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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Fiscal Year Ended July 31, 2001
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File Number 000-26763
NET2PHONE, INC.
(Exact name of registrant as specified in its charter)
Delaware 22-3559037
(State or other jurisdiction (I.R.S. Employer
Of incorporation or organization) Identification No.)
520 Broad Street 07102
Newark, New Jersey (Zip Code)
(Address of principal executive offices)
Registrant's telephone number, including area code: (973) 412-2800
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
(Title of Class)
Common Stock, par value $0.01 per share
Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
The aggregate market value of registrant's common stock held by
non-affiliates on October 19, 2001, was approximately $103.9 million. On such
date, the last sale price of registrant's common stock was $3.62 per share. The
number of shares outstanding of each of registrant's classes of common stock, as
of October 19, 2001, was 29,763,375 shares of common stock and 32,315,500 shares
of Class A common Stock.
DOCUMENTS INCORPORATED BY REFERENCE
Certain sections of the registrant's Proxy Statement to be filed in connection
with the 2001 Annual Meeting of Stockholders are incorporated by reference into
Part III of this Form 10-K where indicated.
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NET2PHONE, INC.
2001 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
Page Number
PART I.
ITEM 1. BUSINESS........................................................................................1
ITEM 2. PROPERTIES.....................................................................................30
ITEM 3. LEGAL PROCEEDINGS..............................................................................31
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............................................32
PART II.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS..........................32
ITEM 6. SELECTED FINANCIAL DATA........................................................................34
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS..........35
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.....................................45
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA....................................................45
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE...........45
PART III.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.............................................45
ITEM 11. EXECUTIVE COMPENSATION.........................................................................45
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.................................46
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................................................46
PART IV.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K................................46
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS......................................................................F-1
PART I
This Form 10-K includes "forward-looking statements." The words "may," "will,"
"should," "continue," "future," "potential," "believe," "expect," "anticipate,"
"project," "plan," "intend," "seek," "estimate" and similar expressions identify
forward-looking statements. We caution you that any forward-looking statements
made by us are not guarantees of future performance and that a variety of
factors, including those discussed below, could cause our actual results and
experience to differ materially from the anticipated results or other
expectations expressed in our forward-looking statements. Please see "Certain
Risk Factors" below for detailed information about the uncertainties and other
factors that may cause actual results to materially differ from the views stated
in such forward-looking statements.
ITEM 1. BUSINESS
General Description of Our Business
We began operations in November 1995, launched our first product in
July 1996 and were incorporated in the State of Delaware as a separate
subsidiary of IDT Corporation in October 1997. Net2Phone enables low-cost,
high-quality calls to be made from computers, telephones and fax machines to
computers, telephones, or fax machines worldwide via the public Internet,
private internet protocol (IP) networks, and broadband. We develop and market
technology and services for IP voice and e-commerce solutions for IP networks.
Through our consumer, enterprise, and carrier businesses, we have
strengthened our position as a leading platform for the migration of voice
traffic onto the Internet and over IP networks -- the IP telephony company of
the future. At the same time, we have established strategic relationships with
leading Internet companies to further extend our reach into the marketplace.
We have developed a sophisticated software application that enables use
of our web-based Internet telephony services. We promote our services through
direct sales and marketing and through strategic partners and international
resellers who buy minutes of use from us in bulk and resell them to customers in
their respective countries. Our software is currently available in eight
languages: English, Spanish, French, Dutch, Portuguese, Italian, German, and
Swedish.
Our company is divided into five core product lines: (1) PC-based
consumer services; (2) phone-based consumer services; (3) enterprise solutions;
(4) carrier services; and (5) broadband. All of our product lines are supported
by our marketing, operations, and network divisions. By delivering voice and
enhanced services to IP networks through each of these product lines as well as
our strategic partners, we hope to achieve ubiquity throughout the marketplace.
Our consumer services enable low-cost high quality calls using the
Internet from PCs or telephones and service more than two million active users
around the world. Our enterprise unit enables businesses nationwide to plug into
our IP network to make clear phone calls at reduced costs as well as layer
enhanced services on the network. We provide carriers and ISPs (Internet Service
Providers) around the world with access to our IP network to route calls
worldwide. Our broadband division is capitalizing on the opportunities in
gaining high-speed "last mile" access into consumers' homes and businesses,
layering voice and enhanced services to provide phone service over broadband
lines using our network.
1
Industry Segments
Althought our company is divided into five core product lines, we
report in only one industry segment. For more detailed information regarding our
industry segment, reference is made to "Notes to Financial Statements -- Note
2."
Description of Business
The Internet is experiencing substantial growth as a global medium for
communications and commerce. People are increasingly using the Internet as a
communications medium. A study by Jupiter, a market research firm, estimated
that 432 billion e-mail messages will be sent in the U.S. in 2003. Instant text
communication through online "chat" rooms is also gaining widespread acceptance.
Emergence of Internet Telephony
TeleGeography, a market research firm, estimates that the international
long distance market will carry 188 billion minutes of traffic by 2003, up from
107 billion in 1999. Despite the large size of this market and the number of
minutes of calls made, traditional international long distance calls are still
relatively expensive for the consumer. We believe that this facet creates a
significant opportunity for us to use the technology by which Internet phone
calls are made to gain market share.
The technology by which Internet phone calls are made is more
cost-effective than the technology by which traditional long distance calls are
made. Internet telephony, therefore, is emerging as a low cost alternative to
traditional long distance calls. Frost & Sullivan projects that the retail Voice
Over IP (VoIP) market will grow to $78 billion by 2007, a 142% compounded growth
over revenues of $1.2 billion in 2000. (Source: Frost & Sullivan World VoIP
Services Update ) We use a technology called "packet-switching" to break voice
and fax calls into discrete data packets, route them over the Internet or our
network and reassemble them into their original form for delivery to the
recipient. Traditional international long distance calls, in contrast, are made
using a technology called "circuit-switching" that carries these calls over
international voice telephone networks. These networks are typically owned by
governments or carriers who require various payments for their use.
Circuit-switching requires a dedicated connection between the caller and the
recipient that must remain open for the duration of the call. As a result,
circuit-switching technology is inherently less efficient than packet-switching
technology, which allows data packets representing multiple conversations to be
carried over the same line. This greater efficiency creates network cost savings
that can be passed on to the consumer in the form of lower long distance rates.
We can use our technology to deliver both basic voice services as well
as enhanced voice services, such as voice activated dialing and voice-enabled
e-mail. Although such services are available in a traditional telecommunications
environment, we believe that delivering services on an IP network eliminates the
need for costly hardware equipment and applications in each location. Because we
host our equipment in centralized locations, we do not need to deploy the same
costly equipment at each of our facilities around the world, thereby keeping
costs down. Per minute costs are also less expensive than traditional telephony
due to packet switching technology.
Integration of Voice into the Web
We believe that Internet telephony offers significant benefits to
consumers and businesses beyond international long distance cost savings. The
technologies that enable Internet telephony can be applied to integrate live
voice capabilities into the Web. We believe that integration can enhance the
potential for the Internet to become the preferred medium for both
communications and commerce.
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For example, the integration of voice into the Web supplements existing
text-based modes of Internet communication such as email and online chat by
adding a live, secure, low-cost voice alternative. We believe that this is
attractive both to consumers and businesses.
Integrating live voice capabilities into IP networks also enables
businesses to offer enhanced phone-based communications services, such as
providing a central source for retrieving voice-mail, e-mail, faxes and pages.
We believe this allows companies to attract more users to their sites. This
increased usage by both online and offline mediums allows Internet companies to
increase revenue.
In addition, voice-enabling the Web gives Internet shoppers the ability
to speak directly with customer service representatives of online retailers in
order to ask questions and alleviate concerns about online security. This may
increase the probability that a sale is made and may give online retailers a key
competitive advantage by providing them with opportunities to sell higher margin
and additional products to these customers. Voice-enabling a commercial Web site
also gives online retailers the ability to provide more responsive customer
support and service.
