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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934 (FEE REQUIRED)
FOR THE YEAR ENDED DECEMBER 31, 1996
COMMISSION FILE NO. 0 - 26728
Tel-Save Holdings, Inc.
(Exact name of registrant as specified in its charter)
Delaware 23-2827736
-------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
6805 Route 202
New Hope, Pennsylvania 18938
(215) 862-1500
(Address, including zip code, and telephone number, including area code,
of registrant's principal executive offices)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
- ------------------- -----------------------------------------
None Not applicable
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.01 per share
Indicate by check mark whether the Registrant (1) has filed all
documents and reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such
shorter period that the Registrant was required to file such reports) and (2)
has been subject to such filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment of this Form 10-K. [ ]
The aggregate market value of voting stock held by non-affiliates of
the registrant as of March 13, 1997 was approximately $681,467,000 based on the
average of the high and low prices of the
Common Stock on March 13, 1997 of $17.19 per share as reported on the Nasdaq
National Market.
As of March 13, 1997, the Registrant had outstanding 62,887,998 shares
of its Common Stock, par value $.01 per share.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Tel-Save Holdings, Inc. definitive proxy statement for
the 1997 Annual Meeting of Stockholders are incorporated by reference into Part
III of this Form 10-K.
TEL-SAVE HOLDINGS, INC.
INDEX TO FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 1996
ITEM PAGE
NO. NO.
--- ---
Part I
1 Business.............................................. 1
2 Properties............................................ 27
3 Legal Proceedings..................................... 27
4 Submission of Matters to a Vote of Security Holders... 27
Part II
5 Market for the Registrant's Common Equity and
Related Stockholder Matters........................... 29
6 Selected Financial Data............................... 30
7 Management's Discussion and Analysis of Financial
Condition and Results of Operations................... 31
8 Financial Statements and Supplementary Data........... 39
9 Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.................. 57
Part III
10 Directors and Executive Officers of the Registrant.... 57
11 Executive Compensation................................ 57
12 Security Ownership of Certain Beneficial Owners
and Management........................................ 57
13 Certain Relationships and Related Transactions........ 57
Part IV
14 Exhibits, Financial Statement Schedules and Reports
on Form 8-K........................................... 58
PART I
ITEM 1. BUSINESS
For the definition of certain terms used in this Form 10-K, see
"Glossary."
OVERVIEW
Tel-Save Holdings, Inc. ("Company") provides long distance services
primarily to small and medium-sized businesses located throughout the United
States. The Company's long distance service offerings include outbound service;
inbound toll-free 800 service; and dedicated private line services for data.
Prior to the fourth quarter of 1996, the Company operated solely as a
switchless, nonfacilities-based reseller of AT&T long distance services. By
purchasing large usage volumes from AT&T pursuant to contract tariffs, the
Company has been able to procure substantial discounts and offer low cost, high
quality long distance services to its customers at rates generally more
favorable than those offered directly by AT&T.
In order to reduce its dependence on AT&T contract tariffs and increase
its growth opportunities, the Company in 1996 deployed its own nationwide
telecommunications network, One Better Net ("OBN"). OBN features five
Company-owned, AT&T (now Lucent Technologies, Inc. hereinafter "Lucent")
manufactured 5ESS-2000 switches connected with AT&T digital transmission
facilities. OBN's reduced cost structure allows the Company to offer rates
competitive with those of non-AT&T resellers while continuing to provide the
quality of AT&T (now Lucent) manufactured switches and AT&T-provided
transmission facilities and billing services. OBN allows the Company to pursue
the non-AT&T based switchless resale market, which represents the majority of
the switchless resale long distance market.
The Company's strategy for expanding its business is to market services
directly to business and residential end users, to continue to support existing
partitions and to attract additional partitions (including those now in the
non-AT&T resale market). The Company intends to attract new partitions and
support existing partitions by, among other things, continuing its current
practice of offering advances to new partitions to enable such partitions to pay
outstanding balances due to their existing long distance providers in order for
such partitions to transfer their end users to the Company's service, and to
existing partitions to support their marketing efforts. The Company also intends
to approach residential customers through its telemarketing operations as well
as new marketing and advertising media, such as the Company's recently announced
arrangement with America Online, Inc. ("AOL") pursuant to
1
which the Company will be the exclusive provider of long distance
telecommunications services to AOL subscribers.
Tel-Save, Inc., the Company's predecessor ("Predecessor Corporation")
and now its operating subsidiary, was incorporated in Pennsylvania in May 1989.
The Company was incorporated in Delaware in June 1995. The address of the
Company's principal executive offices is 6805 Route 202, New Hope, Pennsylvania
18938, and its telephone number is (215) 862-1500. Unless the context otherwise
requires, "Company" includes the Predecessor Corporation and the Company's other
subsidiaries.
DEVELOPMENT OF THE COMPANY
The Company, originally incorporated in 1989 as Tel-Save, Inc., was
formed to capitalize on the FCC mandate allowing the resale of AT&T services.
The Company initially marketed AT&T's multi-location calling plan ("MLCP"),
which provided incremental discounts earned by inclusion of the usage volume of
diverse end user locations under a single service plan. The Company was
successful in marketing MLCP, but realized that there were significant barriers
to growth associated with the product, primarily the lack of reporting from
AT&T, product inflexibility and the lack of control over end user accounts.
In late 1989, the Company successfully obtained an additional AT&T
service plan developed by AT&T and marketed as Software Defined Network Service
("SDN"), an AT&T product designed for larger business customers. SDN provided
the Company with higher margins, network controls, advanced features and the
ability to rebill its end users through AT&T and AT&T's College and University
Systems ("ACUS"), thus enabling the Company to have more control over the end
user account. As a result of SDN, the Company began to offer services on a
wholesale basis through partitions. The Company thereby outsourced its marketing
and end user service expenses to partitions, allowing it to focus on managing
the AT&T relationship and to further develop its billing and information
systems.
In December 1992, the Company obtained the first contract tariff
created by AT&T specifically for the Company. The contract tariff provided the
Company with significant additional price advantages at stabilized rates and the
ability to absorb the traffic of competitors' plans into the contract tariff.
The Company subsequently obtained other contract tariffs, which also provide
AT&T inbound 800 services and AT&T private line services, in order to diversify
its service offerings. This in turn has further enabled the Company to increase
the number of its partitions and end users.
To date, the Company has primarily operated as a "switchless" and
nonfacilities-based provider of long distance services by reselling AT&T
services. The Company offers its partitions and end
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users nationwide access to AT&T long distance network services through contract
tariffs, including outbound long distance, 800 service and private line service.
Outbound long distance service accommodates voice, data and video transmissions.
The Company's 800 service is currently provided by reselling AT&T's 800 Service
(Readyline, Megacom 800, etc.), which is AT&T's inbound, toll-free (recipient of
the call pays the charges) long distance service. The Company's private line
service is currently provided by reselling AT&T Private Line Service, which
includes dedicated transmission lines connecting pairs of sites.
The Company successfully established its position as a switchless
reseller of AT&T long distance services as a result of its ability to negotiate
with and obtain favorable contract tariffs from AT&T, manage and distribute
data, bill accurately and provide partition support. Contract tariff
subscriptions do not impose restrictions on the rates the Company may charge its
partitions and end users. By purchasing large usage volumes from AT&T pursuant
to such contract tariffs, the Company is able to procure substantial volume
discounts and offer long distance services to its partitions and end users at
rates generally more favorable than those offered directly by AT&T. With its
information systems, the Company is able to manage and distribute to partitions
information such as data about end user usage and payment history.
Prior to 1995, substantially all of the Company's services consisted of
reselling AT&T outbound or SDN long distance services. In 1994, the Company
began to offer 800 services, which accounted for 30.9% of 1995 sales, and
private line service, which accounted for 10.2% of 1995 sales. The Company's 800
services and private line service accounted for 32.4% and 7.9%, respectively, of
1996 sales.
In order to reduce its dependence on the AT&T contract tariffs and
increase its growth opportunities, the Company began to develop its own network,
OBN, in late 1995. In 1996, the Company deployed five 5ESS-2000 switches in
Chicago, Dallas, Jacksonville, New York and San Francisco and installed new 5E11
software. The Company began testing new customer calls over its network in the
third quarter of 1996. In the fourth quarter of 1996, the Company began
provisioning on a test basis new customer orders on OBN. To date, the Company
has provisioned approximately 50,000 end users to OBN. OBN enables the Company
to offer its end users and partitions more competitive rates than in the past
and to improve customer provisioning, as well as to improve reporting to
existing and new partitions. Currently the Company is continuing to provision
new customers on OBN while completing the final testing of OBN. The Company
expects final testing of OBN to be completed in April 1997, and at that time
there will be a general release of OBN. Thereafter, the Company expects to
provision a large majority of its new customer orders on OBN.
3
STRATEGY
The Company has historically expanded its business primarily through
the addition of partitions and by providing new and existing partitions with
operational, financing, marketing and management support. The Company's strategy
for future business growth is to market its services directly to business end
users, broaden the Company's target market to include residential customers,
continue to support existing partitions, attract additional partitions and
introduce new services.
Increase Direct Marketing Efforts. By marketing its services directly
to end users, the Company expects to increase its profit margins by
taking advantage of the difference between the reduced costs of
offering services on OBN and the rates charged directly to end users.
Broaden Target Market to Include Residential Customers. The Company
intends to expand its service offerings to attract the residential
segment of the long distance market. New services may include new
features relating to customers reporting and billing as well as
improved rates. The Company will use direct marketing and new
marketing and advertising media, such as online services, to attract
the end users in this customer segment. Recently, the Company
announced its arrangement with AOL pursuant to which the Company will
be the exclusive provider of long distance telecommunications services
to AOL's subscribers. See "SALES AND MARKETING -- Residential."
Provide Operational, Financing, Marketing and Management Support to
Partitions. The Company will continue to sell its services through
partitions. To do so, the Company will continue to provide existing
and new partitions with low rates and operational, marketing and
management support. The operational, marketing and management support
includes financing, training in customer service and use of the data
base, collection services, lists of prospective end users and a
business management system designed and developed by the Company
exclusively for its use and its partitions' use.
The Company's basic strategy for business growth is based on the
deployment of OBN. OBN is expected to lower the Company's costs, to maintain its
access to AT&T services and AT&T (now Lucent) equipment, to improve provisioning
of new accounts, and to provide a network that can be expanded to add new
products and services.
Provide Low Cost, High Quality Alternative to Other Carriers. The
Company's deployment of OBN will reduce its costs and allow it to offer
pricing to its partitions and end users competitive with or below that
typically offered by major long distance carriers and their resellers.
OBN's cost structure is expected
4
to allow the Company to expand its target market beyond the current
AT&T resale market to include the balance of the switchless long
distance market (i.e., the non-AT&T long distance resale market), which
currently represents the majority of the long distance resale market.
The Company also intends to market to AT&T's end users, as well as
other end users including residential and larger commercial accounts.
Emphasize Quality and Functionality of AT&T (now Lucent) Manufactured
Switches, and AT&T-Provided Transmission Facilities and Billing. The
Company offers products and services on OBN similar to those that it
offers as a switchless reseller of AT&T services. OBN has been built
using AT&T (now Lucent) manufactured switches in conjunction with
leased AT&T transmission facilities. The 5ESS-2000 switch is generally
considered the most reliable switch in the telecommunications industry.
In addition to offering services using AT&T as the underlying
facilities-based carrier, the Company will continue to use the billing
services of AT&T and ACUS.
Improve Provisioning of End User Accounts. OBN allows the Company to
establish service directly for or activate end user accounts. The
Company will provide new end user account data directly to the local
exchange carrier ("LEC"), which will then change the end user account
to the service provided by the Company or its partition. This is
expected to increase the timeliness and the acceptance rate of the
establishment of service, or provisioning, and will allow lists of end
users to be maintained confidentially.
Expandable Network With Capability to Support New Products and
Services. The AT&T (now Lucent) 5ESS-2000 switches can be expanded to
increase capacity significantly and can at the same time accommodate
local, long distance, private line and wireless services. OBN thus
enables the Company to provide new products and services beyond those
currently possible as a switchless reseller.
The Company also intends to continue to explore strategic alliances
with other channels of distribution, partitions and nonfacilities-based and
other providers of long distance services.
SALES AND MARKETING
Partitions
----------
To date, the Company has primarily marketed its services to small and
medium-sized business end users (i.e., generally businesses with fewer than 200
employees) throughout the United States through independent long distance and
marketing companies known as "partitions." Partitions resell and market the
Company's products,
5
allowing the Company to minimize its marketing and end user overhead. Partitions
offer end users a variety of services and rates. As compensation for their
services, partitions generally receive the difference between the amount
received by the Company from end users and the amount charged by the Company to
the partition for providing such services. One partition, The Furst Group, Inc.,
accounted for approximately 11% of the Company's sales in 1996; however, the
Company does not expect that any partition will account for 10% or more of the
Company's sales in 1997.
A substantial number of the Company's partitions have executed
partition agreements with the Company pursuant to which the Company agrees to
provide services utilizing the AT&T network service and end user billing
services at agreed upon prices or discounts. The Company requires that the
partitions adhere to certain Company established guidelines in marketing the
Company's services and comply with federal and state regulations. These
requirements include certain representations by each organization that it is
acting as an independent contractor with regard to the sale of the Company's
services, and not as a joint venture partner, agent or employee of the Company,
along with provisions for the proper completion of forms and other sales
procedures. In addition, most of the payments made by end users are paid
directly into a lock-box controlled by the Company. The Company's partition
agreements typically run for three years or for the term of the applicable
tariffs, whichever is less. The partitions generally make no minimum use or
revenue commitments to the Company under these agreements with respect to the
resale of AT&T services. The agreements also are generally non-exclusive. If the
Company were to lose access to services on the AT&T network or AT&T billing
services or experience difficulties with OBN, the Company's agreements with
partitions could be adversely affected.
The Company believes that the discounts it will be able to offer
partitions and end users using OBN, together with the functionality and quality
of OBN operating in conjunction with AT&T-provided transmission facilities and
the accuracy of billing services obtained from AT&T and ACUS, will enable it to
attract current and future partitions to OBN. The Company will continue its
policy of advancing funds to most partitions to support their marketing efforts.
Historically, partitions of the Company have continued to do business under
their partition agreements following changes in the Company's service offerings.
The Company intends to continue to promote increased marketing
activities of certain of its partitions through advances collateralized by
assets of such partitions. In return for providing such marketing advances, the
Company seeks long-term arrangements with such partitions. In 1996, the Company
entered into long term arrangements with several existing and new partitions.
Current marketing practices, including the methods and means to convert
a customer's long distance telephone service from one carrier to another, have
recently been subject to increased regulatory review at both the federal and
state levels. This increased regulatory
6
review could affect possible future acquisition of new business from new
partitions or other resellers. Provisions in the Company's partition agreements
mandate compliance by the partitions with applicable state and federal
regulations. Because the Company's partitions are independent carriers and
marketing companies, the Company is unable to control such partitions'
activities. The Company is also unable to predict the extent of its partitions'
compliance with applicable regulations or the effect of such increased
regulatory review.
Direct Marketing
----------------
The Company began to actively market its telecommunication services
directly to end users in 1996. Through its direct marketing efforts, the Company
expects to increase its profit margins by taking advantage of the difference
between the reduced costs of providing services over OBN and the rates charged
to end users. The Company began its direct marketing in the first quarter of
1996 with a telemarketing operation based in Clearwater, Florida. In December
1996, in connection with the settlement of certain disagreements among the
Company, American Business Alliance, Inc. ("ABA"), a switchless reseller of long
distance telecommunications services and a partition of the Company, and ABA's
shareholders, the Company acquired substantially all of ABA's assets and hired
substantially all of ABA's employees. These actions significantly increased the
Company's capabilities for direct marketing of telecommunication services. The
Company expects that in 1997 a large majority of the Company's new orders will
be generated from direct marketing. The Company currently has 260 employees
involved in its direct marketing operations. Direct marketing efforts have
focused initially on inbound and outbound services to small and medium-sized
businesses and may expand to include residential customers.
Operation of its own direct marketing will require the Company to incur
additional costs above levels historically experienced by the Company. There can
be no assurance that any cost savings will be realized utilizing direct
marketing. Direct marketing by the Company also may adversely affect the
Company's relationships with its partitions as both the Company and the
partitions will be competing to provide similar services. The Company is
required to comply with additional regulatory standards for direct marketing of
telecommunications services, and is subject to increased risk of customer
complaints or federal or state enforcement actions with respect to its marketing
and order verification practices. Actions have been brought against many
carriers based on allegations of "slamming" or the unauthorized conversion of a
customer's chosen long distance carrier.
