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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 January 31, 2005
       
OR
       
    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 No

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 March 8, 2005, the registrant had outstanding 48,513,289 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 6 to the Consolidated Financial Statements included herein.)

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NET2PHONE, INC.

TABLE OF CONTENTS

   
Page No.
   
PART I. FINANCIAL INFORMATION
   
Item 1. Financial Statements:
   
   
   
   
   
   
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
   
Item 3. Quantitative and Qualitative Disclosures About Market Risk
   
Item 4. Controls and Procedures
   
PART II. OTHER INFORMATION
   
Item 1. Legal Proceedings
   
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
   
Item 3. Defaults Upon Senior Securities
   
Item 4. Submission of Matters to a Vote of Security Holders
   
Item 5. Other Information
   
Item 6. Exhibits
   
Signatures

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PART I—FINANCIAL INFORMATION

Item 1. Financial Statements

NET2PHONE, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

 
 
 


(In thousands, except per share data)
January 31,
2005
(unaudited)
July 31,
2004
(note 1)
       
 
 
ASSETS:                
  Current assets:                
  Cash and cash equivalents   $ 2,438   $ 12,408  
  Restricted cash     8,102     919  
  Marketable securities     87,766     99,125  
  Notes receivable from employees     325     925  
  Due from IDT       150     —  
  Other current assets       9,410     8,505  
       
 
 
 
Total current assets
     108,191     121,882  
Property and equipment, net     20,010     18,929  
Restricted cash, cash equivalents and marketable securities — long term     19,716     20,362  
Notes receivable from employees — long term     62     125  
Other assets       4,409     3,959  
       
 
 
 
Total assets
   $ 152,388   $ 165,257  
       
 
 
                   
LIABILITIES AND STOCKHOLDERS’ EQUITY:              
Current liabilities:                
  Accounts payable     $ 1,873   $ 838  
  Accrued expenses       10,248     9,629  
  Deferred revenue       8,169     6,145  
  Capital lease obligations     —     127  
  Due to IDT     —     971  
  Other current liabilities     502     484  
       
   
 
 
Total current liabilities
     20,792     18,194  
Other liabilities     929     1,109  
Long-term obligations     17,756     17,329  
       
 
 
 
Total liabilities
     39,477     36,632  
                   
Stockholders’ equity:              
               
 
Common stock, $.01 par value; 200,000 shares authorized including redeemable shares; 51,748 and 50,083 shares issued and outstanding
     517     501  
 
Class A common stock, $.01 par value; 37,924 shares authorized; 28,912 shares issued and outstanding
     289     289  
  Additional paid-in capital     944,233     938,371  
  Accumulated deficit     (793,358 )   (773,699 )
  Accumulated other comprehensive loss     (1,321 )   (962 )
  Deferred compensation     (3,992 )   (1,159 )
  Loans to stockholders     (927 )   (1,171 )
  Treasury stock, at cost; 3,267 and 3,325 shares     (32,530 )   (33,545 )
   
 
 
 
Total stockholders’ equity
     112,911     128,625  
   
 
 
 
Total liabilities and stockholders’ equity
   $ 152,388   $ 165,257  
   
 
 

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

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

             
(In thousands, except per share data)         
Six months ended
January 31,
Three months ended
January 31,
                 
 
 
                 
2005
2004
2005
2004
  
                 
   
 
 
 
Revenue               $ 38,293      $ 40,216   $ 17,984   $ 19,812  
Costs and expenses:                                        
  Direct cost of revenue (exclusive of items shown below)     23,097       22,190     11,376     11,243  
  Selling, general and administrative                 26,251       24,163     13,556     11,590  
  Depreciation and amortization                 3,991       5,147     2,097     2,659  
 
Non-cash services provided by IDT (attributable to direct cost of revenue and selling, general and administrative)      
   954       2,254     (504 )   2,254  
 
Non-cash compensation (attributable to selling, general and administrative)
   1,848       3,996     1,165     2,155  
  Restructuring, severance, impairment and other items        1,765       1,028     887     833  
                 
   
   
 
 
 
Total costs and expenses
                 57,906       58,778     28,577     30,734  
                 
   
   
 
 
Loss from operations                 (19,613 )     (18,562 )   (10,593 )   (10,922 )
Interest income, net                 1,194       875     571     660  
Other income, net                 (427 )     13,263     (581 )   740  
                 
   
 
 
 
Net loss               $  (18,846 )   $ (4,424 )  $
 (10,603
)
 $
 (9,522
)
                 
   
 
 
 
                                           
Net loss per common share — basic & diluted         $ (0.25 )   $ (0.07 ) $ (0.14 ) $ (0.13 )
                 
   
 
 
 
Weighted average number of common shares used in the calculation of basic and diluted net loss per common share:      
     75,991       65,584     76,166     70,931  
                 
   
 
 
 

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

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NET2PHONE, INC.
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
SIX MONTHS ENDED JANUARY 31, 2005

(in thousands)
 
 
 
Accumulated
 
Total
Common Stock
  
Class A Stock
  
Additional
Other
Treasury Stock
 
Stockholders'
 
 
Paid-In
Accumulated
Comprehensive
Deferred
Loans to
 
Equity
Shares
Amount
  
Shares
  
Amount
  
Capital
(Deficit)
Income (Loss)
Compensation
Stockholders
Shares
Amount
 
(Deficit)
 
   
   
   
   
   
   
   
   
 
   
   
 
Balance at July 31, 2004 50,083   $ 501     28,912   $ 289   $ 938,371   $ (773,699 ) $ (962 ) $ (1,159 ) $ (1,171 ) 3,325   $ (33,545 )   $ 128,625  
Net loss for the six months ended January 31, 2005                               (18,846 )                                 (18,846 )
Foreign currency translation                                     (52 )                           (52 )
Unrealized loss on marketable securities, net                                     (307 )                           (307 )
                                                                 