Limitations of Existing Internet Telephony Solutions
The growth of Internet telephony has been limited to date due to poor
sound quality attributable to technological issues such as delays in packet
transmission and network capacity limitations. However, recent improvements in
packet-switching technology, new software algorithms and improved hardware have
substantially reduced delays in packet transmissions. In addition, the use of
private networks to transmit calls as an alternative to the public Internet is
helping to alleviate network capacity constraints. Finally, the innovation of
new, lower cost Internet access technologies, such as high-speed modems, is
addressing local Internet access issues.
Several large long distance carriers, including MCI WorldCom, Sprint
and Cable & Wireless, have announced Internet telephony service offerings.
However, many of these service offerings have not been deployed on a large
scale. Many also require users to purchase other telecommunications services or
allow only domestic calling. Smaller Internet telephony service providers also
offer low-cost Internet telephony services from PC-to-phone and from
phone-to-phone. These services, however, are available only in limited
geographic areas and require payment by credit card that may preclude many
international customers from signing up for these services. We also believe that
existing Internet telephony service providers rely upon technologies and systems
that lack large-scale billing, network management and monitoring systems, and
customer service capabilities required for the integration of voice
communication into the Web.
In addition, many companies currently provide Internet telephony
software and services that allow Internet telephone calls to be made between
personal computers. However, most of these companies require both the initiator
and the recipient of the call to have the same software installed on their
personal computers and to be online at the same time.
3
Products and Services
Our products and services enable our customers to make low-cost,
high-quality phone calls over our own voice optimized IP Network and the
Internet using their personal computers or traditional telephones. Our principal
current product and service offerings are described in the table below.
Consumer Services
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Product/Service Benefits Description Benefits
----------------------------------- --------------------------------------- ------------------------------------------
Phone-to-Phone Fax2Fax enables customers to make International long distance rates are
o Fax2Fax calls over traditional telephones and substantially lower than the rates
fax machines routed over the charged by traditional long distance
Internet. Customers must dial a local carriers for calls originating in the
or toll-free access number to access United States and up to 95% lower for
the Net2Phone network. calls originating outside the United
States.
o Net2Phone Direct Calling Cards Customers are charged for toll and
long distance calls on a per-minute With direct calling cards, the user does
basis. not need to purchase hardware or
software.
Available in the United States and in
many international locations. High voice quality, as calls travel over
Net2Phone's private IP network.
We market Phone-to-Phone under the
brand "Net2Phone Direct."
----------------------------------- --------------------------------------- ------------------------------------------
Net2Phone CommCenter PC-based software enabling telephone PC- to-Phone services are available to
o PC-to-Phone calls to any other multimedia PC or any Internet user with a sound-equipped
o PC-to-PC regular telephone. personal computer and provide high voice
o Instant Messaging quality.
o Internet Call Waiting Allows for text and voice messaging
from PC-to-PC. Completely reengineered to provide high
voice quality and user experience.
Allows users to hear who is calling
while on the PC through "Internet Online real-time directory of users and
Answering Machine". presence detection installed so that
users know when "buddies" are online and
Customers must download our software, are then able to initiate PC-to-PC and
be connected to the Internet and PC-to-Phone calls.
register in order to make phone
calls. Rates are typically 50%-70% less than
traditional phone calling - both domestic
and international.
Customers can chat for free via voice or
text from PC-to-PC anywhere in the world.
Online real time billing and Auto recharge
and registration via web
Callers no longer get a busy signal while
trying to reach someone on the Internet and
can retrieve Messages instantly.
4
Consumer Services
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Product/Service Benefits Description Benefits
----------------------------------- --------------------------------------- ------------------------------------------
Mail.com Web-based e-mail for consumers and Customers gain access to web-based
co-branded web-based e-mail for other e-mail service.
sites, such as Juno.
----------------------------------- --------------------------------------- ------------------------------------------
VoiceLine Enables users to place and receive Users gain a secondary phone line using
telephone calls over their broadband an existing broadband connection and a
(cable, DSL) connections using regular telephone.
regular telephones and a voice-enabled
device. Cost savings of 50-70% on per-minute charges.
No need for a PC in order to make IP phone
calls.
Users can receive telephone calls on this
service on their regular telephone.
Free calls over the existing network
between voice-enabled broadband devices.
----------------------------------- --------------------------------------- ------------------------------------------
Aplio RAVE Broadband device that enables voice Allows users to gain easy access to
over broadband calling. Users can Net2Phone's network with intelligent IP
plug a telephone into the Aplio RAVE dialtone without a PC.
and then plug the Aplio RAVE into a
broadband router for easy VoIP calling.
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Business Services
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Web-based Internet Telephony
Services
----------------------------------- --------------------------------------- ------------------------------------------
Click2CallMe Web-based phone bridge that allows Enhances customer services on the web.
site web visitors to request a Facilitates online commerce by providing
phone-to-phone call back or a live voice contact between online
PC-to-phone call back with one click. retailers and Internet shoppers.
Includes IVR navigation and Agent Agent and customers can collaborate
Whisper, that provides an audio online in real-time.
message to the business
representative about the customer
location on the web site.
----------------------------------- --------------------------------------- ------------------------------------------
Click2Talk When browsing Web sites that have a Services are available to any Internet
Click2Talk icon, customers may user with a sound-equipped personal
initiate free calls to the business computer.
or site owner from anywhere in the
world. Facilitates online commerce by providing
live voice contact between online
Our basic version of PC-to-phone retailers and Internet shoppers.
client connects online customers to a
business call center with one click Customers do not require multiple
using VoIP. telephone lines and need not log off the
Internet to initiate a call.
----------------------------------- --------------------------------------- ------------------------------------------
5
Business Services
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Advanced IVR navigation features, Software is an applet, eliminating the
enabling calls to be routed to need for a heavy download or account
appropriate agent group or department. registration.
Includes Agent Whisper.
Web site and DTMF page pushing,
allowing the business representative
to control the customer's browser.
----------------------------------- --------------------------------------- ------------------------------------------
ClickTogether ClickTogether is a complete voice-led Assists enterprises in the eCRM field
collaboration solution for web with voice and text collaboration online
sites. Features include: Customer in real-time.
call initiation via web callback
(PSTN) and VoIP, Co-Browsing and URL
Page Push, Form Sharing, Multimedia
Whiteboarding, Chat, File Transfer,
Screen Snapshot Transfer, Call
Queuing, Call Transfer and Detailed
Summary/Status reports.
----------------------------------- --------------------------------------- ------------------------------------------
Enterprise Sales Enables clients to make calls over a International long distance rates are
Voice-Over-IP Long Distance privately managed VoIP managed typically 50% to 70% lower than the rate
Domestic/International network. charged by traditional long distance
carriers for calls originating in the
Installation of gateway on client United States and 20% to 30% on domestic
site. long distance.
Marketed as Net2Phone Enterprise High voice quality.
Sales.
Net2Phone fax services can be used for
Value added services. Enterprise clients as well. They are
transmitted without delay and users
Collaborative browsing. receive immediate delivery and
confirmations.
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Broadband and Carrier
---------------------------------- --------------------------------------- -------------------------------------------
Net2Phone Broadband Net2Phone's Broadband is an end-to-end Low up-front capital
MSO Solution carrier grade IP telephony service
offering clear voice and real Quicker deployment than circuit switching
time fax.
Scaleable platform
Net2Phone Broadband offers an
always-on persistent IP dial tone Managed IP network
over next generation access networks
(Cable, DSL, Satellite and Wireless) Full service provider
providing end users with a high quality
and low cost alternative or Integrated billing system
secondary line phone service at home
and work. Multilingual customer service
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6
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Broadband and Carrier
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International Carrier Services Enables ITO (International Generates cost savings due to Net2Phone's
Telecommunications Operator) to route highly competitive rates.
calls destined to the U.S. and beyond
via Net2Phone's managed VoIP Network.