7
Residential
-----------
On February 25, 1997, the Company announced that it had entered into a
Telecommunications Marketing Agreement (the "AOL Agreement"), dated as of
February 22, 1997 and effective as of February 25, 1997, with AOL, under which
the Company will be the exclusive provider of long-distance telecommunications
services under a distinctive brand name to be used exclusively for the Company's
services. The services will include provision for online sign-up, call detail
and reports and credit card payment. Under the AOL Agreement, AOL will provide
millions of dollars of online advertising and promotion of the services and
provide all of its subscribers with access to a dedicated service area online
for the Company. AOL subscribers who sign-up for the telecommunications services
will be customers of the Company, as the carrier providing such services. The
Company also has certain rights under the AOL Agreement to offer, on a
comparably exclusive basis, local and wireless telecommunications services when
such services become available to the Company through a contract for resale or
otherwise.
It is anticipated that the services will be tested in the early summer
and offered generally to AOL subscribers in the fall of 1997. The AOL Agreement
has an initial term of three years and can be extended by AOL on an annual basis
thereafter.
Under the AOL Agreement, the Company made an initial payment of $100
million to AOL at signing and agreed to provide marketing payments to AOL based
on a percentage of the Company's profits from the services (between 50% and 70%,
depending on the number of subscribers to the services). The AOL Agreement
provides that $43 million of the initial payment will be offset and recoverable
by the Company through reduction of such profit-based marketing payments during
the initial term of the AOL Agreement or, subject to certain monthly reductions
by offset of the amount thereof, directly by AOL upon certain earlier
terminations of the AOL Agreement. The $57 million balance of the initial
payment will be offset and is recoverable through a percentage of such
profit-based marketing payments made after the first five years of the AOL
Agreement (when extended beyond the initial term) and by offset against a
percentage of AOL's share of the profits from the services after termination or
expiration of the AOL Agreement. Any portion of the $43 million not previously
recovered or reduced in amount would be added to the $57 million and would be
recoverable similarly.
Also under the AOL Agreement, the Company issued to AOL at signing two
warrants to purchase shares of the Company's common stock at a premium over the
market value of such stock on the issuance date. One warrant is for 5 million
shares, at an exercise price of $15.50 per share, one-half of which shares will
vest at the time the service is first made generally available to AOL online
network subscribers in accordance with the AOL Agreement or the first
8
anniversary of the warrant issuance, whichever is earlier, and the balance of
which will vest on the first anniversary of issuance if the AOL Agreement has
not terminated. The other warrant is for up to 7 million shares, at an exercise
price of $14.00 per share, which will vest, commencing December 31, 1997, based
on the number of subscribers to the services and would vest fully if there are
at least 3.5 million such subscribers at any one time. The Company also agreed
to issue to AOL an additional warrant to purchase 1 million shares of its common
stock, at market value at the time of issuance, upon each of the first two
annual extensions by AOL of the term of the AOL Agreement, which warrants also
will vest based on the number of subscribers to the services.
In connection with the AOL Agreement, the Company and AOL will jointly
develop the online marketing and advertising for the services. The Company will
provide online customer service as well as inbound calling customer service to
the AOL subscriber base in connection with the services. While the Company
expects to utilize its Clearwater, Florida facility to provide customer service
support to AOL subscribers, the Company may need to increase staffing and
purchase equipment to support this activity. The Company anticipates that it
will incur expenses for the start-up and development of the services
contemplated in the AOL Agreement during 1997, including expenses for the
expansion of the Clearwater operation, for software programming and for software
and hardware additions to the Company's network, OBN, to expand its capacity for
the traffic. The Company believes that the increased revenues to the Company
resulting from the AOL Agreement and the services offered pursuant thereto will
be limited in 1997, but could be significant in 1998, although there can be no
assurance that these results can be achieved in light of a number of
uncertainties, including the following: the Company's ability to timely develop
the online ordering, call detail, billing and customer services for the AOL
subscribers, which will require, among other things, being able to identify and
employ sufficient personnel qualified to provide necessary programming; the
Company's and AOL's ability to work effectively together to jointly develop the
online marketing contemplated by the AOL Agreement; the response rate to online
promotions of AOL's online subscribers, most of whom are expected to be
residential rather than businesses, which have historically been the Company's
customer base; the Company's ability to expand OBN to accommodate increased
traffic levels; and AOL's ability to successfully execute its publicly stated
business plan and implement its announced network changes to improve subscriber
access to its online service.
SERVICES
Partitions
----------
The Company offers operational, financing, marketing and management
support to partitions, which provides the partitions with
9
the ability to operate and manage their businesses and attract and maintain end
users. Such support includes financial resources, low long distance rates,
collection services, prospective customer lists and a management information
system designed and developed by the Company exclusively for use by the Company
and its partitions ("Business Management System" or "BMS"). The Company offers
start-up financing as well as financing to its existing partitions and expects
to increase such financing in the future. The Company's Business Management
System provides a link between the Company's operations center and each
partition, including information relating to billing, collections, provisioning,
network usage and other end user information. The Company also compiles,
evaluates and distributes prospective customer lists.
Service on a long distance network is activated by a process called
provisioning. On a daily basis, through the Business Management System provided
by the Company, the Company's partitions transmit required end user information
to the Company. Orders for AT&T network services resold by the Company as a
switchless reseller are formatted by the Company in the manner required by AT&T
and transmitted to AT&T's information management system, where AT&T processes
the information and sends status updates on orders to the Company which, in
turn, reports such status to the partitions. Orders for OBN services are
processed and controlled by the Company. By controlling the provisioning process
with OBN, the Company believes it can increase acceptance rates of new end users
and reduce the time required to initiate service provided through the Company.
The Company promotes increased marketing activities by certain of its
partitions and attracts new partitions through advances. Such advances are made
in installments subject to the success of marketing efforts by the applicable
partition. As a condition to such advances, the Company generally requires a
partition to agree to utilize the Company's Business Management System, to
accept the Company's billing services and lock-box procedures pursuant to which
sales generated by a partition are paid directly to the Company's lock-box
account and to grant the Company a security interest in such sales. In return
for providing such marketing advances, the Company seeks long-term arrangements
with such partitions. The Company believes that such long-term arrangements
benefit the Company and its partitions as such arrangements foster increases in
the Company's end user base resulting in increases in minutes of traffic.
End Users
---------
The Company offers customer service to end users marketed by its
telemarketing operations as well as to end users of certain partitions. Customer
service representatives are located in the Company's facilities in Clearwater,
Florida and New Hope and
10
Kingston, Pennsylvania. The Company plans to provide online customer service as
well as inbound calling customer service in connection with the services offered
to AOL subscribers.
INFORMATION AND BILLING SERVICES
The Company utilizes the billing services of AT&T and ACUS, a wholly
owned strategic business unit of AT&T. As a result, the Company's end users
benefit from the reliability and accuracy associated with AT&T billing. Detailed
call information on the usage of each end user is produced by AT&T (in the case
the of switchless resale business) and by the Company (in the case of OBN
business). In both cases, AT&T then processes the information and provides
billing information to the Company. ACUS bills the end users pursuant to a
custom billing format bearing the names of either the Company or the applicable
partition in the bill heading.
AT&T has removed the "AT&T" name from the heading of the bills,
although the text of the bills or bill inserts may still refer to the fact that
an AT&T unit provides billing services. AT&T could further obscure its role in
providing billing services altogether, which could have an adverse impact on the
Company. The Company is developing its own information systems in order to have
its own billing capacity, although the Company has not provided such direct
billing services to end users in the past.
BMS is provided to each partition. BMS resides at the partitions'
locations and communicates with the Network Management System ("NMS") located at
the Company's headquarters. NMS allows direct interface with the LECs and the
Company's network to perform functions historically handled by AT&T. These
computerized management systems control order processing, accounts receivable,
billing and status information in a streamlined fashion between the Company and
its partitions. Furthermore, when applicable, the systems interface with the
AT&T Provisioning System and ACUS for order processing and billing services,
respectively. Enhancements and additional features are provided as needed.
Electronic processing and feature activation are designed to maintain the
Company's goal of minimizing overhead.
The Company has developed its own new information systems through the
use of client/server technology. The Company purchased symmetrical
multi-processing ("SMP") hardware in conjunction with SQL Database software from
Informix Corporation. This system is now operational and has the capacity to
process the Company's current volume of information services and exceeds the
Company's needs for the foreseeable future, except with respect to the
information and billing systems that the Company will need to develop in
connection with the AOL Agreement, including online sign-up, call detail and
billing reports and credit card billing.
11
The information functions of the system are designed to provide easy
access to all information about an end user, including volume and patterns of
use, which will help the Company and partitions identify value-added services
that might be well suited for that end user. The Company also expects to use
such information to identify emerging end user trends and respond with services
to meet end users' changing needs. Such information should also allow the
Company and its partitions to identify unusual or declining use by an individual
end user, which frequently indicates that an end user is switching its service
to a competitor.
In addition, in connection with the AOL Agreement, the Company will
need to develop systems for online sign-up, call detail and billing reports and
credit card payments. Any delay or difficulties in developing systems or hiring
personnel could adversely affect the timing of the implementation of this
service offering to AOL subscribers and, in turn, the success of this service
offering.
ONE BETTER NET
In order to reduce its dependence on AT&T contract tariffs and to
increase its growth opportunities, the Company developed its own
telecommunications network, OBN, which utilizes AT&T (now Lucent) manufactured
switches owned by the Company in conjunction with AT&T-provided lines and
digital cross-connect equipment (herein referred to as "transmission
facilities") and AT&T-provided billing systems that the Company uses pursuant to
agreements with AT&T and ACUS. OBN includes five AT&T (now Lucent) 5ESS-2000
switches, which are generally considered the most reliable switches in the
telecommunications industry. The Company was one of the first installation site
for AT&T's 5ESS-2000 switching equipment featuring the new Digital Networking
Unit -- SONET technology, a switching interface designed to increase the
reliability of the 5ESS-2000 and to provide much greater capacity in a
significantly smaller footprint. The five switches -- in Jacksonville, New York,
Chicago, Dallas and San Francisco -- were initially deployed with AT&T 5E10
software and were recently upgraded to 5E11 software, increasing the Company's
trunk capacity by approximately 33%.
OBN allows the Company to offer long distance services directly to its
end users and partitions throughout the continental United States at rates that
are competitive with or below those offered by the major long distance
providers. OBN also allows the Company to control provisioning of end user
accounts.
The Company's current contract tariffs under which it resells AT&T
services require the Company to pay one all-inclusive "bundled" charge to AT&T
for the delivery of services, including switching and transmission services and
the payment of LEC access fees. As a result of the deployment of OBN, the
Company will pay "unbundled" charges consisting of charges paid directly to the
LECs for access
12
charges and, under AT&T contract tariffs, charges paid to AT&T for use of its
network transmission facilities. The Company will pay AT&T "bundled" charges for
use of its international facilities to handle the international portion of a
call on OBN. The total cost per call to the Company for the LEC access fees, the
charges for use of AT&T's transmission facilities and the overhead cost for
calls using OBN is expected to be less than the "bundled" charge currently paid
under AT&T contract tariffs. LEC access fees represent a substantial portion of
the total cost of providing long distance services. As a result of the
Telecommunications Act, it is generally expected that the entry over time of
competitors into LEC markets will result in lowering of access fees, but there
is no assurance that this will occur. To the extent it does occur, the Company,
by using OBN, will receive the benefit of any future reduction in LEC access
fees, which it would not automatically receive under contract tariffs.
In October 1996, the Company subscribed to a new AT&T contract tariff,
which permits the Company to continue to resell through mid- 1998 AT&T long
distance services, including AT&T SDN service and other services, at rates which
are more favorable to the Company than prior tariffs. As a result, the Company
decided only to provision new end users on OBN and to leave existing end users
on AT&T service. The new AT&T contract has enabled the Company to earn higher
margins on existing traffic, minimize possible attrition that might result from
moving existing end users from the AT&T network to OBN. This has permitted a
more gradual introduction of OBN, which has reduced the expense of providing the
capacity required in a more rapid phase-in of OBN and lessened the impact of any
technical difficulties during the phase-in of OBN.
In 1997, the Company will continue to offer private line service
through contract tariffs with AT&T. Although the Company will continue to
provide such private line service through AT&T, the Company also will begin to
offer private line service using OBN to new and existing customers.
In order for the Company to provide service over OBN, the Company has
installed and operates, and is responsible for the maintenance of, its own
switching equipment. The Company also has installed lines to connect its OBN
switches to LEC switches and is responsible for maintaining these lines. The
Company entered into a contract with GTE with respect to the monitoring,
servicing and maintenance of the switching equipment purchased from AT&T. There
can be no assurance that the Company will be successful in operating as a
switch-based carrier. Additional management personnel and information systems
are required to support OBN, the costs of which have increased the Company's
overhead. Moreover, operation as a switch-based provider subjects the Company to
risk of significant interruption in the provision of services on OBN in the
event of
13
damage to the Company's facilities (switching equipment or connections to AT&T
transmission facilities) such as could be caused by fire or natural disaster.
Such interruption could have a material adverse impact on the Company's
financial condition and results of operations.
The Company began testing new customer calls over OBN in the third
quarter of 1996. In the fourth quarter of 1996, the Company began provisioning
on a test basis new customer orders on OBN. To date, the Company has provisioned
approximately 50,000 end users to OBN. Currently the Company is continuing to
provision new customers on OBN while completing the final testing of OBN. The
Company expects final testing of OBN to be completed in April 1997, and at that
time there will be a general release of OBN. Thereafter, the Company expects to
provision a large majority of its new customer orders on OBN.
The 5ESS-2000 switches make it possible for the Company in the future
to offer a number of additional or enhanced services. For example, the Company's
5ESS-2000 switches could support the offering of Centrex features, such as call
waiting, conference calling, distinctive ringing and least cost routing, that
traditionally were available only to end users with their own equipment or
through purchase from the end users' local exchange carrier ("LEC"). The
5ESS-2000 switches could support Advanced Intelligent Network ("AIN"), which
provides an open network architecture allowing for interconnections of
inexpensive peripheral equipment and databases and the deployment of such
services as calling cards, debit cards, voice recognition and caller
identification, without the involvement of switch manufacturers. The 5ESS-2000
switches could help the Company to provide competitive telecommunications
services to tenants of multi-tenant office and residential buildings and
complexes. The 5ESS-2000 switch also has the capacity to direct local service as
well as long distance service.
AT&T CONTRACT TARIFFS
The Company historically has obtained services from AT&T through
contract tariffs and has been able to obtain the services it seeks and to do so
at increasingly favorable contract tariff rates. The deployment of OBN decreases
the Company's dependence on AT&T contract tariffs. To the extent the Company
will need future contract tariffs, there is no guarantee the Company will be
able to obtain favorable contract tariffs, although the Company has been
successful in the past in obtaining such contract tariffs.
On October 1996, the Company subscribed to a new AT&T contract tariff,
which was further revised in December 1996 and permits the Company to continue
to resell AT&T long distance services, including AT&T-SDN service, through
mid-1998. The new AT&T contract tariff also includes other AT&T services (such
as international long
14
distance, inbound and outbound services) that will be used in the Company's new
nationwide telecommunications network, OBN. The rates that the Company will pay
under the new AT&T contract tariff are more favorable to the Company than under
previous tariffs. During its term, the new AT&T contract tariff will enable the
Company to minimize possible attrition that might result from moving exiting end
users from the AT&T network to OBN. The new AT&T contract tariff also permits a
more gradual introduction of OBN, which should reduce the expense of providing
the capacity required in a more rapid phase-in of OBN and lessen the impact of
any technical difficulties during the phase-in of OBN. The more gradual
introduction of OBN, however, will postpone the Company's realization of the
anticipated benefit of the more favorable margins for OBN service, and the new
AT&T contract tariff requires the Company to commit to purchase $300 million of
service from AT&T over the next 4 years, including at least $1 million per month
of international service. If minimum usage requirements are not met, the Company
is obligated to pay shortfall fees to AT&T based on a percentage of the
difference between the minimum requirement and the actual billed usage. In
addition, if the contract tariffs with AT&T are terminated prior to the end of
the contract tariff term, either by the Company or by AT&T for non-payment, the
Company may be liable for "termination with liability" or "termination charges"
and subject to material monetary penalties. This commitment is larger than any
previous commitment that the Company has made, but the Company believes that it
can be met based on its current purchases of long distance service from AT&T
which are in execess of $10 million per month. Further the Company can terminate
the new contract tariff without liability to AT&T at the end of 18 months if the
Company has generated at least $120 million in usage charges, including at least
$15 million in international usage charges. The Company also may discontinue the
new contract tariff without liability prior to the 18th month if the Company and
AT&T enter into a new contract tariff or another contract with a revenue
commitment of at least $7.5 million per month and a term of at least the
difference between 18 months and the number of months that the Company
subscribed to the contract tariff, provided that the Company must purchase or
pay for AT&T services under the contract tariff of at least $6.7 million per
month for the months prior to such termination, including $1 million per month
of international usage.
