Treasury stock, at cost; 3,323 and 3,326 shares		(33,487	)		(33,545	)

	Total stockholders’ equity		123,758			128,625

	Total liabilities and stockholders’ equity	$	160,534		$	165,257

The accompanying notes are an integral part of these condensed consolidated financial statements.

NET2PHONE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)

			Three months ended October 31,

			2004			2003
(In thousands, except per share data)

Revenue		$	20,309		$	20,405

Costs and expenses:
	Direct cost of revenue (exclusive of items shown below)		11,720			10,948
	Selling, general and administrative		12,695			12,573
	Depreciation and amortization		1,894			2,488
	Non-cash services provided by IDT (attributable to direct cost of revenue and selling, general and administrative)		1,459			—
	Non-cash compensation		683			1,841
	Restructuring, severance, impairment and other items		878			195

	Total costs and expenses		29,329			28,045

Loss from operations			(9,020	)		(7,640	)
Interest income, net			622			215
Other income, net			155			12,523


Net (loss) income available to common stockholders		$	(8,243	)	$	5,098


Net (loss) income per common share-basic & diluted		$	(0.11	)	$	0.08


Weighted average of number of common shares used in the calculation of basic net (loss) income per common share			77,028			60,250


Weighted average of number of common shares used in the calculation of diluted net (loss) income per common share			77,028			63,160

The accompanying notes are an integral part of these condensed consolidated financial statements.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
THREE MONTHS ENDED OCTOBER 31, 2004

	Common Stock			Class A Stock			Additional Paid-In		Accumulated			Accumulated Other Comprehensive			Deferred			Loans to			Treasury Stock					Total Stockholders’
	Shares	Amount		Shares	Amount		Capital		(Deficit)			Income (Loss)			Compensation			Stockholders			Shares		Amount			Equity (Deficit)

(in thousands)
Balance at July 31, 2004	50,083	$	501	29,958	$	299	$	938,361	$	(773,699	)	$	(962	)	$	(1,159	)	$	(1,171	)	3,326		$	(33,545	)	$	128,625
Net loss for the three months ended October 31, 2004	—		—	—		—		—		(8,243	)		—			—			—		—			—			(8,243	)
Foreign currency translation	—		—	—		—		—		—			(35	)		—			—		—			—			(35	)
Unrealized gain on marketable securities, net	—		—	—		—		—		—			397			—			—		—			—			397

Comprehensive loss	—		—	—		—		—		—			—			—			—		—			—			(7,881	)
Treasury share funding of 401K Plan	—		—	—		—		—		(47	)		—			—			—		(3	)		58			11
Issuance of stock bonuses to employees and officers	1,421		14	—		—		4,019		—			—			(2,762	)		—		—			—			1,271
Shares which may be released to IDT per memorandum of understanding	—		—	345		4		1,455		—			—			—			—		—			—			1,459
Forgiveness of loan to stockholders	—		—	—		—		—		—			—			—			122		—			—			122
Amortization of deferred compensation	—		—	—		—		—		—			—			151			—		—			—			151

Balance at October 31, 2004	51,504	$	515	30,303	$	303	$	943,835	$	(781,989	)	$	(600	)	$	(3,770	)	$	(1,049	)	3,323		$	(33,487	)	$	123,758

NET2PHONE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)

		Three Months Ended October 31,

			2004			2003
(In thousands)
Operating activities:
	Net (loss) income	$	(8,243	)	$	5,098
Adjustments to reconcile net (loss) income to net cash (used in) operating activities:
	Depreciation and amortization		1,894			2,488
	Non-cash compensation		683			1,841
	Non-cash services provided by IDT		1,459			—
	Gain on buyout of Minority Interests		—		(12,182		)
	Restructuring, severance, impairment, and other non-cash items		854			756
	Changes in assets and liabilities		(1,280	)		(3,762	)

Net cash used in operating activities			(4,633	)		(5,761	)

Investing activities:
	Purchases of property and equipment		(2,600	)		(1,329	)
	Purchases of marketable securities		(30,026	)	(10,763		)
	Buyout of remaining ADIR minority interests		—			(496	)
	Proceeds from the sale of marketable securities		25,850			20,042
	Other		(12	)		—

Net cash (used in) provided by investing activities			(6,788	)		7,454

Financing activities:
	Payments of capital lease obligations		(127	)		(251	)
	Funding of loan to N2P Charitable Foundation		—			(350	)
	Proceeds from exercise of stock options		—			1,193
	Proceeds from repayment of employee loans		—			664
	Other		(1	)		737

Net cash (used in) provided by financing activities			(128	)		1,993

Net (decrease) increase in cash and cash equivalents			(11,549	)		3,686
Cash and cash equivalents at beginning of period			12,408			9,350

Cash and cash equivalents at end of period		$	859		$	13,036

The accompanying notes are an integral part of these condensed consolidated financial statements.