Provides ITO with access to Offers the ability to reduce costs by
destinations where it has no direct avoiding capital-intensive network build
connections outs.
Gives ITO additional capacity on Facilitates the use of Net2Phone's next
demand for traffic surges. generation of value added Internet-based
communications services.
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Strategic Relationships
We have entered into strategic distribution, integration and
advertising relationships with leading Internet and computer hardware and
software companies. These relationships are sometimes secured by toehold or
other strategic investments. In addition, these relationships typically include
arrangements under which we share with our strategic partners a portion of the
revenue they bring to us. We believe that these relationships are important
because they provide incentives to our partners and allow us to leverage the
strong brand names and distribution channels of these companies to market our
products and services. Our strategic partners include:
AT&T/IDT/LIBERTY MEDIA
On August 11, 2000, a subsidiary of AT&T Corp., purchased four million
newly-issued shares of our Class A common stock from us and 14.9 million shares
of our Class A common stock from IDT. In connection with the transaction, we
agreed with AT&T to cooperate in the development of new Internet voice
applications for cable telephony and the business communications market. AT&T
and IDT were also granted a license to deploy our present and future
technologies on terms, conditions and pricing to be negotiated that are no less
favorable than those granted to other licensees of Net2Phone.
In October 2001, AT&T, IDT and Liberty Media Corporation formed a
limited liability company which through a series of transactions among AT&T, IDT
and Liberty Media, now holds an aggregate of 28,896,750 million shares of our
Class A common stock representing 50 percent of our outstanding capital stock.
Because the LLC holds Class A common stock with two votes per share the LLC has
64 percent of the shareholder voting power in Net2Phone. IDT controls the right
to vote the shares of Class A common stock held by the LLC in most matters.
Microsoft
On June 2, 2000, we entered into a three year agreement with Microsoft
to integrate our Internet telephony products and services into Microsoft's MSN
Messenger. Under this agreement, Net2Phone served as Microsoft's exclusive
Internet Telephony Service Provider. This agreement has been terminated in
anticipation of Microsoft's release of its new SIP-based Internet Telephony
Service Provider Program to be launched in conjunction with a new release of
Microsoft's instant messaging program. The effective date of termination is the
later of, (i) December 1, 2001 or (ii) one month after Microsoft launches the
new program. On October 10, 2001, we signed an Integration and Marketing
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Agreement with Microsoft pursuant to which Microsoft will include Net2Phone
as one of its approved Internet telephony service providers in its new version
of Microsoft's Instant Messaging Service software. Users of the new Internet
Messaging Service will be able to choose Net2Phone as their Internet telephony
service provider for the purpose of making PC-to-phone calls and to access other
telephony related services from Net2Phone. Net2Phone is solely responsible for
establishing the pricing plans and promotions relating to its services. This
Agreement has a one year term and will expire on October 25, 2002.
Yahoo!
In March, 2001 Net2Phone and Yahoo! entered into an agreement
establishing a new business relationship for the provision of paid voice over IP
services by Net2Phone to Yahoo!. The paid services include PC to phone domestic
service, PC to phone international service as well as 800 number voice access to
Yahoo! for users of Yahoo's 1-800 MY Yahoo suite of services. As part of the new
agreement, Net2Phone also provides paid voice hosting services. The
1-800 My Yahoo suite of voice services. The March, 2001 agreement replaced
the Voice Over Internet Protocol Services Agreement between Yahoo! and Net2Phone
dated July 24, 2000.
As of result of this revision in fiscal 2001, Net2Phone recorded a $31
million one-time non-recurring charge in operations to settle all future payment
obligations to Yahoo!. The charge represented significantly lower financial
and resource costs than would have been required to maintain the original
relationship on a going forward basis.
8
Liberty Media.
In June 2001, we announced a multi-year licensing agreement with
Liberty Media. Under the binding Memorandum of Understanding, Liberty Media will
make Net2Phone's VoIP services available to its international cable affiliates
serving over 25 million households. Net2Phone expect to receive licensing fees
totaling approximately $20 million over a five year period.
ADIR Technologies, Inc.
We formed ADIR Technologies, Inc. in 2000 to develop and market network
management software for VoIP and other packet-based multimedia networks. ADIR
offers our industry-leading VoIP network management software to
telecommunications, Internet, wireless, next generation and broadband service
providers and enterprises worldwide. The software platform we contributed to
ADIR was originally created in our research and development laboratory in
Lakewood, NJ.
ADIR's network management software provides a broad view of the health,
capacity and utilization of a packet-based network, including specific
functionality such as real-time advanced call management, rating, routing, and
authentication. These components are essential for managing traditional
circuit-switched networks but have been missing in voice-over-IP networks until
now. ADIR's technology can help provide a much greater quality of service by
providing advanced tools for fault detection, notification and diagnosis of
network equipment from the voice network service perspective.
Cisco Systems, Inc., Softbank Venture Capital, IDT Corporation and
their respective affiliates have purchased a minority equity interest in ADIR.
In connection with Cisco's investment, ADIR and Cisco agreed to a relationship
in which Cisco will jointly market ADIR's network management platform to its
VoIP customers, offering communications providers and enterprises compelling new
choices in VoIP solutions. In furtherance of this relationship, ADIR entered
into a Sales Coordination Agreement with Cisco on June 6, 2001, pursuant to
which Cisco will pay ADIR a fee or a revenue share for certain Cisco gateway,
router and cable broadband products sold by Cisco when such products are
embedded with ADIR software. The agreement commenced on June 6, 2001 and will
end on August 14, 2004.
On August 14, 2001, ADIR acquired all of the issued and outstanding
capital stock of NetSpeak Corporation, a Florida corporation. With this merger,
ADIR is now a significant supplier of highly scalable infrastructure software
and applications that enable the delivery of basic and enhanced voice services
over IP networks. In addition, ADIR now has products that can service the cable
markets, as well as a suite of front-end applications that may generate new
revenue streams.
Other Strategic Relationships
We also have entered into other important strategic relationships with
leading Internet and computer hardware and software companies, including:
o Linksys. Our technology and protocols are integrated into two
of Linksys' products, enabling users to plug their regular
telephones into Linksys devices and make Net2Phone calls using
existing broadband connections. Linksys' home networking
routers with Net2Phone's voice capabilities are sold in retail
stores nationwide, such as Staples and CompUSA. Users have
9
always-on dial tone to make and receive telephone calls
globally, enabling us to continue our strategy of being the
underlying voice provider to IP networks.
o SpeechWorks International, Inc. In September 2000, we entered
into a Master Software License Agreement and Professional
Services Agreement with SpeechWorks International, Inc. under
which SpeechWorks agreed to grant us a software license and
provide professional services and pursue joint marketing and
promotional efforts. We have integrated SpeechWorks' speech
recognition and text to speech technologies within our global
VoIP network and are reselling an integrated voice hosting
solution to enterprises and other telecommunications
companies.
o Nuance Communications Inc. In May 2001, we entered into a
three-year agreement with Nuance Communications. Nuance is a
leading provider of telephony based speech recognition
technologies. We have integrated Nuance's speech recognition
software within our global VoIP network and are reselling an
integrated voice hosting solution to enterprises and other
telecommunications companies. Our agreement with Nuance also
consists of a joint sales agreement providing for Net2Phone
and Nuance to market jointly and to sell Net2Phone's voice
hosting solution.
o Hey Anita, Inc. In December 2000, we entered into a 2-year
strategic agreement and completed a minority investment in Hey
Anita, Inc. as a key step in Net2Phone's strategy to deliver
voice and enhanced services over IP networks worldwide. Under
the agreement, Net2Phone and HeyAnita jointly market
end-to-end voice hosting solutions to telecommunications
companies and broadband service providers. Net2Phone will
provide the telephony infrastructure and hosting platform and
HeyAnita will build voice applications such as voice-activated
dialing, email reading and access to weather and stock quote
information.
o WebDialogs. WebDialogs, Inc. is a privately held provider of
live, voice and Web-based customer interaction solutions that
bring live human interaction and collaboration to Web
experiences, facilitating closer relationships with customers,
prospects and partners and better customer service online.