COMPETITION
The long distance telecommunications industry is highly competitive and
affected by the introduction of new services by, and the market activities of,
major industry participants. Competition in the long distance business is based
upon pricing, customer service, billing services and perceived quality. The
Company competes against various national and regional long distance carriers
composed of both facilities-based providers and switchless resellers offering
essentially the same services as the Company.
15
Several of the Company's competitors are substantially larger and have greater
financial, technical and marketing resources. Although the Company believes it
has the human and technical resources to pursue its strategy and compete
effectively in this competitive environment, its success will depend upon its
continued ability to provide profitably high quality, high value services at
prices generally competitive with, or lower than, those charged by its
competitors.
End users are not obligated to purchase any minimum usage amount and
can discontinue service, without penalty, at any time. There can be no assurance
that end users will continue to buy their long distance telephone service
through the Company or through partitions that purchase service from the
Company. In the event that a significant portion of the Company's end users
decides to purchase long distance service from another long distance service
provider, there can be no assurance that the Company will be able to replace its
end user base from other sources.
A high level of attrition is inherent in the long distance industry,
and the Company's revenues are affected by such attrition. Attrition is
attributable to a variety of factors, including termination of customers by the
Company for non-payment and the initiatives of existing and new competitors as
they engage in, among other things, national advertising campaigns,
telemarketing programs and cash payments and other incentives.
Although the basic rates of the three largest long distance carriers
- -- AT&T, MCI Communications Corp. and Sprint Corporation -- have consistently
increased over the past three years and remained generally unchanged through the
third quarter of 1996, AT&T and other carriers have announced new price plans
aimed at residential customers (the Company's primary target audience under he
AOL Contract) with significantly simplified rate structures, which may have the
impact of lowering overall long distance prices. There can be no assurance that
AT&T or other carriers will not make similar offerings available to the small to
medium-sized businesses that the Company serves. Although OBN makes the Company
more price competitive, a reduction in long distance prices still may have a
material adverse impact on the Company's profitability.
AT&T has split itself into three separate and independently-owned and
operated companies ("AT&T breakup"). One company, which retains the AT&T name
provides, among other services, long distance, wireless and other
telecommunications services. Another, Lucent, manufactures and sells
communications equipment. A third, NCR, includes AT&T's computer operations and
will focus on the financial, retail and communications industries. AT&T has
stated that the breakup will allow it to compete more effectively with providers
of telecommunications services.
16
The Company will link its switching equipment with transmission
facilities and services purchased or leased from AT&T and will continue to
resell services obtained from AT&T, which will remain a competitor of the
Company for the provision of telecommunications services. The Company also
utilizes AT&T and ACUS to provide billing services. There can be no assurance
that either AT&T or ACUS will continue to offer billing services to the Company
at competitive rates or attractive terms.
In October, 1995, the FCC reclassified AT&T as a nondominant
interexchange carrier. The FCC stated that AT&T would have greater incentives to
cut its prices and offer innovative new services. Nondominant carriers are not
subject to price cap regulation and could file tariffs (and tariff changes)
under streamlined procedures that will be presumed lawful on one day's notice.
The Company will therefore no longer be able to file Petitions to Reject or to
Suspend and Investigate AT&T tariff proposals with the FCC before those
offerings take effect. The FCC's reclassification of AT&T as a nondominant
carrier eliminated certain pricing restrictions and regulatory oversight and may
allow AT&T to compete more aggressively with the Company.
As a nondominant carrier, AT&T will be subject to the same regulations
as other long distance service providers. AT&T remains subject to Title II of
the Communications Act (47 U.S.C. Section 151, et seq.) and is required to offer
service under rates, terms and conditions that are just, reasonable and not
unreasonably discriminatory. AT&T is also subject to the FCC's complaint process
and was required to file tariffs, though under streamlined procedures. In
addition, AT&T is also required to give notice to the FCC and to affected
customers prior to discontinuing, reducing, or impairing any services.
In seeking FCC approval of its motion, AT&T made a series of "voluntary
commitments" to the FCC as a transitional mechanism to govern its conduct. With
respect to business term plans and long-term contracts with customers, including
resellers, AT&T agreed for a 12 month period to provide advance notice to the
customer of proposed changes that might affect a customer's reliance on its
contract with AT&T and to file any such changes with advance notice and time for
action by the FCC. AT&T also stated that it was willing to enter into mutually
agreeable private party arbitration agreements with its reseller customers and
was willing to develop a model agreement in negotiations with the
Telecommunications Resellers Association Executive Board. The FCC accepted all
of the "voluntary commitments" offered by AT&T and ordered AT&T's compliance
with those commitments.
The Telecommunications Act of 1996 was intended to introduce more
competition to U.S. telecommunications markets. The legislation opens the local
services market by requiring LECs to permit interconnection to their networks
and establishing, among other
17
things, LEC obligations with respect to access, resale, number portability,
dialing parity, access to rights-of-way, and mutual compensation. The
legislation also codifies the LECs' equal access and nondiscrimination
obligations and preempts most inconsistent state regulation. The legislation
also contains special provisions that eliminate restrictions on the RBOCs
providing long distance services, which means that the Company will face
competition for providing long distance services from well-capitalized,
well-known companies that prior to this time could not compete in long distance
service.
The RBOCs have been prohibited from providing interLATA interexchange
telecommunications services under the terms of the AT&T decree. The
Telecommunications Act authorizes the RBOCs to provide certain interLATA
interexchange telecommunications services immediately and others upon the
satisfaction of certain conditions. Such legislation includes certain safeguards
against anticompetitive conduct by the RBOCs in the provision of interLATA
service. Anticompetitive conduct could result, among other things, from a RBOC's
access to all subscribers on its existing network as well as its potentially
lower costs related to the termination and origination of calls within its
territory. It is impossible to predict whether such safeguards will be adequate
to protect against anticompetitive conduct by the RBOCs and the impact that any
anticompetitive conduct would have on the Company's business and prospects.
Because of the name recognition that the RBOCs have in their existing markets
and the established relationships that they have with their existing local
service customers, and their ability to take advantage of those relationships,
as well as the possibility of favorable interpretations of the
Telecommunications Act by the RBOCs, it may be more difficult for other
providers of long distance services, such as the Company, to compete to provide
long distance services to RBOC customers. At the same time, as a result of the
Telecommunications Act, RBOCs have become potential customers for the Company's
long distance services.
Consolidation and alliances across geographic regions (e.g., Bell
Atlantic/Nynex and SBC Communications Inc./Pacific Telesis Group domestically
and BT/MCI and France Telecom/Deutsche Telekom/Sprint internationally) and
across industry segments (e.g., WorldCom/MFS/UUNet) may also intensify
competition in the telecommunications market from significantly larger,
well-capitalized carriers and materially adversely affect the position of the
Company.
INDUSTRY BACKGROUND
The $72.5 billion U.S. long distance industry is dominated by the
nation's three largest long distance providers, AT&T, MCI and Sprint, which
together generated approximately 80.9% of the aggregate revenues of all U.S.
long distance interexchange carriers in 1995. Other long distance companies,
some with national capabilities, accounted for the remainder of the market.
Based on published
18
Federal Communications Commission ("FCC") estimates, toll service revenues of
U.S. long distance interexchange carriers have grown from $38.8 billion in 1984
to $72.5 billion in 1995. The aggregate market share of all interexchange
carriers other than AT&T, MCI and Sprint has grown from 2.6% in 1984 to 17.13%
in 1995. During the same period, the market share of AT&T declined from 90.1% to
53%.
Prior to the Telecommunications Act, the long distance
telecommunications industry had been principally shaped by a court decree
between AT&T and the United States Department of Justice, known as the
Modification of Final Judgment (the "Consent Decree") that in 1984 required the
divestiture by AT&T of its 22 Bell operating companies and divided the country
into some 200 Local Access and Transport Areas ("LATAs"). The 22 operating
companies, which were combined into the RBOCs, were given the right to provide
local telephone service, local access service to long distance carriers and
intraLATA toll service (service within LATAs), but were prohibited from
providing interLATA service (service between LATAs). The right to provide
interLATA service was maintained by AT&T and other carriers.
To encourage the development of competition in the long distance
market, the Consent Decree and the FCC require most LECs to provide all carriers
with access to local exchange services that is "equal in type, quality and
price" to that provided to AT&T and with the opportunity to be selected by
customers as their preferred long distance carrier. These so-called "equal
access" and related provisions are intended to prevent preferential treatment of
AT&T.
Regulatory, judicial and technological factors have helped to create
the foundation for smaller companies to emerge as competitive alternatives to
AT&T, MCI, and Sprint for long distance telecommunication services. The FCC
requires that AT&T not restrict the resale of its services, and the Consent
Decree and regulatory proceedings have ensured that access to LEC networks is,
in most cases, available to all long distance carriers.
Long distance companies that have their own transmission facilities and
switches, such as AT&T, are referred to as facilities-based carriers.
Facilities-based carriers are switch-based carriers, meaning that they have at
least one switch to direct their long distance traffic. Nonfacilities-based
carriers either (i) depend upon facilities-based carriers for switching and
transmission facilities ("switchless resellers") or (ii) install and operate
their own switches but depend on facilities-based carriers for transmission
facilities ("switch-based resellers").
The relationship between resellers and the major long distance carriers
is predicated primarily upon the fact that the pricing strategies and cost
structures of the major long distance carriers have resulted historically in
their charging higher rates to the
19
small to medium business customer. Small to medium business customers typically
are not able to make the volume commitments necessary to negotiate reduced rates
under individualized contracts. By committing to large volumes of traffic, the
reseller is guaranteeing traffic to the major long distance carrier but the
major long distance carrier is relieved of the administrative burden of
qualifying and servicing large numbers of medium to small accounts. The
successful reseller has lower overhead costs and is able to market efficiently
the long distance product, process orders, verify credit and provide customer
service to large numbers of accounts.
With its own switches, the Company will be significantly less dependent
on AT&T for switching services, although it will continue to be dependent on
AT&T for transmission services. In recent years, national and regional network
providers have substantially upgraded the quality and capacity of their domestic
long distance networks, resulting in significant excess transmission capacity
for voice and data communications. Due to anticipated advances in the technology
involved in digital fiber optic transmission, excess capacity is expected to
persist and may result in decreasing prices for use of transmission facilities.
By deploying its own switches, the Company expects to be able to continue to
provide long distance services using the quality of AT&T transmission facilities
but at lower rates than it has historically charged, with the Company in control
of establishing service or activating new end user accounts ("provisioning") and
maintaining confidential end user lists
REGULATION
The Company's provision of communications services is subject to
government regulation. Federal law regulates interstate and international
telecommunications, while states have jurisdiction over telecommunications that
originate and terminate within the same state. Changes in existing policies or
regulations in any state or by the FCC could materially adversely affect the
Company's financial condition or results of operations, particularly if those
policies make it more difficult for the Company to obtain service from AT&T or
other long distance companies at competitive rates, or otherwise increase the
cost and regulatory burdens of marketing and providing service. There can be no
assurance that the regulatory authorities in one or more states or the FCC will
not take action having an adverse effect on the business or financial condition
or results of operations of the Company. Regulatory action by the FCC or the
states also could adversely affect the partitions, or otherwise increase the
partitions' cost and regulatory burdens of marketing and providing long distance
services.
The Company is classified by the FCC as a nondominant carrier. After
the recent reclassification of AT&T as nondominant, only the LECs are classified
as dominant carriers among domestic carriers. As a consequence, the FCC
regulates many of the rates, charges, and
20
services of the LECs to a greater degree than the Company's. Because AT&T is no
longer classified as a dominant carrier, certain pricing restrictions that
formerly applied to AT&T have been eliminated, which could make it easier for
AT&T to compete with the Company for low volume long distance subscribers.
The FCC generally does not exercise direct oversight over charges for
service of nondominant carriers, although it has the statutory power to do so.
Nondominant carriers are required by statute to offer interstate services under
rates, terms, and conditions that are just, reasonable and not unreasonably
discriminatory. The FCC has the jurisdiction to act upon complaints filed by
third parties, or brought on the FCC's own motion, against any common carrier,
including nondominant carriers, for failure to comply with its statutory
obligations. Nondominant carriers have been required to file tariffs listing the
rates, terms and conditions of service, which were filed pursuant to streamlined
tariffing procedures. The FCC also has the authority to impose more stringent
regulatory requirements on the Company and change its regulatory classification
from nondominant to dominant. In the current regulatory atmosphere, the Company
believes, however, that the FCC is unlikely to do so.
The FCC imposes only minimal reporting, accounting and record-keeping
obligations. International nondominant carriers, including the Company, must
maintain international tariffs on file with the FCC. The FCC has issued an order
requiring non-dominant carriers to withdraw their domestic tariffs, but as of
the date hereof, a court has stayed the FCC's order. The Company currently has
two tariffs on file with the FCC. Although the tariffs of nondominant carriers,
and the rates and charges they specify, are subject to FCC review, they are
presumed to be lawful and are seldom contested. The Company is permitted to make
tariff filings on a single day's notice and without cost support to justify
specific rates. IXCs are also subject to a variety of miscellaneous regulations
that, for instance, govern the documentation and verifications necessary to
change a subscriber's long distance carrier, limit the use of 800 numbers for
pay-per-call services, require disclosure of certain information if operator
assisted services are provided and govern interlocking directors and management.
The Telecommunications Act grants explicit authority to the FCC to "forbear"
from regulating any telecommunications services provider in response to a
petition and if the agency determines that enforcement is unnecessary and the
public interest will be served.
At present, the FCC exercises its regulatory authority to set rates
primarily with respect to the rates of dominant carriers, and it has
increasingly relaxed its control in this area. Even when AT&T was classified as
a dominant carrier, the FCC most recently employed a "price cap" system, which
essentially exempted most of AT&T's services, including virtually all of its
commercial and 800 services, from traditional rate of return regulation because
the FCC believes
21
that these services were subject to adequate competition. Similarly, the FCC is
in the process of changing the regulation and pricing of the local transport
component of access charges (i.e., the fee for use of the LEC transmission
facilities connecting the LEC's central offices and the IXC's access points). In
addition, the LECs have been afforded a degree of pricing flexibility in setting
interstate access charges where adequate competition exists. The impact of such
repricing and pricing flexibility on IXCs, such as the Company, cannot be
determined at this time.
The Company is subject to varying levels of regulation in the states in
which it is currently authorized to provide intrastate telecommunications
services. The vast majority of the states require the Company to apply for
certification to provide intrastate telecommunications services, or at least to
register or to be found exempt from regulation, before commencing intrastate
service. The vast majority of states also require the Company to file and
maintain detailed tariffs listing its rates for intrastate service. Many states
also impose various reporting requirements and/or require prior approval for
transfers of control of certified carriers, corporate reorganizations,
acquisitions of telecommunications operations, assignments of carrier assets,
including subscriber bases, carrier stock offerings and incurrence by carriers
of significant debt obligations. Certificates of authority can generally be
conditioned, modified, canceled, terminated or revoked by state regulatory
authorities for failure to comply with state law and the rules, regulations and
policies of the state regulatory authorities. Fines and other penalties,
including the return of all monies received for intrastate traffic from
residents of a state, may be imposed for such violations. In certain states,
prior regulatory approval may be required for acquisitions of telecommunications
operations. Currently, the Company is certificated and tariffed to provide
intrastate interLATA service in substantially all states where such
authorization can be obtained.
The Company's expansion of its direct marketing efforts, makes the
Company subject to and requires compliance with relevant federal and state
regulations that govern direct sales of telecommunications services. FCC rules
prohibit switching a customer from one long distance carrier to another without
the customer's consent and specify how that consent can be obtained. Most states
have consumer protection laws that further define the framework within which the
Company's marketing activities must be conducted. The constraints of federal and
state restrictions could impact the success of the Company's direct marketing
efforts.