NET2PHONE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of Net2Phone, Inc. and its subsidiaries (collectively “the Company” or “Net2Phone”) have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for annual financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation, including normal recurring accruals and other items, have been included. The results for the interim periods presented are not necessarily indicative of the results that may be expected for any future period. The balance sheet at July 31, 2004 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete audited financial statements. For further information, refer to the audited financial statements and notes thereto included in Net2Phone’s Annual Report on Form 10-K for the year ended July 31, 2004.

The Company’s fiscal year ends on July 31 of each year. Each reference below to a Fiscal Year refers to the Fiscal Year ending in the year indicated (e.g., fiscal 2004 refers to the Fiscal Year ended July 31, 2004).

Certain reclassifications have been reflected in the prior year’s condensed consolidated financial statements to conform to the current year’s presentation.

2. Stock-Based Compensation

We account for our stock-based employee compensation plan under the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and related Interpretations. Compensation expense for stock options issued to employees is measured as the excess of the quoted market price of our stock at the date of grant over the amount an employee must pay to acquire the stock. APB 25 requires that stock options that have been modified to reduce the exercise price be accounted for as variable until the options are exercised, forfeited or expire unexercised. Charges that result from the variable accounting treatment of repriced options are recorded as non-cash compensation.

The following table illustrates the effect on net income and earnings per share if we had applied the fair value based method of SFAS No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, to stock-based employee compensation for the three months ended October 31, 2004 and 2003:

	Three months ended October 31,
	2004			2003

	(in thousands, except per share amounts)

Net (loss) income, as reported	$	(8,243	)	$	5,098

Add: Stock option-related employee compensation expense included in reported net income		—			1,413

Deduct: Total stock option-related employee compensation expense determined under fair value based method for all awards		783			3,033


Pro forma net (loss) income	$	(9,026	)	$	3,478


Basic and diluted earnings per share, as reported	$	(0.11	)	$	0.08


Basic and diluted earnings per share, Pro forma	$	(0.12	)	$	0.06

Restricted Stock Grants

During the three months ended October 31, 2004, we granted 815,000 restricted shares of Net2Phone common stock to officers, employees and a consultant under our 1999 Amended and Restated Stock Option and Incentive Plan. In general, the restrictions on transfer of the restricted shares lapse over four years on or about the anniversary of the date of grant. Total non-cash compensation relating to restricted shares granted was $0.2 million, for the three months ended October 31, 2004. Deferred compensation totaled $3.8 million as of October 31, 2004. No similar compensation expense had been incurred during the three months ended October 31, 2003.

Option Repricing

On December 18, 2001, the Board of Directors approved the repricing of options to purchase 6,373,863 shares of our common stock granted on or before December 18, 2001. The exercise price per share of the repriced options ranged from $3.50 per share to $7.00 per share. The repriced options are subject to variable accounting treatment and, therefore, the repriced options, which are vested and unexercised, must be marked-to-market each quarter. Based on our stock price at October 31, 2004, we recorded no non-cash compensation expense related to these repriced options for the three months ended October 31, 2004, as our stock price at this date was below the exercise price of our repriced options. For the three months ended October 31, 2003, we recorded $1.3 million of non-cash compensation expense relating to repriced options. As our share price changes from period to period, we will record market adjustments related to these price variations over the vesting period, until these options are exercised, are canceled or expire.

Other Stock-Based Compensation

Non-cash compensation expense for other stock-based compensation included in net income, as reported for the three months ended October 31, 2004 and 2003 was $0.5 million and $0.4 million, respectively. These expenses primarily relate to restricted stock, bonuses paid in stock, and to stock funding of the Company’s 401(k) plan.

3. Earnings Per Share

Shares issuable upon the exercise of stock options and warrants, and contingently issuable shares, are excluded from the calculation of earnings per share if their inclusion would be antidilutive. Stock options of 10.4 million and 7.3 million shares for the three months ended October 31, 2004 and 2003, respectively, were not included in the computation of diluted earnings per share as their inclusion would be antidilutive. The weighted average number of common shares outstanding for computing dilutive earnings per share for the three months ended October 31, 2003, includes 2.9 million shares for the assumed conversion of dilutive stock options. 5.5 million of the 6.9 million shares of Class A common stock to be issued in connection with the IDT telecommunications services agreement (see note 4) have been excluded from the calculation of earnings per share for the three months ended October 31, 2004, as their effect would have been antidilutive.