Net2Phone has worked very closely over the past year with
WebDialogs at a development and operational level to integrate
its voice and collaboration applications with the Net2Phone
network, allowing Net2Phone to enter the electronic Customer
Relationship Management (eCRM) market with new services that
enable live interaction between an Enterprise and its web
based visitors. The new services, branded by Net2Phone as
Click2CallMe and ClickTogether, allow businesses to increase
the effectiveness of their interactions with online customers,
resulting in increased productivity, sales and customer
service. Net2Phone has used its partnership with WebDialogs to
position itself as an eCRM ASP. This structure was recently
proven through our relationship with AT&T, in which AT&T has
co-branded our Click2CallMe solution and re-marketed the
service under the InteractiveAnswers brand, resulting in new
enterprise customers for Net2Phone.
o Mail.com. In March 2001, Net2Phone acquired the consumer
assets of Mail.com. Currently, Mail.com provides web-based
email for approximately 3.5 million users directly
(www.mail.com) and through partners in its consumer network.
With this acquisition, Net2Phone gained a base of
approximately 3.5 million users that have used the service
within the last 90 days, 1.7 million opt-in users for
re-marketing initiatives and over 20 million total user/email
boxes data files. Net2Phone will market all of its consumer
services to Mail.com's user base.
10
Sales, Marketing and Distribution
We promote our services and products through online and Internet-based
advertising venues and traditional direct response print advertising in domestic
and international publications. We also sell our services and products
internationally by entering into agreements with resellers in other countries.
We sell these resellers bulk amounts of minutes of use, products and services to
be resold in the resellers' respective countries. To facilitate distribution and
attract users in foreign countries, we have developed our software in eight
languages (English, Spanish, French, Dutch, Portuguese, Italian, German, and
Swedish ) and intend to increase the number of languages as our distribution
broadens. We also market through loyalty programs to existing customers and
through e-mail customer acquisition programs.
As described above, we have entered into strategic relationships with
leading Internet and computer hardware and software companies so that our
software is included with our partners' products and services and distributed
domestically and internationally. We distribute our software through the
Internet, strategic partnerships and international resellers. Customers can also
download our software at no charge from our Web site and through links on other
Web sites, including Yahoo!'s People Search.
Our International Carrier Division is offering International
Telecommunication Operators (ITO) access to its managed VoIP network. By
establishing direct facilities with ITOs in strategic markets, we allow access
to routes worldwide and facilitate the use of our next generation of value added
Internet-based communications services.
We distribute Net2Phone Broadband products and services through
strategic partnerships with broadband service providers and original equipment
manufacturers. Service providers bundle our voice offerings with their
high-speed data services to deliver the ultimate converged communications bundle
to their end users. Original equipment manufactures embed our software into
customer premise equipment (CPE) to offer feature rich, telephony enabled
devices to their customers. Finally, broadband customers may order and provision
services online directly from us.
Broadband products and services are promoted by us and via our
partners' sales and marketing channels. Cooperative marketing arrangements with
partners include launch event sponsorships, advertising agreements and product
collateral in and on device packaging. To facilitate distribution and attract
partnership interest, we demonstrate service offerings at broadband industry
trade shows.
We directly market enterprise products and services to Fortune 1000 and
mid-market companies that fit our qualification criteria. We qualify prospects
by calling volumes and patterns (minimum of 200,000 minutes per month of
domestic long distance and international calls). Our unique value proposition to
the market is high quality of calls based on our voice optimized IP network and
our technology which enables Internet telephony utilizing existing
infrastructure. We have shown savings of 20% to 30% on domestic long distance
and up to 50% to 70% on international calls. Our gateway technology enables both
off-net termination of calls as well as establishing on-net calling for global
organizations.
Customer Service
As part of our goal to attract and retain customers, we offer free live
customer support in multiple languages. As of July 31, 2001, we had
approximately 88 employees in technical support and customer service who offer
customer service support 24 hours a day. Customer services can be reached from
anywhere in the world at no cost using either our toll-free number, where
available, or our Web-based Internet telephony services. The customer support
staff provides technical assistance, as well as general service assistance,
11
for all of our products and services. We also offer customer support via e-mail
and fax. Our integrated customer billing software and call management system
provide our customer support staff with immediate access to user accounts,
calling patterns and billing history, thereby enhancing the quality of service
provided to our customers. In addition, our international resellers typically
provide their own front-line customer support. We have also signed agreements
with international call centers and other domestic centers.
Technology
PC-Client Software
Our software is simple to install and to use and has won various
industry awards. The software is broken into two pieces: an Application
Interface Engine and an Internet Telephony Calling Engine. The software is
flexible and customizable and the newest version of our software supports buddy
lists for building online calling communities. We also have developed a software
development kit that allows other companies to quickly and easily integrate
their products with our PC-2-Phone software. For example, our Internet Telephony
Calling Engine is the core technology used in AOL's ICQ and AIM products, and
Yahoo!'s Pager product. This integration enables Internet telephony service to
be deployed throughout the world through robust Internet software distribution
channels.
Call Management System
To maintain our leadership position in the Internet telephony market,
we believe that reliable and flexible billing, information management,
monitoring and control systems are critical. Accordingly, we have invested
substantial resources to develop and implement our sophisticated real-time call
management information system. Key elements of this system include:
o customer provisioning;
o customer access;
o fraud control;
o network security;,
o call routing;
o monitoring;
o reliability; and
o detailed call records.
The Net2Phone Network
Through an agreement with IDT, we lease capacity on an Internet network
comprised of leased high-speed fiber optic lines connecting eight major cities
across the United States and leased high-speed fiber optic lines connecting
smaller cities to the network. Our high-speed backbone connects traffic at four
major public Internet exchange points and is also facilitated by a growing
number of private peering or exchange points with other networks. Through
peering arrangements, we exchange Internet traffic with 25 other Internet
backbone providers at these points. We operate IDT's network, one of the largest
12
Internet access networks, providing local dial-up access through 36 locations.
Our Internet network also includes more than 700 additional network access
locations owned by local and regional Internet service providers.
We are able to provide service in areas where we do not have dial-up
equipment by using call-forwarding technology to expand our coverage areas by
increasing the total number of local access numbers. We have been closing down
multiple network access points in a number of states in order to consolidate our
equipment into central "Super Point of Presence" locations. For example, one
Super Point of Presence in New Jersey supplies local access for the entire state
of New Jersey.
We seek to retain flexibility by using dynamic call routing
alternatives. This approach is intended to enable us to take advantage of the
rapidly evolving Internet market to provide low-cost service to our customers.
Accordingly, our network employs an "Open Shortest Path First" protocol that
promotes efficient routing of traffic. Additionally, we have placed redundant
hardware for reliability in high traffic areas to minimize loss of data packets.
Each network data exchange point employs hardware to direct network traffic and
a minimum of two dedicated leased data lines to increase reliability.
We manage our network hardware remotely. It is compatible with a
variety of local network systems around the world. We believe our systems are
scalable to four times their current capacity through the purchase and
installation of certain additional hardware. To date, the highest number of
simultaneous calls serviced by our network was approximately 12,000 simultaneous
calls made in January 2001.
The Network Operations Center
Our Network Operations Centers (NOCS), located in both Hackensack and
Newark, New Jersey, employ a staff of approximately 100 people and incorporate
both the Data NOC, the VoIP NOC, and the Service Management Center (SMC). The
SMC is a Tier-One support center for all technical service issues for wholesale
and enterprise accounts. The SMC group works with the NOCS to ensure that issues
are remedied through multiple engineering groups. Net2Phone's customer service
department also relies on the SMC group for resolution of outstanding technical
issues.