To the extent that the Company makes additional telecommunications
service offerings, the Company may encounter additional regulatory constraints.
22
EMPLOYEES
As of December 31, 1996, the Company employed 313 persons, of whom 260
were engaged in marketing and sales, 26 were engaged in partition and end user
support, and 27 were engaged in systems development, finance, administration and
management. None of the Company's employees is covered by collective bargaining
agreements. The Company considers relations with its employees to be good.
PRINCIPAL STOCKHOLDER
Daniel Borislow, the Company's Chairman and Chief Executive Officer,
owns beneficially approximately 38.4% of the Company's outstanding Common Stock,
as of the date hereof. Accordingly, Mr. Borislow effectively has the ability to
control the election of all of the members of the Company's Board of Directors
and the outcome of corporate actions requiring majority stockholder approval.
Even as to corporate actions for which super-majority approval may be required,
such as certain fundamental corporate transactions, Mr. Borislow effectively
will control the outcome.
Future sales of substantial amounts of the Company's Common Stock by
Mr. Borislow or others could adversely affect the market price of the Common
Stock. Of the Company's 62,887,998 shares of Common Stock, 35,737,998 shares are
freely tradeable by persons other than "affiliates" of the Company. Of the
remaining 27,150,000 shares of Common Stock, none are eligible for public resale
until after the expiration of the holding period pursuant to Rule 144 under the
Securities Act.
On March 10, 1997, Mr. Borislow sold 3,911,000 shares of Common Stock
in a private sale (the "Private Sale"), and placed an additional 1,546,400
shares in escrow to be held for the benefit of the purchasers in the Private
Sale and for distribution thereto (in part or in full), if the average current
market price of the Common Stock in the 20 days prior to the fifth business day
after the date on which the Company announces its financial results for the
third quarter of 1997 shall be lower than $16.50 per share. In connection with
the Private Sale. Mr. Borislow agreed that, except for a contribution of up to
2,000,000 shares of Common Stock to a charitable foundation, he will not sell,
assign, transfer or otherwise dispose of any shares of Common Stock for a period
of 12 months from March 10, 1997 (the "Lock-up Period"); provided, however, that
if the current market price of the Common Stock shall increase by an amount
greater than 20% from $16.50 per share for a period of 20 consecutive trading
days, the Lock-up Period shall be reduced to 90 days. Also on March 10, 1997,
Mr. Borislow donated 1,200,000 shares of Common Stock to the Daniel Borislow
Charitable Foundation.
23
GLOSSARY
ACUS: AT&T College and University Systems, a wholly owned strategic
business unit of AT&T.
AIN: Advanced Intelligent Network.
AOL: America Online, Inc.
AT&T: AT&T Corp.
BMS: The Company's database, which it provides to each of its
partitions.
Consent Decree: A 1984 U.S. Department of Justice decree that, among
other things, ordered AT&T to divest its wholly-owned local Bell
operating subsidiaries.
End Users: Customers that utilize long distance telephone services.
Equal Access: Connection provided by a LEC permitting a customer to be
automatically connected to the IXC of the customer's choice when the
customer dials "1."
Facilities-based provider: Long distance service providers who own
transmission facilities.
5ESS-2000: The switching equipment manufactured by AT&T, which the
Company acquired from AT&T.
5E10 Software: AT&T software that enables switches to combine
simultaneously wireline and wireless, local, long distance, voice,
video and data services.
FCC: Federal Communications Commission.
Inbound "800" Service: A service that bills long distance telephone
charges to the called party.
IXC: Interexchange carrier, a long distance carrier providing services
between local exchanges.
LATA: Local Access and Transport Areas, the approximately 200
geographic areas defined pursuant to the AT&T Consent Decree between
which the RBOCs are generally prohibited from providing long distance
service.
LEC: Local Exchange Carrier, a company providing local telephone
services.
24
MEGACOM: An outbound long distance service offering by AT&T that
requires dedicated access.
MEGACOM 800: An inbound 800 service offering provided by AT&T that
requires dedicated access.
MCI: MCI Communications Corporation.
MLCP: AT&T's multi-location calling plan (a discounted long distance
program).
Network: An integrated system composed of switching equipment and
transmission facilities designed to provide for the direction,
transport and recording of telecommunications traffic.
NMS: The Company's computerized internal management information system.
Nonfacilities-based provider: Long distance service providers that do
not own transmission facilities.
OBN: One Better Net, the Company's nationwide long distance network.
Partition: An independent long distance and marketing company that
contracts with the Company to purchase or otherwise provide to end
users the long distance services provided by the Company.
Private Line: A full-time leased line directly connecting two points.
Provisioning: The process of initiating a carrier's service to an end
user.
PUC: A state regulatory body empowered to establish and enforce rules
and regulations governing public utility companies and others, such as
the Company in many of its state jurisdictions.
RBOC: Regional Bell Operating Company -- Any of seven regional Bell
holding companies that the Consent Decree established to serve as
parent companies for the Bell operating companies.
Readyline: An Inbound 800 service offering provided by AT&T.
SDN: The AT&T Software Defined Network.
Sprint: Sprint Corporation.
25
Switching Equipment: A computer that directs telecommunication traffic
in accordance with programmed instructions.
Tariff: The schedule of rates and regulations set by communications
common carriers and filed with the appropriate Federal and state
regulatory agencies; the published official list of charges, terms and
conditions governing provision of a specific communication service or
facility, which functions in lieu of a contract between the user and
the supplier or carrier.
26
ITEM 2. PROPERTIES
The Company owns the 24,000 square foot facility in New Hope,
Pennsylvania which serves as the Company's headquarters. The Company leases
properties in the cities in which OBN switches have been installed.
With respect to the Company's retail telemarketing operations, the
Company owns the 32,000 square foot facility located in Clearwater, Florida and
leases the 11,725 square foot facility in Kingston, Pennsylvania.
ITEM 3. LEGAL PROCEEDINGS
The Company is a party to certain legal actions arising in the ordinary
course of business. The Company believes that the ultimate outcome of these
actions will not result in any liability that would have a material adverse
effect on the Company's financial condition or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the
fourth quarter of the year ended December 31, 1996.
27
EXECUTIVE OFFICERS OF THE COMPANY
The executive officers of the Company are as follows:
NAME AGE POSITION
---- --- --------
Daniel Borislow 35 Chairman of the Board, Chief Executive
Officer and Director
Gary W. McCulla 37 President and Director of Sales and
Marketing and Director
Emanuel J. DeMaio 38 Chief Operations Officer and Director
Joseph A. Schenk 38 Chief Financial Officer, Treasurer and
Director of Investor Relations
and Director
Edward B. Meyercord, III 31 Executive Vice President, Marketing
and Corporate Development
Mary Kennon 38 Director of Customer Care and Human
Resources
Aloysius T. Lawn, IV 38 General Counsel and Secretary
Kevin R. Kelly 32 Controller
Daniel Borislow. Mr. Borislow founded the Company and has served as a
director and as Chief Executive Officer of the Company since its inception in
1989. Prior to founding the Company, Mr. Borislow formed and managed a cable
construction company.
Gary W. McCulla. Mr. McCulla currently serves as President and Director
of Sales and Marketing. In 1991, Mr. McCulla founded GNC and was its President.
Until March 1994, GNC was a privately-held independent marketing company and one
of the Company's partitions. At that time, the Company acquired certain assets
of GNC.
Emanuel J. DeMaio. Mr. DeMaio joined the Company in February 1992 and
currently serves as Chief Operations Officer. Prior to joining the Company, from
1981 through 1992, Mr. DeMaio held various technical and managerial positions
with AT&T.
Joseph A. Schenk. Mr. Schenk joined the Company in January 1996 and
currently serves as Chief Financial Officer and Treasurer. He is a certified
public accountant. From September 1993 to January 1996, Mr. Schenk was Vice
President, Capital Markets Group, with Jefferies & Co. Previously, Mr. Schenk
was Vice President of Transcap Associates, a venture capital firm, and held
various roles with Price Waterhouse and Deloitte & Touche.
Edward B. Meyercord, III. Mr. Meyercord joined the Company in September
1996 and currently serves as Executive Vice President, Marketing and Corporate
Development. From 1993 until joining the Company, Mr. Meyercord worked in the
corporate finance department of Salomon Brothers, where he held various
positions, the most recent of which was Vice President. Prior to joining Salomon
Brothers, Mr. Meyercord worked in the corporate finance department at Paine
Webber Incorporated.
Mary Kennon. Ms. Kennon joined the Company in October 1994 and
currently serves as Director of Customer Care and Human Resources. Prior to
joining the Company, from 1984 through 1994, Ms. Kennon held various managerial
positions with AT&T.
Aloysius T. Lawn, IV. Mr. Lawn joined the Company in January 1996 and
currently serves as General Counsel and Secretary of the Company. Prior to
joining the Company, from 1985 through 1995, Mr. Lawn was an attorney in private
practice.
Kevin R. Kelly. Mr. Kelly joined the Company in April 1994 and
currently serves as Controller. From 1987 to 1994, Mr. Kelly held various
managerial positions with a major public accounting firm. Mr. Kelly is a
certified public accountant.
28
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock, $.01 par value per share ("Common Stock"),
is traded on the Nasdaq National Market, and high and low quotations listed
below are actual sales prices as quoted in the Nasdaq National Market under the
symbol "TALK." All of the following quotations have been adjusted to reflect the
two-for-one stock split of the Common Stock in the form of a 100% stock dividend
that occurred on January 31, 1997.
PRICE RANGE OF COMMON STOCK
------------------------------
HIGH LOW
---- ---
1995
----
Fourth Quarter (from September 20, 1995) $ 5 1/2 $ 4
1996
----
First Quarter 8 1/2 4
Second Quarter 12 8 1/4
Third Quarter 15 1/16 8 1/8
Fourth Quarter 14 3/4 10 1/8
1997
----
First Quarter through (March 13, 1997) 21 1/2 12 1/4
As of March 6, 1997, there were approximately 57 record holders of
Common Stock.
The Company currently intends to retain all future earnings for use in
the operation of its business and, therefore, does not anticipate paying any
cash dividends in the foreseeable future. The declaration and payment in the
future of any cash dividends will be at the election of the Company's Board of
Directors and will depend upon, among other things, the earnings, capital
requirements and financial position of the Company, existing and/or future loan
covenants and general economic conditions.
29
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data should be read in conjunction
with, and are qualified in their entirety by, "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and the Company's
Consolidated Financial Statements included elsewhere in this Form 10-K.
Year ended December 31,
------------------------------------------------------------------------------
1996 1995 1994 1993 1992
----------- ------------ ------------- ------------ ------------
(In thousands, except per share amounts)
Consolidated Statements of Income Data:
Sales $232,424 $180,102 $ 82,835 $ 31,940 $ 17,668
Cost of sales 200,597 156,121 70,104 26,715 14,803
-------- -------- -------- -------- --------
Gross profit 31,827 23,981 12,731 5,225 2,865
Selling, general and administrative expenses 10,039 6,280 3,442 2,060 1,476
-------- -------- -------- -------- --------
Operating income 21,788 17,701 9,289 3,165 1,389
Investment and other income, net 10,585 331 66 108 32
-------- -------- -------- -------- --------
Income before income taxes 32,373 18,032 9,355 3,273 1,421
Provision for income taxes(1) 12,205 7,213 3,742 1,309 568
-------- -------- -------- -------- --------
Net income(1) $ 20,168 $ 10,819 $ 5,613 $ 1,964 $ 853
======== ======== ======== ======== ========
Net income per share - Primary (1) $ 0.35 $ 0.32 $ 0.18 $ 0.07 $ 0.03
======== ======== ======== ======== ========
Weighted average common and common
equivalent shares outstanding - Primary 57,002 33,605 30,663 29,452 28,750
======== ======== ======== ======== ========
Net income per share - Fully Diluted(1) $ 0.35 $ 0.32 $ 0.18 $ 0.07 $ 0.03
======== ======== ======== ======== ========
Weighted average common and common
equivalent shares outstanding - Fully Diluted 58,027 33,605 30,663 29,452 28,750
======== ======== ======== ======== ========
At December 31,
-----------------------------------------------------------------------------
1996 1995 1994 1993 1992
------------ ------------ ------------- ------------ -----------
(In thousands)
Consolidated Balance Sheets Data:
Working capital $175,597 $38,171 $12,265 $4,502 $1,312
Total assets 257,008 71,388 21,435 6,694 2,178
Long-term debt -- -- -- -- --
Total stockholders' equity 230,720 41,314 14,042 4,687 1,414
- ----------
(1) For the years and period ended December 31, 1992, 1993, 1994 and
September 19, 1995, the Predecessor Corporation elected to report as an
S corporation for federal and state income tax purposes. Accordingly,
the Predecessor Corporation's stockholders included their respective
shares of the Company's taxable income in their individual income tax
returns. The pro forma income taxes reflect the taxes that would have
been accrued if the Company had elected to report as a C corporation.
See Note 10 to the Consolidated Financial Statements.
30
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the
Consolidated Financial Statements included elsewhere in this Form 10-K.
INTRODUCTION
The Company was founded in 1989 as a switchless reseller of AT&T long
distance services to small and medium sized businesses and currently has over
500,000 end users. The Company is currently in the process of completing the
deployment of its own nationwide telecommunications network, OBN consisting of
five Company-owned, AT&T (now Lucent) manufactured 5ESS-2000 switches connected
by AT&T transmission facilities. As more fully described below, the Company
believes that gross margins for OBN long distance service will be higher than
those for AT&T long distance service. The majority of the Company's new orders
are now being placed on OBN which now has over 50,000 end users.
Historically, the Company has marketed the majority of its services
through independent carriers and marketing companies known as "partitions",
which allowed the Company to minimize overhead expenses. The Company expanded
its business by adding partitions and providing existing and new partitions with
operational, financing, marketing and management support. Beginning in 1996, the
Company initiated and subsequently expanded through an acquisition in December
1996, a direct marketing effort. Direct marketing requires the Company to incur
costs of marketing, including personnel, occupancy, marketing support and
additional customer service - costs which were historically borne by partitions.
Currently, a large majority of the Company's new sales are generated via direct
marketing.
The Company believes that gross margins for OBN long distance service
will be higher than those for AT&T long distance service. AT&T long distance
service is "bundled," which means that the Company pays a single, all-inclusive
price to AT&T for switching, transmission, and LEC access. OBN long distance
service is "unbundled," which means that the Company provides its own switching,
pays AT&T for transmission, and pays access fees directly to LECs. The
"unbundled" charges per call on OBN are expected to be less than the "bundled"
charge paid to AT&T.
In February 1997 the Company announced a multi-year agreement with
America Online, Inc. ("AOL") under which the Company will be the exclusive
provider of long distance services to be marketed by AOL to all of its
approximate 8 million online subscribers (the "AOL Agreement"). See "RECENT
DEVELOPMENTS."
-31-
The following table presents the Company's sales, operating
income and net income by quarter since the first quarter of 1994.
Operating Net
Quarter Ended Sales Income Income
- ------------- ------- ------------- ----------
(In thousands)
1996:
March 31 $ 51,065 $ 4,546 $ 3,377
June 30 57,015 4,882 4,058
September 30 60,079 5,871 7,032
December 31 64,265 6,489 5,701
-------- -------- ---------
Total $232,424 $ 21,788 $ 20,168
======== ======== ========
1995:
March 31 (A) $ 36,617 $ 4,213 $ 2,555
June 30 (A) 44,728 4,855 2,897
September 30 (A) 48,366 4,008 2,519
December 31 50,391 4,625 2,848
-------- -------- ---------
Total (A) $180,102 $ 17,701 $ 10,819
======== ======== ========
1994:
March 31 (A) $ 14,413 $ 1,806 $ 1,092
June 30 (A) 14,705 1,846 1,102
September 30 (A) 22,521 2,608 1,573
December 31 (A) 31,196 3,029 1,846
-------- -------- ---------
Total (A) $ 82,835 $ 9,289 $ 5,613
======== ======== ========
(A) Pro forma tax provisions have been calculated as if the Company's results
of operations were taxable as a C corporation (the Company's current tax
status) for this period. Prior to September 20, 1995, the Company was an S
Corporation with all earnings taxed directly to its shareholders.