 
Comprehensive loss                                                                   (19,205 )
Treasury share funding of 401K Plan                               (813 )                   (58 )   1,015       202  
Issuance of stock bonuses to employees and officers 1,650     16                 4,908                 (3,580 )                     1,344  
Shares which may be released to IDT per memorandum of understanding                         954                                         954  
Forgiveness of loan to stockholders                                                 244                 244  
Amortization of deferred compensation                                           747                       747  
Other 15                                                                 —  
 
 
 
 
 
 
 
 
 
 
 
   
 
Balance at January 31, 2005 51,748   $ 517     28,912   $ 289   $ 944,233   $ (793,358 ) $ (1,321 ) $ (3,992 ) $ (927 ) 3,267   $ (32,530 )   $ 112,911  
 
 
 
 
 
 
 
 
 
 
 
   
 

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

(In thousands)
Six Months Ended
January 31,
   
   
2005
2004
   
 
 
Operating activities:            
  Net loss $ (18,846 ) $ (4,424 )
Adjustments to reconcile net loss to net cash used in operating activities:            
  Depreciation and amortization   3,991     5,147  
  Non-cash services provided by IDT   954     2,254  
  Non-cash compensation   1,848     3,996  
  Gain on buyout of minority interests   —     (12,182 )
  Restructuring, severance, impairment, and other non-cash items   2,459     1,322  
  Changes in assets and liabilities   415     (9,202 )
   
   
 
Net cash used in operating activities   (9,179 )   (13,089 )
               
Investing activities:            
  Purchases of property and equipment   (5,227 )   (2,885 )
  Purchases of marketable securities   (51,582 )   (139,980 )
  Buyout of remaining ADIR minority interests   —     (496 )
  Proceeds from the sale of marketable securities   62,642     107,454  
  Other   (13 )   (7 )
   
 
 
Net cash provided by (used in) investing activities   5,820     (35,914 )
               
Financing activities:            
  Proceeds from issuance of common stock   —     58,694  
  Payments of capital lease obligations   (127 )   (3,752 )
  Funding of loan to N2P Charitable Foundation   —     (350 )
  Proceeds from exercise of stock options   53     5,298  
  Proceeds from repayment of employee loans   —     668  
  Increase in restricted cash obligations   (6,537 )   (1,637 )
  Other   —     820  
   
 
 
Net cash (used in) provided by financing activities   (6,611 )   59,741  
 
 
 
Net (decrease) increase in cash and cash equivalents   (9,970 )   10,738  
Cash and cash equivalents at beginning of period   12,408     9,350  
   
 
 
Cash and cash equivalents at end of period $ 2,438   $ 20,088  
   
 
 

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

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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. Also, the weighted average number of common shares used in the calculation of basic and diluted net loss per common share, for the three and six months ended January 31, 2004, have been restated from previously reported amounts to reflect the reversal of 127,379 and 63,689 weighted shares, respectively. This restatement did not have any impact on basic or diluted earnings per share. In addition, Class A common stock par value and additional paid-in capital amounts as of July 31, 2004 have been restated for the reversal of 1,046,129 shares. The shares that were reversed relate to shares we expect to issue to IDT Corporation (“IDT”) in accordance with the October 29, 2003 Memorandum of Understanding with IDT (see Note 6). Such shares will not be treated as outstanding until a definitive agreement is reached with IDT and the shares vest in accordance with the terms of such agreement.
   
2. Recent Accounting Pronouncements
 
On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123 (R) supersedes APB No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. SFAS No. 123 (R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values (i.e., pro forma disclosure is no longer an alternative to financial statement recognition). SFAS No. 123 (R) is effective for public companies at the beginning of the first interim or annual period beginning after June 15, 2005. This would require us to adopt SFAS No. 123 (R) effective August 1, 2005.
 
As permitted by SFAS No. 123, the Company currently accounts for share-based payments to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and related Interpretations. As such, the Company generally recognizes no compensation cost on grants of employee stock options. Accordingly, the adoption of SFAS No. 123 (R) may have a significant impact on the Company’s results of operations, although it will have no impact on its overall financial position. The impact of adoption of SFAS No. 123 (R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted SFAS No. 123 (R) in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net loss and net loss per share in Note 3 to our condensed consolidated financial statements. SFAS No. 123 (R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement is not anticipated to be material since the Company does not currently recognize a benefit of excess tax deductions because of federal and state net operating loss carryforwards available to offset future U.S. federal and state taxable income.
 

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Public entities that used the fair-value-based method of accounting under the original provisions of SFAS No. 123 (whether for recognition or pro forma disclosure purposes) must adopt the provisions of SFAS No. 123 (R) using either the modified-prospective-transition (MPT) or the modified-retrospective-transition (MRT) methods. Under the MPT transition method entities will be required to apply all the measurement, recognition and attribution provisions of SFAS No. 123 (R) to all share-based payments granted, modified or settled after the date of adoption, while under the MRT transition method companies would restate prior periods by recognizing in the financial statements the same amount of compensation cost as previously reported in the pro forma footnote disclosures under the provisions of SFAS No. 123. We will use the MPT transition method when we adopt SFAS No. 123 (R).
   
3. Stock-Based Compensation
 
We account for our stock-based employee compensation plan under the intrinsic value method in accordance with APB 25. 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 loss and net loss 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 and six months ended January 31, 2005 and 2004:
 
    Six Months Ended January 31,   Three Months Ended January 31,  
   
 
 
    2005   2004   2005   2004  
 
 
 
 
 
(in thousands, except per share amounts )                          
                           
Net loss, as reported   $ (18,846 ) $ (4,424 ) $ (10,603 ) $