Customers
We have a diverse, global customer base. As of July 31, 2001,
approximately 24 percent of our customers were based outside of the United
States and we had signed agreements with 14 International Telecommunications
Operators. Also, as of July 31, 2001, we served over 2.8 million active
customers who had used our services during the preceding three months and we
have Enterprise agreements in place with 25 Fortune 500 accounts and 30 mid
market companies.
Competition
Long Distance Market
The long distance telephony market and, in particular, the Internet
telephony market, is highly competitive. There are several large and numerous
small competitors, and we expect to face continuing competition based on price
and service offerings from existing competitors and new market entrants in the
future. The principal competitive factors in the market include price, quality
of service, breadth of geographic presence, customer service, reliability,
network capacity and the availability of enhanced communications services. Our
competitors include MCI WorldCom and Sprint in the United States and foreign
telecommunications carriers. Although we have forged a strategic relationship
with AT&T, and
13
notwithstanding that AT&T has a significant equity interest in us, AT&T and its
affiliates still provide competing services.
Many of our competitors have substantially greater financial, technical
and marketing resources, larger customer bases, longer operating histories,
greater name recognition and more established relationships in the industry than
we have. As a result, certain of these competitors may be able to adopt more
aggressive pricing policies, which could hinder our ability to market our
Internet telephony services. One of our key competitive advantages is the
ability to route calls through Internet service providers, that allows us to
bypass the international settlement process and realize substantial savings
compared to traditional telephone service. Any change in the regulation of
Internet service providers could force us to increase prices and offer rates
that are comparable to traditional telephone call providers.
Web-Based Internet Telephony Services
As consumers and telecommunications companies have come to understand
the benefits that may be obtained from transmitting voice over the Internet, a
substantial number of companies have emerged to provide voice over the Internet.
In addition, companies currently in related markets have begun to provide voice
over the Internet services or adapt their products to enable voice over the
Internet services. These related companies, as described below, may potentially
migrate into the Internet telephony market as direct competitors.
o Internet Telephony Service Providers. During the past several
years, a number of companies have introduced services that
make Internet telephony services available to businesses and
consumers. In addition to us, AT&T Jens (a Japanese affiliate
of AT&T), deltathree.com (a subsidiary of RSL Communications),
iBasis, ITXC, and Dialpad provide a range of voice over the
Internet services. These companies offer PC-to-phone or
phone-to-phone services that are similar to the services we
offer. Some companies, including AT&T Jens, offer these
services within limited geographic areas. Additionally, a
number of companies have recently introduced Web-based
voice-mail services and voice-chat services to Internet users.
However, several, companies have stopped offering such
services due to lack of funding.
o Software/Hardware Providers. Many companies produce software
and other computer equipment that may be installed on a user's
computer to permit voice communications over the Internet.
These products generally require each user to have compatible
software and hardware equipment and rely on the public
Internet for the transmission of traffic, which often results
in reduced quality of communications.
o Telecommunications Companies. A number of telecommunications
companies, including AT&T, Deutsche Telekom, MCI WorldCom and
Qwest, may currently maintain, or may plan to maintain,
packet-switched networks to route the voice traffic of other
telecommunications companies. These companies, which tend to
be large entities with substantial resources, generally have
large budgets available for research and development and
therefore may enhance the quality and acceptance of the
transmission of voice over the Internet. However, many of
these companies are new to the Internet telephony market and
may not build brand recognition among consumers for these
services. These companies also may not have the range of
product and service offerings that is necessary to
independently provide a broad set of voice-enabled Web
services.
14
o Network Hardware Manufacturers. Several of the world's major
providers of telecommunications equipment, such as Alcatel,
Cisco, Lucent, Northern Telecom and Dialogic (which was
acquired by Intel), have developed or plan to develop network
equipment to use in connection with the provision of voice
over the Web services, including routers, servers and related
hardware and software. By developing this equipment, these
manufacturers may exert substantial influence over the
technology that enables transmission of voice over the Web,
and they may develop products that facilitate the quality and
timely roll-out of these networks. However, these companies
are dependent upon the operators of Internet telephony
networks to purchase and install their equipment into their
networks. They are also dependent upon the developers of
hardware and software to market their systems to end users.
Although, Cisco which currently manufactures Internet
telephony equipment for low to medium scale networking, is a
minority investor and strategic partner with ADIR, majority
owned subsidiary, as described above, ADIR intends to
commercialize the existing network management software that we
have used exclusively since 1995 and market its products to
service providers and telecommunications companies, as well as
to equipment manufacturers looking to migrate voice traffic to
IP networks. Lucent has co-developed with VocalTec a set of
industry standards that have been adopted by major competitors
and is currently marketing Internet telephony hardware,
including servers that allow the transmission of calls and
faxes over the Internet.
o Lucent. Offers related support products, such as billing
centers and "Internet call centers," that allow Internet
access and conversation with a customer support agent on a
single line.
o Voice-Enabled Online Commerce Providers. Several providers
apply Internet telephony technologies in connection with
e-commerce transactions. These providers compete with services
of ours such as Click2Talk by integrating voice communications
into commercial Web sites. These competitors include Lipstream
and USA Global Link, which introduced its Instant Call service
in 1998, a system that permits voice communications between a
customer on the Web and customer service representatives. In
addition, AT&T's Inter@active Communications group of services
integrates voice into the Web, including AT&T Chat'N Talk, a
voice-enabled chat service, and Click2Dial Conferencing
Services that initiate and manage conference calls.
Research and Development
At our research and development centers in Lakewood and to be located
in West Long Branch Newark, New Jersey, we employ approximately 30 engineers,
whose specialties include software, hardware, switching, Internet security,
voice compression, protocols, Web applications, PC development, interactive
voice response systems, VoiceXML, speech recognition, speech applications,
broadband technologies, engineering real-time online transactions, billing and
network and call management. This staff is devoted to the improvement and
enhancement of our existing product and service offerings, as well as to the
development of new products and services. Current research and development
activities include the following:
o enhancements to our PC-to-phone software to increase
functionality;
o encapsulation of our PC-to-phone software as an OEM engine
product;
o porting of our PC-to-phone software to other operating system
platforms;
o enhancements to our call processing platform to increase
scalability and performance;
15
o enhancements to our billing platforms to increase scalability
and performance;
o development of a calling application platform to host
interactive voice response and VoiceXML applications;
o development of speech enabled calling applications;
o multiprotocol voice-over-IP support to embrace multiple voice
over IP calling devices and platforms; and
o protocol support for IP calling software, devices and
broadband initiatives.
Our future success will depend, in part, on our ability to improve
existing technology, retaining services of talented employees and developing new
products and services that incorporate leading technology.
Costs for the internal development of new software products and
substantial enhancements to existing software products are expensed as incurred
until technological feasibility has been established, at which time any
additional costs would be capitalized. Software development costs are our only
research and development expenditures. For the years ended July 31, 2001, 2000,
and 1999, research and development costs totaled approximately $10,360,000,
$4,692,000, and $757,000, respectively.
Regulation
The use of the Internet and private IP networks to provide
voice communications services is a relatively recent market development.
Although the provision of such services is currently permitted by United States
law and largely unregulated within the United States, several foreign
governments have adopted laws and/or regulations that could restrict or prohibit
the provision of voice communications services over the Internet or private IP
networks. Increased regulation of the Internet in general and Internet telephony
specifically may slow the growth of our services, and adversely affect our
business, financial condition, operating results and future prospects,
particularly if increased numbers of governments impose regulations restricting
the use and sale of our services.