-32-
RESULTS OF OPERATIONS
The following table sets forth for the periods indicated certain financial
data as a percentage of sales:
Percentage of Sales, Year Ended December 31,
---------------------------------------------
1996 1995 1994
----------- ----------- -----------
Sales 100.0% 100.0% 100.0%
Cost of sales 86.3 86.7 84.6
----------- ----------- -----------
Gross profits 13.7 13.3 15.4
Selling, general and administrative expenses 4.3 3.5 4.2
----------- ----------- -----------
Operating income 9.4 9.8 11.2
Investment and other income, net 4.5 0.2 0.1
----------- ----------- -----------
Income before income taxes 13.9 10.0 11.3
Provision for income taxes 5.2 4.0(A) 4.5(A)
----------- ----------- -----------
Net income 8.7% 6.0% 6.8%
=========== =========== ===========
(A) Pro forma tax provisions have been calculated as if the Company's results of
operations were taxable as a C corporation (the Company's current tax status)
for the years ended December 31, 1995 and 1994. Prior to September 20, 1995, the
Company was an S Corporation with all earnings taxed directly to its
shareholders.
-33-
YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995
Sales. Sales increased by 29.1% to $232.4 million in 1996 from $180.1
million in 1995. The increase in sales related primarily to the continued
expansion of the Company's distribution network of partitions, as well as
increases in the number of orders submitted by the Company's existing
partitions. One partition, The Furst Group, Inc. accounted for approximately 11%
of the Company's sales in 1996 versus zero in 1995. In addition, significant
partition marketing efforts focused on inbound 800 service resulted in sales of
$75.3 million for the year ended December 31, 1996 versus $55.6 million for the
year ended December 31, 1995.
Although the Company expects sales to increase through the Company's
direct marketing efforts, the AOL Agreement, the addition of new partitions, the
growth of end user business through existing partitions and possible future
acquisitions, there can be no assurance that the Company will continue to
increase sales on a quarter-to-quarter or year-to-year basis.
Cost of Sales. The Company's cost of sales, consisting primarily of
network usage charges for AT&T long distance services, increased by 28.5% to
$200.6 million in 1996 from $156.1 million in 1995 and is directly related to
the 29.1% increase in sales.
As a switchless reseller of AT&T long distance services and in order to
provide its OBN services, the Company subscribes to contract tariffs. The
ability of the Company to negotiate competitive terms of these tariffs has been
an important reason for the Company's success. In October 1996, the Company
subscribed to a new AT&T contract tariff, which was further revised in December
1996 and permits the Company to continue to resell AT&T long distance services,
including AT&T-SDN service, through mid-1998. The new AT&T contract tariff also
includes other AT&T services (such as international long distance, inbound and
outbound services) that will be used in the Company's nationwide
telecommunications network, OBN. The rates that the Company will pay under the
new AT&T contract tariff are more favorable to the Company than under previous
tariffs. During its term, the new AT&T contract tariff will enable the Company
to minimize possible attrition that might result from moving existing end users
from the AT&T network to OBN. The new AT&T contact tariff also permits a more
gradual introduction of OBN, which should reduce the expense of providing the
capacity required in a more rapid phase-in of OBN and lessen the impact of any
technical difficulties during the phase-in of OBN. The more gradual introduction
of OBN, however, will postpone the Company's realization of the anticipated
benefit of the more favorable margins for OBN service, and the new AT&T contract
tariff requires the Company to commit to purchase $300 million of service from
A&T over the next 4 years, including at least $1 million per month of
international service. This commitment is larger than any previous commitment
that the Company has made, but the Company believes that it can be met based on
its current purchases of long distance service from AT&T which are in excess of
$10 million per month. Further, the Company can terminate the new contract
tariff without liability to AT&T at the end of 18 months if the Company has
generated at least $120 million in usage charges, including at least $15 million
in international usage charges. The Company also may discontinue the new
contract tariff without liability prior to the 18th month if the Company and
AT&T enter into a new contract tariff or another contract with a revenue
commitment of at least $7.5 million per month and a term of at least the
difference between 18 months and the number of months that the Company
subscribed to the contract tariff, provided that the Company must purchase or
pay for AT&T services under the contract tariff of at least $6.7 million per
month for the months prior to such termination, including $1 million per month
of international usage.
OBN and the operation of the Company's own switches and network will
require the Company to incur systems and equipment maintenance, lease, and
network personnel expenses significantly above the levels historically
experienced by the Company as a switchless reseller of AT&T services. However,
these per call costs, in combination with "unbundled" charges paid to LECs and
AT&T, are expected to be less than the per call cost currently incurred by the
Company as a switchless reseller paying "bundled" charges to AT&T.
In December 1996, the Company, in connection with the settlement of
certain disagreements among the Company, America Business Alliance, Inc.
("ABA"), an independent long distance and marketing company, and the
shareholders of ABA, acquired substantially all of the assets of ABA. Operations
of its own direct marketing will require the Company to incur additional costs
including personnel, occupancy, and marketing support, which may be
significantly above levels historically experienced by the Company. There can be
no assurance that any cost savings will be realized utilizing direct marketing
when compared to the costs historically incurred by the Company utilizing its
partitions.
-34-
The AOL Agreement will initially require the Company to provide
competitively priced residential long distance service along with various
on-line capabilities including on-line sign-up, call detail and reports and
credit card payment. The Company may incur significant expenses for the start-up
and development of the services contemplated in the agreement particularly
during the second and third quarters of 1997. These costs may result in higher
costs of sales in 1997 than historically experienced by the Company.
Gross Margin. Gross margin, the gross profit as a percentage of sales,
increased to 13.7% for the year ended December 31, 1996 from 13.3% for the year
ended December 31, 1995. The increase in gross margin was due to greater
discounts obtained from AT&T on network usage partially offset by direct
marketing expenses and higher volume discounts granted to certain partitions. To
the extent that the Company may incur additional costs associated with OBN,
direct marketing and the AOL Agreement (see Cost of Sales above) gross margin
may decline in 1997.
The Company believes that gross margins for OBN long distance service
will be higher than those for AT&T long distance service. AT&T long distance
service is "bundled," which means that the Company pays a single, all-inclusive
price to AT&T for switching, transmission, and LEC access. OBN long distance
service is "unbundled," which means that the Company provides its own switching,
pays AT&T for transmission, and pays access fees directly to LECs. The
"unbundled" charges per call on OBN are expected to be less than the "bundled"
charge paid to AT&T .
Although the basic rates of the three largest long distance carriers-
AT&T, MCI and Sprint-have consistently increased over the past three years, AT&T
and other carriers have announced new price plans and significantly simplified
rate structures aimed at residential customers, the Company's primary target
audience under the AOL Agreement, which may have the impact of lowering overall
long distance prices. There can be no assurance that AT&T or other carriers will
not make similar offerings available to the small to medium sized businesses
that the Company currently serves. Although OBN is expected to make the Company
more price competitive, further reductions in long distance prices charged by
competitors still may have a material adverse impact on the Company's gross
margin in future periods.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased by 59.9% to $10.0 million in 1996 from $6.3
million in 1995. The increase in selling, general and administrative expenses
was due primarily to the costs associated with hiring additional management
personnel to support the Company's continuing growth and increased fees for
professional services.
The Company expects selling, general and administrative expenses to
increase as it implements, operates and maintains OBN, its direct marketing
efforts and the rollout of the AOL service offering. These efforts will require
additional personnel, equipment and support. The additional selling, general and
administrative expenses may be offset by the increased sales and profit gained
as a result of the implementation of the components of the Company's strategic
plan, but increased costs may have an adverse impact on results of operations.
Investment and Other Income. Investment and other income was $10.6
million in 1996 versus $331,000 in 1995. Investment and other income for the
year ended December 31, 1996 includes two nonrecurring gains : a $1.4 million
gain on the sale of securities of another long distance company and a $1.5
million gain on the sale of short term U.S. Treasury securities. The remainder
of investment and other income consists primarily of interest income earned on
the Company's cash balances resulting primarily from the unapplied proceeds of
the Company's public offering in April and May 1996 and excess cash from
operations.
As a result of the Company's purchase of ABA for approximately $21.4
million in total consideration and the $100 million initial payment to AOL,
interest income for future periods is expected to be significantly less than
amounts realized in 1996.
Provision for income taxes. The Company's effective tax rate declined
to 37.7% in 1996 from the pro forma effective tax rate of 40.0% in 1995 due to
the lower effective state tax rate in 1996.
-35-
YEAR ENDED DECEMBER 31, 1995 COMPARED TO YEAR ENDED DECEMBER 31, 1994
Sales. Sales increased by 117.4% to $180.1 million in 1995 from $82.8
million in 1994. The increase in sales related primarily to the continued
expansion of the Company's distribution network of partitions, as well as
increases in the number of end users obtained by the Company's existing
partitions. As a result of the favorable contract tariffs obtained from AT&T,
which took effect in July 1994, revenue from marketing inbound 800 service
increased significantly in 1995, totaling $55.6 million for the year ended
December 31, 1995 and accounting for approximately 30.9% of 1995 sales compared
to $7.9 million, or 9.5% of sales, for the year ended December 31, 1994. The
Company's revenues for private line services represented approximately 10.2% of
1995 sales compared to an insignificant amount from such services in 1994.
Cost of Sales. The Company's cost of sales increased by 122.7% to
$156.1 million in 1995 from $70.1 million in 1994, primarily as a result of the
increase in sales by 117.4%. Cost of sales as a percentage of revenues increased
at a higher rate than sales because the Company offered higher volume discounts
to certain partitions.
Gross Margin. Gross margin decreased to 13.3% for the year ended
December 31, 1995 from 15.4% for the year ended December 31, 1994. The decrease
in gross margin was attributable primarily to the addition of new partitions who
received higher volume discounts. Billing costs remained relatively constant as
a percentage of sales during both of these periods.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased by 82.5%, to $6.3 million in 1995 from $3.4
million in 1994, but decreased as a percentage of sales to 3.5% from 4.2%.
Selling, general and administrative expenses decreased as a percentage of sales
due to the Company's ability to spread its overhead expenses over a larger sales
base. The increase in selling, general and administrative expenses was due
primarily to the increase in personnel from 27 to 37 employees, resulting from
the increased administrative and management demands on the Company as it has
grown, and an increase in fees for professional services.
Pro Forma Income Taxes. On June 1, 1991, the Company, with the consent
of its stockholders, elected to be taxed as an S Corporation. As a result of the
election, all earnings of the Predecessor Corporation were taxed directly to the
stockholders. Accordingly, the statements of income, prior to the termination of
the S Corporation status on September 19, 1995, did not include provisions for
income taxes. Pro forma income tax provisions have been calculated as if the
Company's results of operations were taxable as a C Corporation under the
Internal Revenue Code for all periods presented. See Note 10 to Consolidated
Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES
The Company consummated its initial public offering of 10,350,000
shares of Common Stock in September and October of 1995. The Company received
net proceeds from such offering of $42.8 million, of which $4.5 million was used
to pay the minority stockholder. The Company consummated a public offering of
17,068,000 shares of Common Stock in April and May, 1996. The Company received
net proceeds from such offering of approximately $139.1 million. In addition,
during 1996, certain options and warrants to purchase shares of the Company's
Common Stock were exercised and the Company received net proceeds of
approximately $4.9 million and $7.4 million, respectively. The tax benefit
realized from the exercise of options and warrants was approximately $21.3
million and is reflected as an adjustment to additional paid-in capital and
taxes payable. At December 31, 1996, the Company had cash, cash equivalents and
marketable securities of approximately $157.3 million.
-36-
Since its inception, the Company has funded its operations primarily
from cash generated by operations and, to a lesser extent, advances from
stockholders and bank borrowings. The Company's net cash flow provided by
operations was $10.7 million, $24.5 million and $1.6 million for the years ended
December 31, 1996, 1995 and 1994, respectively. Cash provided was $43.9 million,
$10.5 million and $10.2 million for the years ended December 31, 1996, 1995 and
1994, respectively, resulting from net income plus reconciling items. The
primary reconciling item for the year ended December 31, 1996 was the tax
benefit associated with the exercise of stock options and warrants. Cash was
used for accounts receivable, advances to partitions and note receivables
increases. Increases in advances to partitions and note receivables are due to
the Company's increased assistance to new and existing partitions to support
their marketing efforts.
The Company's working capital was $175.6 million and $38.2 million at
December 31, 1996 and 1995, respectively. The significant increase in working
capital is primarily a result of the completion of the Company's public offering
in April and May, 1996.
The Company invested $27.7 million in capital equipment during the year
ended December 31, 1996, of which $22.7 million was used for the acquisition of
capital equipment and installation costs relating to the deployment of OBN. To
date, through December 31, 1996, the Company has invested $24.9 million for the
acquisition of capital equipment and installation costs relating to the
deployment of OBN . In June 1996, the Company purchased a new headquarters
building in New Hope, Pennsylvania for approximately $1.5 million. In July 1996,
the Company also purchased a building in Clearwater, Florida which is used for
direct marketing and customer service for approximately $900,000.
In March 1996, the Company negotiated an unsecured, committed line of
credit with PNC Bank, N.A. ("Credit Facility") under which borrowings of up to
$50.0 million are available. The Company is required to pay an availability fee
of $62,500 per annum, or 0.125% of the total available borrowings. Interest on
borrowings is payable monthly at PNC Bank's prime rate less 0.5% or LIBOR plus
0.875%, at the Company's option. Principal is payable upon demand by PNC Bank.
Under the terms of the Credit Facility, the Company must maintain certain
financial covenants and adhere to certain restrictions. At December 31, 1996,
the Company had no borrowings outstanding under the Credit Facility. During
February 1997, the bank provided a temporary increase in the amount available
under the agreement to $60.0 million under similar terms to the existing credit
facility. See "RECENT DEVELOPMENTS".
The Company has used a portion of the proceeds from its 1996 stock
offering for: (i) advances to new and existing partitions to support their
marketing efforts, (ii) procurement of additional hardware and software for OBN,
(iii) direct marketing efforts, including the ABA transaction, and a direct
marketing center in Clearwater, Florida, and (iv) the purchase of a new
headquarters building in New Hope, Pennsylvania. In February 1997, the Company
made an initial payment of $100 million to AOL in conjunction with the AOL
Agreement more fully described in Recent Developments. The Company intends to
use the remaining proceeds: (i) to further fund new and existing partitions,
(ii) to expand direct marketing efforts, and (iii) to take advantage of growth
opportunities, including but not limited to, possible acquisitions. At December
31, 1996, excess cash was invested primarily in a U.S. Treasury Bill. Generally,
excess cash is invested primarily in short term government securities and cash
equivalents consisting of money market accounts with major international
brokerage firms. The Company has had to spend less of the proceeds of the 1996
stock offering to start up OBN than originally planned because of the new AT&T
contract tariff, which allows the Company to avoid some of the costs associated
with moving existing end users to OBN and permits the Company to phase in OBN
more cost effectively by not leasing transmission facilities before traffic
levels are sufficient to fill them.
The Company does not have a significant concentration of credit risk
with respect to accounts receivable due to the large number of partitions and
end users comprising the Company's customer base and their dispersion across
different geographic regions. The Company maintains reserves for potential
credit losses and, to date, such losses have been within the Company's
expectations.
The Company believes that its current cash position, marketable
securities, the Credit Facility and the cash flow expected to be generated from
operations, will be sufficient to fund its capital expenditures, working capital
and other cash requirements for at least the next twelve months.
RECENT DEVELOPMENTS
On February 25, 1997, the Company announced that it had entered into a
Telecommunications Marketing Agreement (the "AOL Agreement"), dated as of
February 22, 1997 and effective as of February 25, 1997, with America Online,
Inc. ("AOL"), under which the Company will be the exclusive provider of
long-distance telecommunications services to be marketed by AOL to all of the
subscribers to AOL's online network under a distinctive brand name to be used
exclusively for the Company's services. The services will include provision for
online sign-up, call detail and reports and credit card payment. Under the AOL
Agreement, AOL will provide millions of dollars of online advertising and
promotion of the services and provide
-37-
all of its subscribers with access to a dedicated service area online for the
Company. AOL subscribers who sign-up for the telecommunications services will be
customers of the Company, as the carrier providing such services. The Company
also has certain rights under the AOL Agreement to offer, on a comparably
exclusive basis, local and wireless telecommunications services when available.
It is anticipated that the services will be tested in the early summer
and offered generally to AOL subscribers in the fall of 1997. The AOL Agreement
has an initial term of three years and can be extended by AOL on an annual basis
thereafter.