4. Related Party Transactions

Our strategic investors include IDT, a global telecommunications, media and technology company, and Liberty Media Corporation, a global media company. IDT and Liberty Media together own NTOP Holdings, L.L.C., which, as of December 3, 2004, holds an aggregate of 37.9 percent of our outstanding capital stock and 54.9 percent of our aggregate voting power. IDT is currently the controlling member of NTOP Holdings, and, together with the 1.5 million shares IDT holds directly, IDT controls 56.4 percent of our aggregate voting power as of December 3, 2004. On December 8, 2004, IDT announced that it is in discussions with Liberty Media to acquire all of Liberty Media’s direct and indirect interests in Net2Phone. If this transaction is consummated, IDT would hold an aggregate of 41.5 percent of our outstanding capital stock and 57.6 percent of our aggregate voting power. We have also entered into a Memorandum of Understanding with IDT, which calls for us to issue an additional 6.9 million shares of Class A common stock to IDT upon entering into a definitive telecommunications services agreement with IDT. If these 6.9 million shares were issued, IDT would have controlled 61.4 percent of our aggregate voting power based on our outstanding stock on December 3, 2004.

IDT Corporation

We maintain several business relationships with IDT and its affiliates, and IDT maintains a controlling ownership interest in us. Consequently, we interact with IDT and its affiliates in several different areas and on several different levels. In the three months ended October 31, 2004 and 2003, we provided carrier services to IDT of $2.2 million and $1.3 million, respectively. In the three months ended October 31, 2004 and 2003, we purchased wholesale carrier services from IDT of $1.3 million and $1.0 million, respectively.

Our corporate headquarters and several other facilities are leased from IDT. In the three months ended October 31, 2004 and 2003, IDT charged us $0.5 million and $0.5 million, respectively, for leasing their facilities. On occasion, IDT’s treasury function provides investment management services relating to our portfolio of marketable securities. During the three months ended October 31, 2004, IDT’s treasury group did not process any securities purchases or sales for us, and IDT was not providing investment management services to us during the three months ended October 31, 2003.

On occasion, we have aggregated long distance minutes and other services purchases with IDT.

We outsource some of our administrative and support functions to IDT. These administrative functions include, but are not limited to, tax consulting services, payroll services and internal audit support services. In most cases, fees for services are negotiated on a cost recovery basis. In March 2004, we entered into an Intellectual Property Legal Services Agreement with IDT, pursuant to which we receive legal services from IDT related to a wide variety of intellectual property matters, including, but not limited to, patent and trademark prosecution and technology protection and development. Based upon this agreement, we will pay IDT a percentage of licensing fees we may receive related to specific technologies as a result of IDT’s assistance in these matters, in addition to a $25,000 monthly fee for these services. The agreement has a two-year term, which can be terminated with 30 days notice upon a material breach, or with 90 days notice at the discretion of either party. In addition, we are party to a Tax Services Agreement pursuant to which we pay IDT $10,000 a month for tax services, and an Internal Audit Agreement pursuant to which we pay IDT on a cost recovery basis. We are currently negotiating other service agreements with IDT. During the three months ended October 31, 2004 and 2003, we paid IDT approximately $0.1 million and $0.04 million, respectively, for such services.

On occasion, we provide administrative, technical development and support services to IDT based on the need for such services. During the three months ended October 31, 2004 and 2003, we charged IDT reimbursement fees of $0.3 million and $0.05 million, respectively, for such services.

The due to IDT balances represent net amounts due to IDT by us principally for wholesale carrier services and facilities lease payments. On October 31, 2004 and July 31, 2004, we owed IDT $0.3 million and $1.0 million, respectively. The average balance we owed to IDT during the three months ended October 31, 2004 was $0.6 million, compared with an average of $0.4 million owed to IDT for the three months ended October 31, 2003.

During the second quarter of fiscal 2004, we executed an agreement with Union Telecard Alliance, LLC (“UTA”), a subsidiary of IDT, which ended UTA’s distribution of Net2Phone disposable calling cards effective December 31, 2003, and provided for an orderly wind-down over a two-year period of our disposable calling card business. This resulted in exit costs of $0.5 million to compensate UTA for estimated obligations associated with the Net2Phone disposable calling cards currently in the marketplace. These exit costs were recorded in restructuring, severance, impairment and other items during the three months ended January 31, 2004. Pursuant to the terms of our agreement with UTA, the parties will settle the aforementioned obligations over a two-year period ending December 31, 2005, through monthly reconciliations of on-going wind down activities, with final settlement to be completed by February 15, 2006. Consequently, no sales of disposable calling cards to IDT affiliates were recorded for the three months ended October 31, 2004 and nominal sales were recorded for the three months ended October 31, 2003.