United States. In an April 10, 1998 Report to Congress, the Federal
Communications Commission (FCC) declined to conclude that IP telephony services
constitute telecommunications services and instead indicated that it would
undertake a subsequent examination of the question whether certain forms of
phone-to-phone Internet telephony are information services or telecommunications
services. The FCC indicated that in the future it would consider the extent to
which phone-to-phone-Internet telephony providers could be considered
"telecommunications carriers" such that they could be subject to the regulations
governing traditional telephone companies. The FCC also recognized, however,
that it would consider whether it should forbear from imposing any of the rules
that would apply to phone-to-phone Internet telephony providers as
"telecommunications carriers." Thus, the FCC currently does not impose
regulatory surcharges or traditional common carrier regulation upon providers of
Internet communications services, although it could determine to do so in the
future.
Although the FCC to date has determined that providers of Internet
telephony services should not be required to pay interstate access charges, this
decision may be reconsidered in the future. The FCC could determine, for
instance, that certain types of Internet telephony should be regulated like
basic interstate telecommunications services. Thus, Internet telephony would no
longer be exempt from the
16
access charge regime that permits local telephone companies to charge
long-distance companies for the use of the local telephone network to originate
and terminate long-distance calls, generally on a per minute basis. Similarly,
the FCC could conclude that Internet telephony providers should contribute to
the Universal Service Fund, which provides support to ensure universal access to
telephone service. The imposition of interstate access charges or universal
service contributions would substantially increase our costs of serving our
customers.
Several recent efforts have been made in the United States to enact
federal legislation that would affect the regulatory status of voice services
provided over the Internet. Any conclusion reached by the FCC with respect to
Internet telephony could result in legislation by Congress requiring the FCC to
impose more or less regulation. In addition, other aspects of our operations may
be subject to state or federal regulation, such as regulations relating to the
confidentiality of data and communications, copyright issues, taxation of
services, universal service funding, and licensing. Similarly, changes in the
legal and regulatory environment relating to the Internet connectivity market,
including regulatory changes that affect telecommunications costs or that may
increase the likelihood of competition from the regional Bell operating
companies or other telecommunications companies, could increase our costs of
providing service.
Moreover, state governments and their regulatory authorities may assert
jurisdiction over the provision of intrastate IP communications services.
Selected state regulatory authorities have initiated proceedings to examine the
regulatory status of Internet telephony services, and a state court in Colorado
has ruled that the use of the Internet to provide certain intrastate services
does not exempt an entity from paying intrastate access charges. As state
governments, courts, and regulatory authorities continue to examine the
regulatory status of Internet telephony services, they could adopt regulations
affecting providers of Internet telephony services or requiring such providers
to pay intrastate access charges or to make contributions to universal service
funding.
International. We also provide our Internet telephony services in
various countries throughout the world, where the regulatory treatment of our
services varies widely and is subject to continuous change. Until recently, many
countries either did not have regulations addressing Internet telephony or other
IP communications services or classified such services as unregulated enhanced
services. As the Internet telephony market has expanded, increasing numbers of
regulators have begun to reconsider whether to regulate Internet telephony
services. Some countries currently impose little or no regulation on Internet
telephony services, as in the United States. Other countries, including those in
which the governments prohibit or limit competition for traditional voice
telephony services, generally do not permit Internet telephony services or
strictly limit the terms under which those services may be provided. Still other
countries regulate Internet telephony services like traditional voice telephony
services, requiring Internet telephony companies to make universal service
contributions and pay other taxes.
In cases in which access to some of our services has been blocked in
certain countries by government-controlled telecommunications companies, we have
been successful in negotiating agreements to continue to provide our services,
and we intend to continue to do the same as similar situations may arise. No
assurances can be given, however, that we will be successful in such
negotiations or that we will be able to provide alternative means of accessing
our services that will not be blocked by foreign governments or
government-controlled telecommunications companies. The varying and continually
changing regulatory treatment of Internet telephony in the countries in which we
currently provide or may provide services may materially adversely affect our
business financial condition, and results of operations.
17
Changes in the regulatory regimes of countries in which we currently do
business could have the effect of limiting or prohibiting Internet telephony or
other Internet services or of imposing new or additional regulatory requirements
on providers of such services. Any such developments could result in our being
unable to provide services to one or more countries in which we currently
operate. In addition, as we expand into additional foreign countries, some
countries may conclude that we are required to qualify to do business in their
country, that we are otherwise subject to regulation, or that we are prohibited
from conducting our business in such countries. Our failure to qualify as a
foreign corporation in jurisdictions in which we are required to do so, or to
comply with foreign laws and regulations, may adversely affect our business.
Moreover, our partners in various foreign countries may be or may
become subject to various regulatory requirements. We cannot be certain that our
partners are currently in compliance with regulatory or other legal requirements
in their respective countries, that they will be able to comply with existing or
future requirements, and/or that they will remain in compliance with any
requirements. Failure of our partners to comply with these requirements could
adversely affect our business.
Regulation of the Internet. In addition to regulations addressing
Internet telephony specifically, other regulatory issues relating to the
Internet in general could affect our ability to provide our services. Congress
has adopted legislation that regulates certain aspects of the Internet,
including online content, user privacy, taxation, liability for third-party
activities, and jurisdiction. In addition, a number of initiatives pending in
Congress and state legislatures would prohibit or restrict advertising or sale
of certain products and services on the Internet, which may have the effect of
raising the cost of doing business on the Internet generally. The European Union
has also enacted several directives relating to the Internet, one of which
addresses online commerce. In addition, federal, state, local and foreign
governmental organizations are considering other legislative and regulatory
proposals that would regulate the Internet. Increased regulation of the Internet
may decrease its growth, which may negatively impact the cost of doing business
via the Internet or otherwise materially adversely affect our business,
financial condition, and results of operations.
Intellectual Property
Our performance and ability to compete depend to a significant degree
on our proprietary and licensed technology. We rely on a combination of patent,
copyright, trademark and trade secret laws and contractual restrictions to
establish and protect our technology. All key employees have signed
confidentiality agreements, and we intend to require newly hired employee to
execute confidentiality agreements. These agreements provide that confidential
information developed by or with an employee or consultant, or disclosed to such
person during his or her relationship with us, may not be disclosed to any third
party except in certain specified circumstances. These agreements also require
our employees to assign their rights to any inventions to us. The steps taken by
us may not, however, be adequate to prevent the misappropriation of our
proprietary rights or technology. In addition, our competitors may independently
develop technologies that are substantially equivalent or superior to our
technology.
We currently have one patent issued in the United States and four
foreign patents. We own twenty one registered trademarks in the United States
and nineteen foreign registered trademarks. We are currently engaged in a
worldwide program to file trademark applications throughout the world for our
"net2Phone" and "adir" marks.
There can be no assurance that we will be able to secure protection for
all of our marks. Competitors of ours or others may adopt product or service
marks similar to our marks, or try to prevent us from using our marks, thereby
interfering with our to build brand identity and possibly leading to
18
customer confusion. We have encountered trademark oppositions challenging our
registration of the "net2Phone" mark in Argentina, China, Czech republic,
Colombia, Guatemala, Japan, New Zealand, Paraguay, Peru, South Korea, Taiwan,
Thailand and Venezuela.
Even if trademark rights are acquired through registration in countries
outside the United States, we may not be able to protect our marks or assure
that we are not infringing other parties' marks in those countries. Moreover,
although we have taken steps to commence the registration of "net2phone" as a
domain name with the various international registries, we cannot assure you that
we will be successful in all locations. In fact, we have encountered several
instances of third parties who have registered our domain name in different
countries. We have generally had success in obtaining the rights to those
domains through the domain dispute resolution process, but we cannot assure you
that we will be successful in the future.
Although we believe that we do not infringe upon the patent rights of
any third party, on February 15, 2000, Multi-Tech Systems, Inc. filed suit
against us and other companies in the United States Federal District Court in
Minneapolis, Minnesota. See Item 3. Legal Proceedings.