Under the AOL Agreement, the Company made an initial payment of $100
million to AOL at signing and agreed to provide marketing payments to AOL based
on a percentage of the Company's profits from the services (between 50% and 70%,
depending on the number of subscribers to the services). The AOL Agreement
provides that $43 million of the initial payment will be offset and recoverable
by the Company through reduction of such profit-based marketing payments during
the initial term of the AOL Agreement or, subject to certain monthly reductions
by offset of the amount thereof, directly by AOL upon certain earlier
terminations of the AOL Agreement. The $57 million balance of the initial
payment will be offset and is recoverable through a percentage of such
profit-based marketing payments made after the first five years of the AOL
Agreement (when extended beyond the initial term) and by offset against a
percentage of AOL's share of the profits from the services after termination or
expiration of the AOL Agreement. Any portion of the $43 million not previously
recovered or reduced in amount would be added to the $57 million and would be
recoverable similarly.
Also under the AOL Agreement, the Company issued to AOL at signing two
warrants to purchase shares of the Company's common stock at a premium over the
market value of such stock on the issuance date. One warrant is for 5 million
shares, at an exercise price of $15.50 per share, one-half of which shares will
vest at the time the service is first made generally available to AOL online
network subscribers in accordance with the AOL Agreement or the first
anniversary of the warrant issuance, whichever is earlier, and the balance of
which will vest on the first anniversary of issuance if the AOL Agreement has
not terminated. The other warrant is for up to 7 million shares, at an exercise
price of $14.00 per share, which will vest, commencing December 31, 1997, based
on the number of subscribers to the services and would vest fully if there are
at least 3.5 million such subscribers at any one time. The Company also agreed
to issue to AOL an additional warrant to purchase 1 million shares of its common
stock, at market value at the time of issuance, upon each of the first two
annual extensions by AOL of the term of the AOL Agreement, which warrants also
will vest based on the number of subscribers to the services.
In connection with the AOL Agreement, the Company and AOL will jointly
develop the online marketing and advertising for the services. The Company will
provide online customer service as well as inbound calling customer service to
the AOL subscribers in connection with the services. While the Company expects
to utilize its Clearwater, Florida facility to provide customer service support
to AOL subscribers, the Company may need to increase staffing and purchase
equipment to support this activity. The Company anticipates that it will incur
expenses for the start-up and development of the services contemplated in the
AOL Agreement during 1997, including expenses for the expansion of the
Clearwater operation, for software programming and for software and hardware
additions to the Company's network, OBN, to expand its capacity for the traffic.
The Company believes that the increased revenues to the Company resulting from
the AOL Agreement and the services offered pursuant thereto will be limited in
1997, but could be significant in 1998, although there can be no assurance that
these results can be achieved in light of a number of uncertainties, including
the following: the Company's ability to timely develop the online ordering, call
detail, billing and customer services for the AOL subscribers, which will
require, among other things, being able to identify and employ sufficient
personnel qualified to provide necessary programming; the Company's and AOL's
ability to work effectively together to jointly develop the online marketing
contemplated by the AOL Agreement; the response rate to online promotions of
AOL's online subscribers, most of whom are expected to be residential rather
than businesses, which have historically been the Company's customer base; the
Company's ability to expand OBN to accommodate increased traffic levels; and
AOL's ability to successfully execute its publicly stated business plan and
implement its announced network changes to improve subscriber access to its
online service.
The Company funded the $100 million initial payment by borrowing $50
million under its Credit Facility under a temporary increase in the facility to
$60 million, and an additional $50 million as a margin advance from one of its
brokers. Currently, the Company holds a U.S. Treasury Bill with a face value of
$150 million, which matures in November 1997, as security for the advance.
-38-
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Certified Public Accountants 40
Consolidated balance sheets as of December 31, 1996 and 1995 41
Consolidated statements of income for the years ended
December 31, 1996, 1995, and 1994 42
Consolidated statements of stockholders' equity for the years
ended December 31, 1996, 1995 and 1994 43
Consolidated statements of cash flows for the years ended
December 31, 1996, 1995 and 1994 44
Notes to consolidated financial statements 45
-39-
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors
and Stockholders of Tel-Save Holdings, Inc.
We have audited the accompanying consolidated balance sheets of
Tel-Save Holdings, Inc. and subsidiaries as of December 31, 1996 and 1995, and
the related consolidated statements of income, stockholders' equity and cash
flows for each of the three years in the period ended December 31, 1996. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Tel-Save
Holdings, Inc. and subsidiaries as of December 31, 1996 and 1995, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1996 in conformity with generally accepted
accounting principles.
/s/ BDO Seidman, LLP
BDO Seidman, LLP
New York, New York
January 29, 1997
-40-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except for share data)
December 31,
---------------------------------------
1996 1995
---------------------------------------------------------------------------- --------------------- -----------------
ASSETS
CURRENT:
Cash and cash equivalents $ 8,023 $41,211
Marketable securities 149,237 -
Accounts receivable, trade net of allowance for 19,971 19,088
uncollectible accounts of $987 and $804, respectively
Advances to partitions and note receivables 13,410 3,563
Due from broker 867 1,100
Prepaid expenses and other current assets 10,377 194
---------------------------------------------------------------------------- --------------------- -----------------
TOTAL CURRENT ASSETS 201,885 65,156
Property and equipment, net 30,097 2,667
Intangibles, net 21,102 1,490
Note receivable from stockholder - 2,075
Other assets 3,924 -
---------------------------------------------------------------------------- --------------------- -----------------
TOTAL ASSETS $257,008 $71,388
---------------------------------------------------------------------------- --------------------- -----------------
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT:
Accounts payable and accrued expenses:
Trade and other $ 17,812 $12,622
Partitions 4,398 3,047
Sales and excise taxes payable 1,592 1,406
Other 1,619 514
Securities sold short, at cost to purchase 867 1,100
Income taxes payable - 2,375
Note payable to stockholder - 5,921
---------------------------------------------------------------------------- --------------------- -----------------
TOTAL CURRENT LIABILITIES 26,288 26,985
Deferred credits - 280
Deferred income taxes payable - 2,809
---------------------------------------------------------------------------- --------------------- -----------------
TOTAL LIABILITIES 26,288 30,074
---------------------------------------------------------------------------- --------------------- -----------------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY
Preferred stock, $.01 par value, 5,000,000 shares - -
authorized; no shares outstanding
Common stock - $.01 par value, 100,000,000 shares 622 195
authorized; 62,237,998 and 19,500,000 issued and
outstanding, respectively
Additional paid-in capital 210,616 37,245
Retained earnings 24,042 3,874
Treasury stock (4,560) -
---------------------------------------------------------------------------- --------------------- -----------------
TOTAL STOCKHOLDERS' EQUITY 230,720 41,314
---------------------------------------------------------------------------- --------------------- -----------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $257,008 $71,388
---------------------------------------------------------------------------- --------------------- -----------------
See accompanying notes to consolidated financial statements.
-41-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except for per share data)
Year Ended December 31,
-----------------------
1996 1995 1994
---- ---- ----
Sales $232,424 $180,102 $ 82,835
Cost of sales 200,597 156,121 70,104
- -------------------------------------------- ------------------ -------------------- -----------------
Gross profit 31,827 23,981 12,731
Selling, general and administrative
expenses 10,039 6,280 3,442
- -------------------------------------------- ------------------ -------------------- -----------------
Operating income 21,788 17,701 9,289
Investment and other income, net 10,585 331 66
- -------------------------------------------- ------------------ -------------------- -----------------
Income before provision for income taxes 32,373 18,032 9,355
Provision for income taxes 12,205 8,997 -
- -------------------------------------------- ------------------ -------------------- -----------------
Net income $ 20,168 $ 9,035 $ 9,355
============================================ ================== ==================== ==================
Pro forma:
Income before provision for income taxes $ 18,032 $ 9,355
Pro forma provision for income taxes 7,213 3,742
- -------------------------------------------- ------------------ -------------------- -----------------
Pro forma net income $ 10,819 $ 5,613
- -------------------------------------------- ------------------ -------------------- -----------------
Net income per share - Primary $ .35 $ .32 $ .18
- -------------------------------------------- ------------------ -------------------- -----------------
Weighted average common and common
equivalent
shares outstanding - Primary 57,002 33,605 30,663
- -------------------------------------------- ------------------ -------------------- -----------------
Net income per share - Fully Diluted $ .35 $ .32 $ .18
- -------------------------------------------- ------------------ -------------------- -----------------
Weighted average common and
common equivalent
shares outstanding - Fully Diluted 58,027 33, 605 30,663
- -------------------------------------------- ------------------ -------------------- -----------------
See accompanying notes to consolidated financial statements.
-42-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(In thousands)
Common Stock Additional
--------------------- Paid-in Retained Treasury
Shares Amount Capital Earnings Stock Total
- --------------------------------------------------------------------------------------------------------------------------
Balance, January 1, 1994 9,550 $ 95 $ -- $ 4,592 $ -- $ 4,687
Net income -- -- -- 9,355 -- 9,355
------- -------- -------- -------- -------- ---------
Balance, December 31, 1994 9,550 95 -- 13,947 -- 14,042
Net income -- -- -- 9,035 -- 9,035
Cash distributions -- -- -- (13,200) -- (13,200)
Stock redemption -- -- -- (11,400) -- (11,400)
Reclassification of S Corporation deficit -- -- (5,492) 5,492 -- --
Sale of common stock 3,450 35 42,802 -- -- 42,837
Three-for-two stock split 6,500 65 (65) -- -- --
------- -------- -------- -------- -------- ---------
Balance, December 31, 1995 19,500 195 37,245 3,874 -- 41,314
Net income -- -- -- 20,168 -- 20,168
Issuance of warrants to partitions -- -- 1,077 -- -- 1,077
Sale of common stock 8,534 85 138,984 -- -- 139,069
Exercise of common stock options 1,079 11 4,927 -- -- 4,938
Exercise of warrants 2,006 20 7,383 -- -- 7,403
Income tax benefit related to
exercise of common stock options
and warrants -- -- 21,311 -- -- 21,311
Acquisition of treasury stock -- -- -- -- (4,560) (4,560)
Two-for-one stock split 31,119 311 (311) -- -- --
------- -------- -------- -------- -------- ---------
Balance, December 31, 1996 62,238 $ 622 $ 210,616 $ 24,042 $(4,560) $ 230,720
- --------------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
-43-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Year Ended December 31,
-----------------------------------------------
1996 1995 1994
- ------------------------------------------------------------------------------------------------------------------------------------
Cash flows from operating activities:
Net income $ 20,168 $ 9,035 $ 9,355
Adjustment to reconcile net income to net
cash provided by operating
activities:
Unrealized loss on securities 179 234 --
Provision for bad debts 38 (28) 52
Depreciation and amortization 2,462 1,287 477
Deferred credits (280) -- 280
Income tax benefit related to exercise of options and warrants 21,311 -- --
(Increase) decrease in:
Accounts receivable, trade (1,065) (2,996) (10,899)
Advances to partitions and note receivables (20,797) (1,700) (1,862)
Prepaid expenses and other current assets (10,183) 1,400 (804)
Other assets (3,924) -- --
Increase (decrease) in:
Accounts and partition payables and accrued expenses 7,978 12,047 5,023
Income taxes payable (5,184) 5,184 --
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 10,703 24,463 1,622
- ------------------------------------------------------------------------------------------------------------------------------------
Cash flows from investing activities:
Acquisition of intangibles (9,800) (1,057) (2,007)
Capital expenditures, net (27,679) (2,330) (343)
Securities sold short (411) 866 --
Due from broker 233 (1,100) --
Loans to stockholder (3,034) (2,075) --
Repayments of stockholder loan 5,109 -- --
Purchase of marketable securities (149,238) -- --
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used in investing activities (184,820) (5,696) (2,350)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash flows from financing activities:
Proceeds from related party transactions -- -- 7,767
Payments to related parties -- (1,725) (7,038)
Payment of note payable to stockholder (5,921) (979) --
Proceeds from sale of common stock 139,069 42,837 --
Proceeds from exercise of options and warrants 12,341 -- --
Acquisition of treasury stock (4,560) -- --
Distributions to stockholders -- (13,200) --
Stock redemption -- (4,500) --
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 140,929 22,433 729
- ------------------------------------------------------------------------------------------------------------------------------------
Net (decrease) increase in cash and cash equivalents (33,188) 41,200 1
Cash and cash equivalents, at beginning of period 41,211 11 10
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents, at end of period $ 8,023 $ 41,211 $ 11
- ------------------------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
-44-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 -- SUMMARY OF ACCOUNTING POLICIES
(a) Business
Tel-Save Holdings, Inc. (the "Company"), which is incorporated in
Delaware, provides long distance services to small and medium-sized businesses
located throughout the United States. The Company's long distance service
offerings include outbound service, inbound toll-free 800 service and dedicated
private line services for data. The Company markets these services nationally
primarily through direct marketing and an established distribution network of
independent long distance and marketing companies known as "partitions".
(b) Reorganization
On September 21, 1995, the Company consummated its initial public
offering ("IPO") (Note 8(b)). The shares of Tel-Save, Inc., a Pennsylvania
corporation (the "Predecessor Corporation"), owned by the two founding
stockholders were contributed to the Company as of the date of the IPO. The
majority stockholder exchanged all of his shares of the Predecessor Corporation
for 21,060,000 shares of the common stock of the Company plus loans of up to
$5,000,000. The majority stockholder repaid his outstanding indebtedness,
including interest, using a portion of his proceeds from the sale of 1,500,000
shares of common stock in connection with the Company's public offering in April
1996 (Note 8(a)).
The minority stockholder exchanged all his shares of the Predecessor
Corporation for 7,590,000 shares of the common stock of the Company, $4,500,000
in cash plus a note (the "Cash Flow Note") in the original principal amount of
$6,900,000 bearing interest at 10% per annum which was guaranteed by the
majority stockholder. The payment and the issuance of the Cash Flow Note to the
minority stockholder are accounted for as a distribution of capital. In January
1996, the Company paid the remaining balance of $5,921,000 due under the Cash
Flow Note. The transactions described above are collectively referred to as the
"Reorganization."
(c) Basis of financial statements presentation
The consolidated financial statements include the accounts of Tel-Save
Holdings, Inc. and its two wholly-owned subsidiaries and have been prepared as
if the entities had operated as a single consolidated group since their
respective dates of incorporation. All intercompany balances and transactions
have been eliminated.
In preparing financial statements in conformity with generally accepted
accounting principles, management is required to make estimates and assumptions
that affect the reported amounts of assets and liabilities and the disclosure of
contingent assets and liabilities at the date of the financial statements and
revenues and expenses during the reporting period. Actual results could differ
from those estimates.
(d) Recognition of revenue
The Company recognizes revenue upon completion of telephone calls by
end users. Allowances are provided for estimated uncollectible usage.
(e) Cash and cash equivalents
The Company considers all temporary cash investments purchased with a
maturity of three months or less to be cash equivalents.
-45-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(f) Marketable securities
The Company buys and holds securities principally for the purpose of
selling them in the near term and therefore, they are classified as trading
securities and carried at market. Unrealized holding gains and losses
(determined by specific identification) on investments classified as trading
securities are included in earnings.
(g) Prepaid marketing costs
Certain costs associated with direct marketing to end users are
amortized over a six month period.
(h) Property and equipment and depreciation
Property and equipment are recorded at cost. Depreciation and
amortization is calculated using the straight-line method over the estimated
useful lives of the assets, which range from three to thirty-nine years.
(i) Intangibles and amortization
Intangibles include the costs to acquire billing bases of customer
accounts, long-distance service contract pricing plans and goodwill arising from
business acquisitions. Amortization is computed on a straight-line basis over
the estimated useful lives of the intangibles which range from 1 to 40 years.
(j) Long-lived assets
The Company adopted SFAS No. 121, "Accounting For the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed of" as of January 1,
1996 and its implementation did not have a material effect on the consolidated
financial statements.
(k) Income taxes
Deferred tax assets and liabilities are recorded for the estimated
future tax effects attributable to temporary differences between the basis of
assets and liabilities recorded for financial and tax reporting purposes (Note
10).
(l) Net income per share
The computation of net income per share is based on the weighted
average number of common shares outstanding during the period plus the effect of
common shares issuable upon exercise of stock options and warrants. Fully
diluted earnings per share also reflect additional dilution related to stock
options and warrants due to the use of the market price at the end of the period
when this price is higher than the average price for the period. Net income per
share for the years ended December 31, 1995 and 1994 is based on pro forma net
income.