On October 29, 2003, we entered into a binding memorandum of understanding (“MOU”) with IDT, which requires us to issue 6.9 million shares of Class A common stock to IDT at the time we execute definitive telecommunications services and related agreements with IDT. No definitive agreements have been executed as of December 10, 2004. The parties’ efforts to establish detailed terms and conditions continue. Once issued, the shares will be held in escrow to secure IDT’s performance obligations under the agreements and are to be released to IDT in equal annual installments over five years, with the first release to occur when definitive agreements are signed. During the second quarter of fiscal 2004, IDT started providing us with services and benefits under the terms of the MOU. The issuance of the 6.9 million shares is subject to variable accounting treatment and, therefore, the shares must be marked-to-market each quarter based on their current market value. Consequently, we recorded charges of $1.5 million to non-cash services provided by IDT related to this agreement during the three months ended October 31, 2004, which represents marked-to-market adjustments on the 1.0 million shares we have previously recognized as potentially earned by IDT during fiscal 2004, plus new charges relating to 0.4 million shares, which we have recognized as potentially earned by IDT during the three months ended October 31, 2004, that we may issue and subsequently release from escrow to IDT for services and benefits provided by IDT during the aforementioned periods.

We determined that non-cash services provided by IDT are attributable to direct cost of revenue and selling, general and administrative expense. However, given that the services provided by IDT do not individually have readily identifiable market values, and that the variable accounting treatment will result in different values being ascribed to the same services from period to period, we believe differentiating between direct cost of revenue and selling, general and administrative is not practicable. Therefore, we have classified the non-cash services provided by IDT in a separate line in the consolidated statements of operations. In accordance with EITF Topic D-90, Grantor Balance Sheet Presentation of Unvested, Forfeitable Equity Instruments Granted to a Nonemployee, the 1.4 million shares we may release from escrow for services received from IDT have been included in the total number of Class A common stock shares reported as issued and outstanding as of October 31, 2004, in our condensed consolidated financial statements, although such shares have not yet been issued to IDT.

The MOU memorializes IDT’s agreement to provide Net2Phone Cable Telephony, directly or through its subsidiaries, with local and inter-exchange network access, termination, origination and other related services, including sales and marketing assistance and an agreement by IDT not to compete in the cable telephony market. IDT is a competitive local exchange carrier and an inter-exchange carrier and its network includes switching facilities in several U.S. cities and additional points of presence in various countries, allowing us to co-locate our equipment and interconnect to IDT’s network at those points. On May 12, 2004, IDT announced its intention to reorganize its Winstar/IDT Solutions affiliate, which we expected to provide some of the services under the MOU. While we are examining the impact of this reorganization as we continue to negotiate definitive agreements, IDT has advised us that it can continue to support and provide all the contracted for services.

Liberty Media Corporation

As of December 3, 2004, Liberty Media Corporation beneficially owned 39.5 percent of our outstanding stock directly and through its ownership in NTOP Holdings, L.L.C. On October 22, 2003, one of our wholly owned subsidiaries, Net2Phone Cable Telephony, LLC and Liberty Cablevision of Puerto Rico, Inc., an affiliate of Liberty Media Corporation, executed a Cable Telephony Production Agreement. According to the terms of this agreement, Net2Phone Cable Telephony provides cable telephony services to Liberty Cablevision of Puerto Rico’s customers, and Net2Phone Cable Telephony acts as Liberty Cablevision of Puerto Rico’s agent in requisitioning, configuring, staging and installing all infrastructure and technology components that facilitate these telecommunication services. During the three months ended October 31, 2004, we recorded $0.3 million in revenue from Liberty Cablevision of Puerto Rico, $0.7 million in receivables and $0.7 million in deferred revenue from this agreement. Net2Phone Cable Telephony obtains up-front fees for certain of its services that are amortized over the life of the agreement, as Net2Phone Cable Telephony has a continuing performance obligation under the terms of the agreement to maintain and provide access to its platform for the life of the agreement.