It is possible that other patent infringement claims might be asserted
successfully against us in the future. Our ability to make, use, sell or offer
for sale our products and services depends on our freedom to operate. That is,
we must ensure that we do not infringe upon the patents of others or have
licensed all such rights. We are aware that patents have been granted to others
based on fundamental technologies in the Internet telephony area. Moreover,
because patent applications in the Unites States are not publicly disclosed
until issued, other applications may have been filed which, if issued as
patents, could relate to our services and products.
A party making an infringement claim could secure a substantial
monetary award or obtain injunctive relief that could effectively block our
ability to provide services or products in the United States or abroad. If any
of these risks materialize, we could be forced to suspend operations, to pay
significant amounts to defend our rights, and a substantial amount of the
attention of our management may be diverted from our ongoing business, each of
which could materially adversely affect our ability to operate and our financial
condition and results of operations.
Employees
As of July 31, 2001, we had 695 Full-time employees, 42 part-time
employees and 5 temporary employees, including approximately 354 in technical
support and customer service, 181 in marketing and sales, 51 in management and
finance, 88 in operations and 68 in research and development. Our employees are
not represented by a union, and we consider our employee relations to be good.
We have never experienced a work stoppage.
Revenues and Assets by Geographic Area
For the year ended July 31, 2001, 24 percent of our revenue was derived
from international customers, and 76 percent from customers in the United
States. Substantially all of our long-lived assets are located in the United
States. For more detailed information concerning our geographic segment,
reference is made to "Notes to Financial Statements -- Note 18"
19
Executive Officers
The following are the executive officers of the Company as of October
29, 2001:
Name Age Executive Officer Since Present Office
---- --- ----------------------- --------------
Howard S. Jonas 45 2001 Chief Executive Officer
Stephen M. Greenberg 57 2000 President
Ilan M. Slasky 31 1999 Chief Financial Officer
Glenn J. Williams 38 1999 Corporate Secretary and
Executive Vice President of
Legal and Business Affairs
Jonathan Reich 35 1999 Executive Vice President
Morris Berger 43 1999 Chief Marketing Officer
Jeffrey Skelton 35 2000 Chief Technology Officer
Scott Anderson 41 2000 Executive Vice President of Sales
Brian Haimm 32 2000 Executive Vice President
Howard S. Jonas is presently our Chief Executive Officer. Upon Clifford
M. Sobel's resignation from our Board, Mr. Jonas will resign as our CEO and
become our Chairman of The Board. Mr. Jonas founded IDT in August 1990 and has
served as Chairman of the Board and Treasurer since its inception. Mr. Jonas
served as Chief Executive Officer of the Company from December 1991 until July
2001. He served as President of the Company from December 1991 through September
1996. Mr. Jonas serves as the Chairman of the Board of Directors of IDT Telecom,
Inc. and IDT Ventures, Inc. Mr. Jonas is also the founder and has been President
of Jonas Publishing Corp. ("Jonas Publishing"), a publisher of trade
directories, since its inception in 1979. Mr. Jonas received a B.A. in Economics
from Harvard University.
Stephen M. Greenberg is presently the President of Net2Phone and
serves on our Board as a Director. Upon Howard S. Jonas's resignation as our
Chief Executive Officer, Mr. Greenberg will become our Chief Executive Officer.
Mr. Greenberg practiced law for 32 years prior to joining Net2Phone. His legal
career began in Newark, New Jersey in 1968. He served as Executive Assistant to
the United States Attorney for the District of New Jersey from 1969 to 1971.
Before joining Net2Phone, Mr. Greenberg was a founder of and senior partner in
the New Jersey law firm of Stern & Greenberg. Mr. Greenberg has received many
honors including one for Outstanding Personal Achievement from the New Jersey
Bar Association. He is also a Commissioner of the New Jersey Public Broadcasting
Authority and a member of the New Jersey Israel Commission.
Ilan M. Slasky has been our Chief Financial Officer since January 1999.
Prior to his employment with us, Mr. Slasky was IDT Corporation's Executive Vice
President of Finance from December 1997 to January 1999, IDT Corporation's
director of carrier services from November 1996 to July 1997 and IDT
Corporation's Director of Finance from May 1996 to November 1996. From 1991 to
1996, Mr. Slasky worked for Merrill Lynch in various areas of finance, including
risk management, fixed income trading and equity derivatives.
20
Glenn J. Williams has been our Executive Vice President of Legal and
Business Affairs and Corporate Secretary since February, 2001. From October 1999
to February, 2001, Mr. Williams served as our General Counsel and Corporate
Secretary. Prior to joining us, Mr. Williams served as Associate General Counsel
to IDT Corporation since 1998. Prior to joining IDT, Mr. Williams served as
Associate General Counsel to a privately held company and worked for a number of
years as an attorney in private practice, including representing the New Jersey
Sports and Exposition Authority from 1994 to 1997. Prior to becoming a lawyer,
Mr. Williams worked for a number of years in a sales capacity for commercial
contracting firms.
Jonathan Reich has been our Executive Vice President--Marketing and
Corporate Development since January 1999. Prior to his employment with us, Mr.
Reich was IDT Corporation's Senior Vice President of Advertising, Marketing and
Business Development in charge of strategic relationships for both us and IDT
Corporation from June 1997 to December 1998 and IDT Corporation's director of
advertising from January 1995 to November 1997. From 1992 to 1993, Mr. Reich
worked for Sanford Bernstein & Co. as an associate analyst. Prior to this, Mr.
Reich was an internal consultant for Morgan Stanley & Co.
Morris Berger has been our Chief Marketing Officer since December 1999.
Prior to that Mr. Berger served as Vice President of Creative Services. Mr.
Berger served as Chief Executive Officer of Multi-Media Tutorial Services, Inc.,
from 1995-1999, a New York-based direct marketing firm.
Jeffrey Skelton has been our Chief Technology Officer since September
2000 and a senior engineer since December 1997. Prior to his employment with us,
Mr. Skelton was a principal technical staff member and a software engineer at
AT&T from 1988 to December 1997.
Scott Andersen has been our Executive Vice President of Sales since
December 2000. From March 2000 to the commencement of his employment with
Net2Phone, Mr. Andersen served as CEO and Co-Chairman of Exist Corporation.
Prior to that, Mr. Andersen was a Senior Operating Executive at MCI Systemhouse,
Inc. between 1995 and 1999. Mr. Andersen also brings over 13 years of experience
from Andersen Consulting in selling and implementing enterprise-wide solutions
for Global 500 clients.
Brian Haimm joined Net2Phone in February 2000 as an Executive Vice
President, and was instrumental in the formal creation of ADIR Technologies and
Cisco's investment in ADIR. From January 1998 until he joined Net2Phone, Mr.
Haimm was a vice president in Sakura Bank's Mergers and Acquisitions group.
Prior to his position at Sakura, Mr. Haimm was a Senior Financial Analyst at
SOFTBANK/Ziff-Davis from October 1996 through January 1998.
CERTAIN RISK FACTORS
Our future operating results and financial condition are dependant on a
number of factors that we must successfully manage in order to achieve favorable
future operating results and financial condition. The following potential risk
and uncertainties, together with those mentioned elsewhere herein, could affect
our future operating results, financial condition and the market price of our
common stock
Risks Related to Our Financial Condition and Our Business
Our limited operating history makes evaluating our business
difficult.
IDT formed us as a subsidiary in October 1997. Prior to that, we
conducted business as a division of IDT. Therefore, we have only a limited
operating history with which you may evaluate our business.
21
You must consider the numerous risks and uncertainties an early stage company
like ours faces in the new and rapidly evolving market for Internet-related
services. These risks include our ability to:
o increase awareness of our brand and continue to build user
loyalty;
o maintain our current, and develop new, strategic
relationships;
o respond effectively to competitive pressures; and
o continue to develop and upgrade our network and technology.
If we are unsuccessful in addressing these risks, sales of our products
and services, as well as our ability to maintain or increase our customer base,
will be substantially diminished.
We have never been profitable.