All references in the consolidated financial statements with regard to
average number of common stock and related per share amounts have been
calculated giving retroactive effect to the exchange of shares in the
Reorganization and the stock splits.
-46-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(m) Financial instruments and risk concentration
Financial instruments which potentially subject the Company to
concentrations of credit risk are cash investments and marketable securities. At
December 31, 1996, a large majority of the Company's cash investments and
marketable securities were invested in U.S. government securities and money
market funds. The carrying amount of these cash investments approximates the
fair value due to their short maturity. The Company believes no significant
concentration of credit risk exists with respect to these cash investments and
marketable securities.
(n) Securities sold short/financial investments with off-balance sheet
risk
At December 31, 1996, securities sold short by the Company, which
consist of equity securities valued at market, resulted in an obligation to
purchase such securities at a future date. The short position was closed in
March 1997 and the Company recorded a loss of $54,000.
NOTE 2 -- MAJOR PARTITIONS
Partitions who provided end user accounts, which in the aggregate
account for more than 10% of sales, are as follows:
Number Of Total Percentage
Partitions Of Sales
----------- ---------------
Year ended December 31, 1996 1 11%
Year ended December 31, 1995 -- --
Year ended December 31, 1994 1 13%
NOTE 3 -- PROPERTY AND EQUIPMENT
December 31,
-------------------------
1996 1995
---- ----
(In thousands)
Land $ 220 $ --
Buildings and building improvements 3,398 --
Switching equipment under construction 24,861 2,126
Equipment, vehicles and other 2,117 791
-------- --------
30,596 2,917
Less: Accumulated depreciation (499) (250)
-------- --------
$ 30,097 $ 2,667
======== ========
Switching equipment under construction represents the costs associated
with the purchase of AT&T switching equipment and the related installation costs
incurred through December 31, 1996 for the deployment of the Company's
telecommunications network -- One Better Net ("OBN").
-47-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4 - INTANGIBLES
Year ended December 31,
--------------------------
1996 1995
---- ----
(In thousands)
Goodwill $18,356 $ -
Other 6,533 3,064
------- -----
24,889 3,064
Less: Accumulated amortization 3,787 1,574
------- -----
$21,102 $1,490
======= ======
Amortization expense was $2,213,000, $1,157,000 and $417,000 for the
years ended December 31, 1996, 1995 and 1994.
NOTE 5 - ACQUISITION
On December 13, 1996, in connection with the settlement of certain
disagreements among the Company, American Business Alliance, Inc. ("ABA") and
the shareholders of ABA, the Company acquired substantially all of the assets of
ABA, an independent long distance and marketing company which was previously a
partition of the Company, for a total purchase price of $21,369,000, comprised
of: (1) cash payment of $9,450,000, (2) assumption of $970,000 of liabilities
and (3) the release of ABA's outstanding obligations to the Company of
$10,949,000.
This transaction was accounted for as a purchase with the results of
ABA included in the consolidated financial statements from the acquisition date.
The cost in excess of the net assets acquired (goodwill) was approximately
$18,356,000 and is being amortized over forty years using the straight-line
method.
The following pro forma consolidated financial information has been
prepared to reflect the acquisition of the assets of ABA. The pro forma
financial information is based on the historical financial statements of the
Company and ABA. The pro forma financial information is unaudited and is not
necessarily indicative of what the actual results of operations of the Company
would have been assuming the transaction had been completed as of January 1,
1995 and neither is it necessarily indicative of the results of operations for
future periods.
Year ended December 31,
----------------------------
1996 1995
------------ -----------
(unaudited) (unaudited)
(In thousands)
Net sales $233,067 $181,220
Net income 13,778 10,269
Net income per share .24 .31
The above pro forma operating results include each company's results of
operations for the indicated years and have been adjusted to adopt the Company's
accounting policy for ABA's marketing costs (amortization of certain direct
marketing costs over a six month period), reflect the amortization of the
goodwill, as generated by the acquisition, over a 40 year period, elimination of
the interest income on the $9,450,000 cash payment in connection with the
acquisition and reduction of provision for income taxes resulting from the
utilization of ABA's net operating losses.
-48-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6 -- REVOLVING LOAN AGREEMENT
In March 1996, the Company entered into a revolving loan agreement with
an unsecured, committed line of credit with a bank under which borrowings of $50
million are available through March 18, 1997. The Company is required to pay an
availability fee per annum of 0.125% of the total available borrowings.
Principal is payable upon demand by the bank. Interest is payable monthly at the
bank's prime rate less 0.5% or LIBOR plus 0.875%, at the Company's option. Under
the terms of the agreement, the Company must maintain certain financial
covenants and adhere to certain restrictions. At December 31, 1996, the Company
had no borrowings outstanding under the agreement. During February 1997, the
bank provided a temporary increase in the amount available under the agreement
to $60 million.
NOTE 7 -- RELATED PARTY TRANSACTIONS
In connection with the Reorganization (Note 1(b)), the Company made
distributions of the Company's 1995 taxable income through September 19, 1995 of
approximately $13,200,000 in 1995 to its two founding stockholders.
NOTE 8 -- STOCKHOLDERS' EQUITY
(a) 1996 Public Offering
The Company consummated a public offering (the "1996 Offering") of
18,568,000 shares of common stock (adjusted to reflect the most recent stock
split, Note 8(c)), including the underwriter's over-allotment, at a price of
$8.75 per share in April and May, 1996. Of the 18,568,000 shares offered,
17,068,000 were sold by the Company and 1,500,000 were sold by the majority
stockholder. Proceeds of the 1996 Offering to the Company, less underwriting
discounts of approximately $9,302,000, were approximately $140,043,000. Expenses
for the 1996 Offering were approximately $974,000 resulting in net proceeds to
the Company of approximately $139,069,000. The majority stockholder used a
portion of his proceeds to repay his outstanding indebtedness, including
interest, to the Company.
(b) Initial Public Offering
In September and October, 1995, the Company consummated its IPO of
10,350,000 shares of common stock (adjusted to reflect stock splits, Note 8(c)),
including the underwriter's overallotment option, at a price of $4.59 per share.
Proceeds of the offering less underwriting discounts of approximately $3,151,000
were $44,287,000. Expenses for the IPO totaled approximately $1,450,000,
resulting in net proceeds to the Company of approximately $42,837,000.
In connection with the IPO, the Company issued warrants to purchase
900,000 shares of common stock to the underwriter. The exercise price of the
warrants is $5.73 per share of common stock and such warrants expire on
September 21, 2000.
(c) Stock Splits
On January 3, 1997, the Company's Board of Directors approved a
two-for-one split of the common stock in the form of a 100% stock dividend. The
additional shares resulting from the stock split were distributed on January 31,
1997 to all stockholders of record at the close of business on January 17, 1997.
The consolidated balance sheet as of December 31, 1996 and the consolidated
statement of stockholders' equity for the year ended December 31, 1996 reflect
the recording of the stock split as if it had occurred on December 31, 1996.
-49-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
On February 16, 1996, the Company's Board of Directors approved a
three-for-two split of the common stock in the form of a 50% stock dividend. The
additional shares resulting from the stock split were distributed on March 15,
1996, to all stockholders of record at the close of business on February 29,
1996. The consolidated balance sheet as of December 31, 1995 and the
consolidated statement of stockholders' equity for the year ended December 31,
1995 reflect the recording of the stock split as if it had occurred on December
31, 1995.
Further, all references in the consolidated financial statements to
average number of shares outstanding and related prices, per share amounts,
warrant and stock option data have been restated for all periods to reflect the
stock splits.
(d) Authorized Shares
During 1996, the Board of Directors and stockholders approved the
increase in the number of authorized shares of the Company's $0.01 par value
common stock to 100,000,000 shares.
NOTE 9 - STOCK OPTIONS AND WARRANTS
(a) Stock Options
At December 31, 1996, the Company had option agreements with most of
its key employees and had one stock option plan. The agreements and plan are
more fully described below. The Company applies Accounting Principles Board
Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees," and related
Interpretations in accounting for the agreement and the plan. Under APB No. 25,
when the exercise price of the Company's employee stock options equals the
market price of the underlying stock on the date of the grant, no compensation
cost is recognized. The following is a summary of the agreements and the option
plan:
Prior to the Company's Initial Public Offering in September, 1995, the
Company granted ten key employees options to purchase shares of the Company's
common stock. The options, which were valued based on the fair market value of
the Company at the date of grant, vest 22 months from the date of issuance and
expire five years from the date of grant. All options were vested as of December
31, 1996.
In September 1995 and March 1996, the Company granted options to
purchase a total of 70,000 shares of common stock to each of the two nonemployee
directors of the Company.
In September 1995, the Company's Board of Directors and stockholders
adopted the Company's 1995 Employee Stock Option Plan (the "Option Plan") which
provided for the granting of up to 1,950,00 shares of common stock. An amendment
to the Option Plan was approved by the Board of Directors and stockholders in
April 1996 increasing the authorized number of options which can be granted
under the Option Plan to 5,000,000 shares of common stock. As of December 31,
1996, 4,985,000 options had been granted under the Option Plan.
In 1996 the Company granted certain employees 3,561,000 non-qualified
options to purchase shares of the Company's common stock.
The exercise price of all stock options granted under the agreements
and Option Plan is at least equal to the fair market value of such shares on the
date of the grant. Options become exercisable from one to three years from the
date of the grant.
-50-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SFAS No. 123, "Accounting for Stock-Based Compensation," requires the
Company to provide pro forma information regarding net income and earnings per
share as if compensation cost for the Company's stock options had been
determined in accordance with the fair value-based method prescribed in SFAS No.
123. The Company estimates the fair value of each stock option at the grant date
by using the Black-Scholes option-pricing model with the following
weighted-average assumptions used for grants in 1995 and 1996, respectively: no
dividends paid for all years; expected volatility of 40.4% for all years (due to
the Company's limited trading history, average volatility of several similar
telecommunication companies was used); weighted average risk-free interest rates
of 5.8% and 5.7%, respectively; and expected lives of 1 to 4 years.
Under the accounting provisions of SFAS No. 123, the Company's net
income and earnings per share would have been reduced to the pro forma amounts
indicated below.
1996 1995
---- ----
Net income (in thousands)
As reported $ 20,168 $ 10,819
Pro forma $ 16,521 $ 10,436
Primary earnings
As reported $ .35 $ .32
Pro forma $ .29 $ .31
Fully diluted earnings per share
As reported $ .35 $ .32
Pro forma $ .28 $ .31
-51-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following tables contain information on stock options for the three
year period ended December 31, 1996:
Exercise Weighted
price range average
Option Shares per share exercise price
- -------------------------------------------------------------------------------------------------------------
Outstanding, January 1, 1994 1,515,600 $.32 $.32
Granted 940,200 $.59-$1.57 $.75
- -------------------------------------------------------------------------------------------------------------
Outstanding, December 31, 1994 2,455,800 $.32-$1.57 $.48
Granted 1,950,000 $4.58 $4.58
- -------------------------------------------------------------------------------------------------------------
Outstanding, December 31, 1995 4,405,800 $.32-$4.58 $2.30
Granted 6,736,000 $4.09-$12.00 $7.96
Exercised (2,158,000) $.32-$5.67 $2.28
- -------------------------------------------------------------------------------------------------------------
Outstanding, December 31, 1996 8,983,800 $.32-$12.00 $6.54
- -------------------------------------------------------------------------------------------------------------
Exercise Weighted
price range average
Exercisable at year-end Option Shares per share exercise price
- -------------------------------------------------------------------------------------------------------------
1994 - - -
1995 1,515,600 $.32 $.32
1996 2,649,800 $.32-$4.58 $2.82
- -------------------------------------------------------------------------------------------------------------
Options granted in Weighted-average fair value
- -------------------------------------------------------------------------------------------------------------
1995 $1.14
1996 $2.39
- -------------------------------------------------------------------------------------------------------------
The following table summarizes information about stock options
outstanding at December 31, 1996:
Range of exercise prices
- -------------------------------------------------------------------------------------------------------------
$.32-$1.57 $4.09-$5.92 $8.25-$9.63 $10.50-$12.00 $.32-$12.00
-------------- -------------- ------------- --------------- -------------
Outstanding Options
Number outstanding
at December 31, 1996 1,114,800 4,308,000 505,000 3,056,000 8,983,800
Weighted-average
remaining contractual
life (years) 1.64 2.07 2.42 2.59 2.21
Weighted-average
exercise price $.38 $4.74 $8.68 $10.98 $6.54
Exercisable options
Number outstanding
at December 31, 1996 1,114,800 1,535,000 - - 2,649,800
Weighted-average
exercise price $.38 $4.58 - - $2.82
-52-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(b) Warrants
At December 31, 1996, the Company had warrant agreements with certain
partitions and the underwriter for its IPO (Note 8(b)). All warrants
were issued with exercise prices equal to or above the market price of
the underlying stock at the date of the grant. These warrants are
accounted for based on their fair value. At December 31, 1996,
1,900,000 warrants were outstanding with exercise prices ranging from
$4.67 to $5.73 and an average weighted exercise price of $5.00 and
600,000 which were currently exercisable at a weighted exercise price
of $5.73. The remaining warrants are exercisable over a one to two year
period beginning in January 1997. Further, at December 31, 1996, an
additional 1,812,000 warrants were outstanding although the Company
currently does not believe that the performance criteria associated
with these warrants will be satisfied. In January 1997, 800,000 of the
warrants were purchased by the Company and recorded as a reduction in
additional paid-in capital. See also Note 13.
NOTE 10 -- INCOME TAXES
On June 1, 1991, the Company, with the consent of its stockholders,
elected to be taxed as an S Corporation. As a result of the election, all
earnings of the Predecessor Corporation were taxed directly to the stockholders.
Accordingly, the statements of income prior to September 20, 1995 did not
include provisions for income taxes. In connection with the Company's IPO, as
described in Note 8(b), on September 19, 1995, the Company terminated its S
Corporation status. Pro forma tax provisions have been calculated as if the
Company's results of operations were taxable as a C Corporation under the
Internal Revenue Code for the years ended December 31, 1995 and 1994.
The following summarizes the provision for pro forma income taxes:
Year ended December 31,
-----------------------
1995 1994
---- ----
(In thousands)
Current:
Federal $5,574 $2,892
State and local 1,639 850
----- ---
Pro forma provision for income taxes $7,213 $3,742
====== ======
The provision for pro forma income taxes on adjusted historical income
for the two years in the period December 31, 1995 differs from the amounts
computed by applying the applicable Federal statutory rates due to the
following:
Year ended December 31,
-------------------------
1995 1994
---- ----
(In thousands)
Provision for Federal income taxes at the statutory rate $6,311 $3,274
State and local income taxes, net of Federal benefit 1,082 561
Other (180) (93)
-------- ---------
Pro forma provision for income taxes $7,213 $3,742
======== =========
-53-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
As a result of the termination, the Company was required to provide for
taxes on income for the period subsequent to September 19, 1995 and for the
previously earned and untaxed S Corporation income which has been deferred
primarily as a result of reporting on a cash basis. The provision for income
taxes for the years ended December 31, 1996 and 1995 consisted of the following:
Year ended December 31,
-------------------------------
1996 1995
---- ----
(In thousands)
Current:
Federal $10,995 $4,379
State and local 1,817 1,809
--------- -------
Total current 12,812 6,188
Deferred:
Federal (607) 2,201
State and local - 608
--------- -------
Total deferred (607) 2,809
--------- ------
$12,205 $8,997
========= =======
A reconciliation of the Federal statutory rate to the provision for
income taxes is as follows:
Year ended December 31,
--------------------------------------------------------------------
1996 1995
-------------------------------- --------------------------------
(In thousands) (In thousands)
Federal income taxes computed at the
statutory rate $11,331 35.0% $6,311 35.0%
Increase (decrease):
Federal income taxes at the statutory rate
from January 1, 1995 to September 19, 1995 - - (4,086) (22.7)
Federal and state taxes resulting from cash to
accrual basis for tax reporting - - 6,399 35.5
State income taxes less Federal benefit 1,199 3.7 373 2.1
Other (325) (1.0) - -
------------- -------------- ------------- ---------------
Total provision for income taxes $12,205 37.7% $8,997 49.9%
============= ============== ============= ==============
Deferred tax (assets) liabilities at December 31, 1996 and 1995 are
comprised of the following elements:
Year ended December 31,
-----------------------------------
1996 1995
------------- --------------
(In thousands)
Taxable loss carryforwards $(3,705) $ -
Federal and state taxes resulting from cash
to accrual basis for tax reporting 2,342 3,130
Amortization of certain intangibles (85) (227)
Other (55) (94)
-------------- --------------
Deferred tax (assets) liabilities (included in other assets for 1996) $(1,503) $2,809
============== ==============
-54-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 11 -- STATEMENTS OF CASH FLOWS
Year ended December 31,
----------------------------------
1996 1995 1994
---- ---- ----
(In thousands)
Supplemental disclosure of cash flow information:
Cash paid for:
Interest $ 47 $ 24 $ 55
======== ======== =====
Income taxes $1,090 $3,813 $ --
======== ======== =====
In connection with the acquisition of the assets of ABA, the Company
released ABA of its outstanding obligations to the Company of $10,949,000 (Note
5). During 1996, the Company recorded an intangible of $1,077,000 in connection
with the issuance of warrants to certain partitions (Note 9(b)).