Loans with Chairman

In April 2002, we loaned our then Chief Executive Officer and now Chairman, Stephen Greenberg, the sum of $3.6 million. The loan bears interest at a market rate and principal and interest are due on April 9, 2005 (“Maturity Date”). The loan is non-recourse to Mr. Greenberg and is secured by options to purchase 300,000 shares of our common stock granted to Mr. Greenberg in April 2002. Under certain circumstances, the Board of Directors may request Mr. Greenberg to exercise sufficient options and sell sufficient stock to pay the unpaid balance of the loan. In addition, the Board may request that Mr. Greenberg not sell the stock, which will result in the unpaid loan and interest balance being reduced based upon a formula set forth in the loan agreement. On the Maturity Date, Mr. Greenberg will have to return to us all or a portion of the unexercised options and/or shares of unsold stock and his unpaid loan and accrued interest balance will be reduced based upon a formula set forth in the loan agreement. Due to the uncertainty surrounding the number of options Mr. Greenberg will ultimately receive, we are accounting for the options using a variable accounting model until the options are exercised or returned to us. Furthermore, due to the non-recourse nature of the loan, we are recording compensation expense for the $3.6 million principal amount of the note over its three-year maturity period.

However, total compensation expense will be calculated at each reporting date as the greater of the compensation expense resulting from (i) variable accounting treatment of the options, or (ii) amortizing the $3.6 million loan balance over the maturity period of the loan. We recorded compensation expense of $0.3 million during both the three months ended October 31, 2004 and 2003, relating to this loan.

We previously loaned Mr. Greenberg $600,000 pursuant to his original employment agreement with us entered into in July 2000, which was paid in full, plus interest, in the first quarter of fiscal 2004.

Agreement with Chief Executive Officer

On September 23, 2004, we announced that Liore Alroy would become our new Chief Executive Officer, and that our then current Chief Executive Officer, Stephen Greenberg, would assume the role of Chairman of the Board. This management change took effect on October 31, 2004. Pursuant to an employment agreement we entered into with Mr. Alroy effective October 31, 2004, we granted Mr. Alroy 800,000 stock options and 800,000 shares of restricted stock pursuant to our 1999 Amended and Restated Stock Option and Incentive Plan. The stock options have a grant price equal to $3.45, which was the fair market value of our stock on the grant date, and will vest over the three-year term of the agreement, 33 percent on each anniversary of the effective date of the agreement. Similarly, the restrictions on the sale of the restricted stock will lapse over the three-year term of the agreement, 33 percent on each anniversary of the effective date of the agreement. During the three months ended October 31, 2004, we recorded $2.8 million in deferred compensation related to Mr. Alroy’s restricted stock grant.

5. Other Comprehensive Income

The accumulated balances for each classification of other comprehensive income (loss) consists of the following:


		Unrealized gain (loss) on available for sale securities			Foreign currency translation			Accumulated other comprehensive income (loss)

					(in thousands)
Balance at July 31, 2004	$	(1,093	)	$	131		$	(962	)
Change during the period		397			(35	)		362

Balance at October 31, 2004	$	(696	)	$	96		$	(600	)

6. Legal Proceedings

We are subject to legal proceedings that have arisen in the ordinary course of business and have not been finally adjudicated. Although there can be no assurance in this regard, in the opinion of management, none of the legal proceedings to which we are a party will have a material adverse effect on our results of operations, cash flows or our financial condition.

7. Restructuring, Severance, Impairment and Other Items

During the three months ended October 31, 2004, we incurred exit and other costs of $0.7 million, which related primarily to contract termination costs incurred in the implementation of a secondary disaster recovery site that is being migrated to an existing backup facility. During the three months ended October 31, 2003, we incurred exit and other costs of $0.2 million related primarily to losses on existing office leases.

During the three months ended October 31, 2004 and 2003, we incurred severance expense of $0.2 and $0.3 million, respectively, primarily related to ongoing charges related to the separation agreements we entered into with our former Chief Executive Officer and former Chief Financial Officer during fiscal 2002.

During the three months ended October 31, 2003, restructuring, severance, impairment and other items was reduced by $0.3 million of reserve adjustments, primarily related to the recovery of assets held for sale.

As of July 31, 2004, the restructuring, severance, impairment and other items reserve balance amounted to $2.1 million. During the three months ended October 31, 2004, the reserve balance was increased by $0.7 million of expenses and reduced by payments of $0.3 million. As of October 31, 2004, the reserve balance amounted to $2.5 million.

8. Business Segment Information

The Company has two reportable business segments: Net2Phone Global Services, which includes our International Channel Sales division, U.S. Co