During 1995, the Company issued the Cash Flow Note in the amount of
$6,900,000 to the minority stockholder of the Predecessor Corporation in
connection with the IPO and Reorganization (Note 1(b)).
NOTE 12 -- QUARTERLY FINANCIAL DATA (UNAUDITED)
First Second Third Fourth
Quarter Quarter Quarter Quarter
------- ------- ------- -------
(In thousands, except for share data)
1996
Sales $51,065 $57,015 $60,079 $64,265
Gross profit 6,832 7,387 8,323 9,285
Operating income 4,546 4,882 5,871 6,489
Net income 3,377 4,058 7,032 5,701
Net income per share - Primary 0.08 0.07 0.11 0.09
Net income per share - Fully Diluted 0.07 0.07 0.11 0.09
1995
Sales $36,617 $44,728 $48,366 $50,391
Gross profit 5,374 6,113 5,670 6,824
Operating income 4,213 4,855 4,008 4,625
Net income 2,555 2,897 2,519 2,848
Net income per share - Primary 0.08 0.09 0.08 0.07
Net income per share-Fully Diluted 0.08 0.09 0.08 0.07
-55-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 13 - SUBSEQUENT EVENT
On February 25, 1997, the Company announced that it had entered into a
Telecommunications Marketing Agreement (the "AOL Agreement"), dated as of
February 22, 1997 and effective as of February 25, 1997, with America Online,
Inc. ("AOL"), under which the Company will be the exclusive provider of
long-distance telecommunications services to be marketed by AOL to all of the
subscribers to AOL's online network under a distinctive brand name to be used
exclusively for the Company's services. The services will include provision for
online sign-up, call detail and reports and credit card payment. Under the AOL
Agreement, AOL will provide millions of dollars of online advertising and
promotion of the services and provide all of its subscribers with access to a
dedicated service area online for the Company. AOL subscribers who sign-up for
the telecommunications services will be customers of the Company, as the carrier
providing such services. The Company also has certain rights under the AOL
Agreement to offer, on a comparably exclusive basis, local and wireless
telecommunications services when available.
It is anticipated that the services will be tested in the early summer
and offered generally to AOL subscribers in the fall of 1997. The AOL Agreement
has an initial term of three years and can be extended by AOL on an annual basis
thereafter.
Under the AOL Agreement, the Company made an initial payment of
$100,000,000 to AOL at signing and agreed to provide marketing payments to AOL
based on a percentage of the Company's profits from the services (between 50%
and 70%, depending on the number of subscribers to the services). The AOL
Agreement provides that $43 million of the initial payment will be offset and
recoverable by the Company through reduction of such profit-based marketing
payments during the initial term of the AOL Agreement or, subject to certain
monthly reductions by offset of the amount thereof, directly by AOL upon certain
earlier terminations of the AOL Agreement. The $57 million balance of the
initial payment will be offset and is recoverable through a percentage of such
profit-based marketing payments made after the first five years of the AOL
Agreement (when extended beyond the initial term) and by offset against a
percentage of AOL's share of the profits from the services after termination or
expiration of the AOL Agreement. Any portion of the $43 million not previously
recovered or reduced in amount would be added to the $57 million and would be
recoverable similarly.
Also under the AOL Agreement, the Company issued to AOL at signing two
warrants to purchase shares of the Company's common stock at a premium over the
market value of such stock on the issuance date. One warrant is for 5 million
shares, at an exercise price of $15.50 per share, one-half of which shares will
vest at the time the service is first made generally available to AOL online
network subscribers in accordance with the AOL Agreement or the first
anniversary of the warrant issuance, whichever is earlier, and the balance of
which will vest on the first anniversary of issuance if the AOL Agreement has
not terminated. The other warrant is for up to 7 million shares, at an exercise
price of $14.00 per share, which will vest, commencing December 31, 1997, based
on the number of subscribers to the services and would vest fully if there are
at least 3.5 million such subscribers at any one time. The Company also agreed
to issue to AOL an additional warrant to purchase 1 million shares of its common
stock, at market value at the time of issuance, upon each of the first two
annual extensions by AOL of the term of the AOL Agreement, which warrants also
will vest based on the number of subscribers to the services.
The Company funded the $100 million initial payment by borrowing $50
million under its revolving loan agreement under a temporary increase in the
agreement to $60 million (Note 6), and an additional $50 million as a margin
advance from one of its brokers. Currently, the Company holds a U.S. Treasury
Bill with a face value of $150 million, which matures in November 1997, as
security for the advance.
-56-
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS AND FINANCIAL
DISCLOSURE
Not applicable.
PART III
ITEMS 10 THROUGH 13.
Information required by Part III (Items 10 through 13) of this Form
10-K is incorporated by reference to the Company's definitive proxy statement
for the Annual Meeting of Stockholders to be held in April or May of 1997, which
will be filed with the Securities and Exchange Commission not later than 120
days after the end of the fiscal year to which this Form 10-K relates.
-57-
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this annual Report on
Form 10-K.
1. Consolidated Financial Statements:
The Consolidated Financial Statements filed as part of this Form 10-K
are listed in the "Index to Consolidated Financial Statements" in Item 8.
2. Consolidated Financial Statement Schedule:
The Consolidated Financial Statement Schedule filed as part of this
report is listed in the "Index to S-X Schedule."
Schedules other than those listed in the accompanying Index to S-X
Schedule are omitted for the reason that they are either not required, not
applicable, or the required information is included in the Consolidated
Financial Statements or notes thereto.
-58-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
INDEX TO S-X SCHEDULE
PAGE
----
Report of Independent Certified Public Accountants 60
Schedule II -- Valuation & Qualifying Accounts 61
-59-
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors
and Stockholders of Tel-Save Holdings, Inc.
The audits referred to in our report dated January 29, 1997 relating to
the consolidated financial statements of Tel-Save Holdings, Inc. and
subsidiaries, which is contained in Item 8 of this Form 10-K, included the
audits of the financial statement schedule listed in the accompanying index for
each of the three years in the period ended December 31, 1996. This financial
statement schedule is the responsibility of management. Our responsibility is to
express an opinion on this schedule based on our audits.
In our opinion, the financial statement Schedule II -- Valuation and
Qualifying Accounts, presents fairly, in all material respects, the information
set forth therein.
/s/ BDO Seidman, LLP
BDO Seidman, LLP
New York, New York
January 29, 1997
-60-
TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)
Charged
Balance at to Costs
Beginning of and Other Balance at
Description Period Expenses Changes Deductions End of Period
- ----------- ------ -------- ------- ---------- -------------
Year ended December 31, 1996:
Reserves and allowances deducted from asset accounts:
Allowance for uncollectible
accounts $804 $38 $145(a) $ -- $987
==== === ======= ==== ====
Year ended December 31, 1995:
Reserves and allowances deducted
from asset accounts:
Allowance for uncollectible
accounts $987 $(13) $(170)(a) $ -- $804
==== ===== ========= ====== ====
Year ended December 31, 1994:
Reserves and allowances deducted from asset accounts:
Allowance for uncollectible
accounts $287 $53 $647(a) $ -- $987
==== === ======= ======= ====
(a) Amount represents portion of change in allowance for uncollectible
accounts applied against Accounts Payable - Partitions.
-61-
(3) Exhibits:
EXHIBIT NO. DESCRIPTION
- ---------- ----------------------------------------------------------------------------------------------
2.1 Plan of Reorganization Between and among Tel-Save Holdings, Inc., a Delaware Corporation,
Tel-Save, Inc., a Pennsylvania Corporation, Daniel Borislow and Paul Rosenberg, and Exhibits
Thereto (Incorporated by reference to Exhibit 2.1 to the Company's registration statement
on Form S-1 (File No. 33-94940)).
3.1 Amended and Restated Certificate of Incorporation of the Company, as amended (incorporated
by reference to Exhibit 3.1 to the Company's registration statement on Form S-1 (File No.
33-94940)).
3.2 Bylaws of the Company (incorporated by reference to Exhibit 3.2 to the Company's
registration statement on Form S-1 (File No. 33-94940)).
9.1 Voting Trust Agreement between Daniel Borislow and Paul Rosenberg (included as part of
Exhibit 2.1).
10.1* Employment Agreement between the Company and Daniel Borislow and related Agreement
(incorporated by reference to Exhibit 10.1 to the Company's registration statement on Form
S-1 (File No. 33-94940)).
10.2* Employment Agreement between the Company and Emanuel J. DeMaio (incorporated by reference to
Exhibit 10.2 to the Company's registration statement on Form S-1 (File No. 33-94940)).
10.3* Employment Agreement between the Company and Gary W. McCulla (incorporated by reference to
Exhibit 10.3 to the Company's registration statement on Form S-1 (File No. 33-94940)).
10.4* Employment Agreement between the Company and Joseph A. Schenk (incorporated by reference to
Exhibit 10.4 to the Company's registration statement on Form S-1 (File No. 333-2738)).
10.5* Employment Agreement between the Company and Aloysius T. Lawn, IV(incorporated by reference
to Exhibit 10.5 to the Company's registration statement on Form S-1 (File No. 333-2738)).
10.6* Employment Agreement between the Company and Edward B. Meyercord, III.
10.7 Indemnification Agreement between the Company and Daniel Borislow (incorporated by reference
to Exhibit 10.4 to the Company's registration statement on Form S-1 (File No. 33-94940)).
10.8 Indemnification Agreement between the Company and Emanuel J. DeMaio (incorporated by
reference to Exhibit 10.5 to the Company's registration statement on Form S-1 (File No.
33-94940)).
10.9 Indemnification Agreement between the Company and Gary W. McCulla (incorporated by reference
to Exhibit 10.6 to the Company's registration statement on Form S-1 (File No. 33-94940)).
-62-
10.10 Indemnification Agreement between the Company and Joseph M. Morena (incorporated by
reference to Exhibit 10.7 to the Company's registration statement on Form S-1 (File No.
33-94940)).
10.11 Indemnification Agreement between the Company and Peter K. Morrison (incorporated by
reference to Exhibit 10.8 to the Company's registration statement on Form S-1 (File No.
33-94940)).
10.12 Indemnification Agreement between the Company and Kevin R. Kelly (incorporated by reference
to Exhibit 10.9 to the Company's registration statement on Form S-1 (File No. 33-94940)).
10.13 Indemnification Agreement between the Company and Aloysius T. Lawn, IV (incorporated by
reference to Exhibit 10.12 to the Company's Form 10-K for the Fiscal year ended December 31,
1995).
10.14 Indemnification Agreement between the Company and Edward B. Meyercord, III.
10.15 Agreement dated as of March 15, 1994 between the Company and Global Network Communications
(incorporated by reference to Exhibit 10.10 to the Company's registration statement on Form
S-1 (File No. 33-94940)).
10.16 AT&T Contract Tariff No. 516 (incorporated by reference to Exhibit 10.11 to the Company's
registration statement on Form S-1 (File No. 33-94940)).
10.17 AT&T Contract Tariff No. 1715 (incorporated by reference to Exhibit 10.15 to the Company's
registration statement on Form S-1 (File No. 333-2738)).
10.18 AT&T Contract Tariff No. 2039 (incorporated by reference to Exhibit 10.16 to the Company's
registration statement on Form S-1 (File No. 333-2738)).
10.19 AT&T Contract Tariff No. 2432 (incorporated by reference to Exhibit 10.17 to the Company's
registration statement on Form S-1 (File No. 333-2738)).
10.20 AT&T Contract Tariff No. 3628 (incorporated by reference to Exhibit 10.18 to the Company's
registration statement on Form S-1 (File No. 333-2738)).
10.21 AT&T Contract Tariff No. 5776.
10.22 $50,000,000 line of credit from PNC Bank, N.A., dated March 22, 1996 (incorporated by
reference to Exhibit 10.19 to the Company's registration statement on Form S-1 (File No.
333-2738)).
10.23 Modification Agreement between the Company and PNC Bank, N.A. dated February 24, 1997.
10.24+ General Agreement between Tel-Save, Inc. and AT&T Corp. dated June 26, 1995 (incorporated by
reference to Exhibit 10.14 to the Company's registration statement on Form S-1 (File No.
33-94940)).
10.25* Tel-Save Holdings, Inc. 1995 Employee Stock Option Plan (incorporated by reference to
Exhibit 10.15 to the Company's registration statement on Form S-1 (File No. 33-94940)).
-63-
10.26* Tel-Save Holdings, Inc. Employee Bonus Plan (incorporated by reference to page 13 of the
Company's Proxy Statement for the Company's 1996 Annual Meeting of Stockholders dated April
3, 1996).
10.27* Non-Qualified Stock Option Agreement between the Company and Daniel Borislow (incorporated
by reference to Exhibit 10.17 to the Company's registration statement on Form S-1 (File No.
33-94940)).
10.28* Non-Qualified Stock Option Agreement between the Company and Emanuel J. DeMaio (incorporated
by reference to Exhibit 10.18 to the Company's registration statement on Form S-1 (File No.
33-94940)).
10.29* Non-Qualified Stock Option Agreement between the Company and Mary Kennon (incorporated by
reference to Exhibit 10.19 to the Company's registration statement on Form S-1 (File No.
33-94940)).
10.30* Non-Qualified Stock Option Agreement between the Company and Gary W. McCulla (incorporated
by reference to Exhibit 10.20 to the Company's registration statement on Form S-1 (File No.
33-94940)).
10.31* Non-Qualified Stock Option Agreement between the Company and Peter K. Morrison (incorporated
by reference to Exhibit 10.22 to the Company's registration statement on Form S-1 (File No.
33-94940)).
10.32++ Telecommunications Marketing Agreement by and among the Company, Tel-Save, Inc. and America
Online, Inc., dated February 22, 1997.
11.1 Net Income Per Share Calculation.
21.1 Subsidiaries of the Company.
23.1 Consent of BDO Seidman, LLP.
27 Financial Data Schedule.
- ----------
* Management contract or compensatory plan or arrangement.
+ Confidential treatment previously has been granted for a portion of this exhibit.
++ Confidential treatment has been requested for a portion of this exhibit.
(b) Reports on Form 8-K.
The following Current Reports on Form 8-K were filed by the Company during
the three months ended December 31, 1996:
1. Current Report on Form 8-K dated December 30, 1996.
2. Current Report on Form 8-K dated November 18, 1996.
-64-
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
Dated: TEL-SAVE HOLDINGS, INC.
March 18, 1997
By: /s/ Daniel Borislow
----------------------------
Daniel Borislow
Chairman of the Board,
Chief Executive Officer
and Director
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
March 18, 1997 By: /s/ Daniel Borislow
-------------------
Daniel Borislow
Chairman of the Board,
Chief Executive
Officer and Director
By:
-------------------
Gary W. McCulla
President, Director of Sales
and Marketing and Director
March 18, 1997 By: /s/ Emanuel J. DeMaio
---------------------
Emanuel J. DeMaio
Chief Operations
Officer and Director
March 18, 1997 By: /s/ Joseph A. Schenk
--------------------
Joseph A. Schenk
Chief Financial Officer,
Treasurer and Director
March 18, 1997 By: /s/ Kevin R. Kelly
------------------
Kevin R. Kelly
Controller
March 18, 1997 By: /s/ George Farley
-----------------
George Farley
Director
March 18, 1997 By: /s/ Harold First
----------------
Harold First
Director
March 18, 1997 By: /s/ Ronald R. Thoma
-------------------
Ronald R. Thoma
Director
-65-