We have never been profitable on an annual basis. We had an accumulated
deficit of approximately $515 million as of July 31, 2001. Our operating and
marketing expenses have continuously increased since inception and we expect
them to continue to increase significantly during the next several years.
Accordingly, we will need to generate significant revenue to achieve
profitability. We may not be able to do so. Even if we do achieve profitability,
we cannot assure you that we will be able to sustain or increase profitability
on a quarterly or annual basis in the future.
In addition, we recognized significant charges relating to non-cash
executive compensation expense in fiscal 2001 and will recognize additional
significant charges on an ongoing basis, in connection with the grants of
options to purchase shares of our common stock. With respect to these options,
we recognized a charge of approximately $17.9 million in the fourth quarter of
fiscal 1999, $48.1 million during fiscal 2000, $19.7 million during fiscal 2001,
and will recognize charges of approximately $13.3 million during fiscal 2002,
$3.2 million during fiscal 2003, and $2 million in fiscal 2004.
We intend to pursue new streams of revenue, which we have not attempted
to generate before and which may not be profitable.
In addition to our minutes-based revenue, we are beginning to generate
new Web-based revenue opportunities from banner and audio advertising.
Furthermore, with ADIR, we will be commercializing our existing network
management software. ADIR will market its products to service providers,
telecommunications companies, and equipment manufacturers. We also intend to
explore the availability of revenue-sharing opportunities with online retailers.
We intend to devote significant capital and resources to create these new
revenue streams and we cannot ensure that these investments will be profitable.
We may have difficulties managing our expanding operations, which may
reduce our chances of achieving profitability.
Our future performance will depend, in part, on our ability to manage
our growth effectively. To that end, we will have to undertake the following
tasks, among others:
o develop our operating, administrative, financial and
accounting systems and controls;
o improve coordination among our engineering, accounting,
finance, marketing and operations personnel;
22
o enhance our management information systems capabilities; and
o hire and train additional qualified personnel.
If we cannot accomplish these tasks, our chances of achieving
profitability may be diminished.
If we fail to establish and maintain strategic relationships our
ability to meet analyst expectations and our sales would suffer.
We currently have strategic relationships with AT&T, AOL, ICQ, Yahoo!,
Cisco, Liberty Media and others. We depend on these relationships to:
o expand our customer base;
o distribute our products to potential customers;
o increase usage of our services;
o build brand awareness; and
o cooperatively market our products and services.
We believe that our success depends, in part, on our ability to develop
and maintain strategic relationships with leading Internet companies and
computer hardware and software companies, as well as key marketing distribution
partners. In cases where our products and services are integrated into our
strategic partners' product and service offerings, our ability to meet analyst
expectations and our sales depend upon a timely release of these offerings. If
any of our strategic relationships are discontinued or if the release of these
partners' offerings that integrate our products and services are delayed, sales
of our products and services and our ability to maintain or increase our
customer base may be substantially diminished.
Competition could reduce our market share and decrease our revenue.
The market for our services has been extremely competitive. Many
companies offer products and services like ours, and many of these companies
have a substantial presence in this market. In addition, many of these companies
are larger than we are and have substantially greater financial, distribution
and marketing resources than we do. We therefore may not be able to compete
successfully in this market. If we do not succeed in competing with these
companies, we will lose customers and our revenue will be substantially reduced.
Our competitors include the following:
o Internet Telephony Service Providers. Internet telephony
service providers such as AT&T Jens (a Japanese affiliate of
AT&T), deltathree.com, iBasis (formerly known as VIP Calling),
IPVoice.com, and ITXC route voice traffic over the Internet.
o Software/Hardware Providers. Companies such as VocalTec
produce software and other computer equipment that may be
installed on a user's computer to permit voice communications
over the Internet.
23
o Telecommunications Companies. A number of telecommunications
companies, including AT&T, Deutsche Telekom, MCI WorldCom and
Qwest, currently maintain, or plan to maintain,
packet-switched networks to route the voice traffic of other
telecommunications companies.
o Network Hardware Manufacturers. A number of large
telecommunications providers and equipment manufacturers,
including Alcatel, Cisco, Lucent, Northern Telecom and
Dialogic (which was acquired by Intel), have announced that
they intend to offer products similar to ours. We expect these
products to allow live voice communications over the Internet
between parties using a personal computer and a telephone and
between two parties using telephones. Cisco Systems has also
taken additional steps by recently acquiring companies that
produce devices that help Internet service providers carry
voice over the Internet while maintaining traditional phone
usage and infrastructure.
o Voice-Enabled Online Commerce Providers. ITXC has begun to
apply Internet telephony technologies in connection with
online commerce transactions. ITXC competes with services of
ours such as Click2Talk by integrating voice communications
into commercial Web sites.
Pricing pressures may lessen our competitive pricing advantage.
Our success is based partly on our ability to provide discounted
domestic and international long distance services by taking advantage of cost
savings achieved by carrying voice traffic over the Internet, as compared to
carrying calls over long distance networks, such as those owned by AT&T, Sprint
and MCI WorldCom. In recent years, the price of long distance calls has fallen.
In response, we have lowered the price of our service offerings. AT&T, Sprint
and MCI WorldCom have adopted pricing plans in which the rates that they charge
for U.S. domestic long distance calls are not always substantially higher than
the rates that we charge for our U.S. domestic service. The price of long
distance calls may decline to a point where we no longer have a price advantage
over these traditional long distance services. Alternatively, other providers of
long distance services may begin to offer unlimited or nearly unlimited use of
some of their services for an attractive monthly rate. We would then have to
rely on factors other than price to differentiate our product and service
offerings, which we may not be able to do.
We may not be able to compete with providers that can bundle long
distance services with other offerings.
Our competitors may be able to bundle services and products that we do
not offer together with long distance or Internet telephony services. These
services could include wireless communications, voice and data services,
Internet access and cable television. This form of bundling would put us at a
competitive disadvantage if these providers can combine a variety of service
offerings at a single attractive price. In addition, some of the
telecommunications and other companies that compete with us may be able to
provide customers with lower communications costs or other incentives with their
services, reducing the overall cost of their communications packages, and
significantly increasing pricing pressures on our services. This form of
competition could significantly reduce our revenues.
If our customers do not perceive our services to be effective or of
high quality, our brand and name recognition would suffer.
We believe that establishing and maintaining a brand and name
recognition is critical for attracting and expanding our targeted client base.
We also believe that the importance of reputation and name recognition will
increase as competition in our market increases. Promotion and enhancement of
24
our name will depend on the effectiveness of our marketing and advertising
efforts and on our success in continuing to provide high-quality products and
services, neither of which can be assured.
We depend on our international operations, which subject us to
unpredictable regulatory and political situations.
As of July 31, 2001, approximately 76 percent of our customers were
based outside of the United States, generating approximately 24 percent of our
revenue during fiscal 2001. A significant component of our strategy is to
continue to expand internationally. We cannot assure you that we will be
successful in expanding into additional international markets. In addition to
the uncertainty regarding our ability to generate revenue from foreign
operations and expand our international presence, there are certain risks
inherent in doing business on an international basis, including:
o changing regulatory requirements, which vary widely from
country to country;
o action by foreign governments or foreign telecommunications
companies to limit access to our services;
o increased bad debt and subscription fraud;
o legal uncertainty regarding liability, tariffs and other trade
barriers;
o political instability; and
o potentially adverse tax consequences.
We cannot assure you that one or more of these factors will not
materially adversely affect the growth of our business or our customer base.
All of the IP telephony calls made by our customers are connected
through local telephone companies and, at least in part, through leased networks
that may become unavailable.
We are not a local telephone company or a local exchange carrier. Our
network covers only portions of the United States. Accordingly, we must route
parts of some domestic and all international calls made by our customers over
leased transmission facilities. In addition, because our network does not extend
to homes or businesses, we must generally route calls through a local telephone
company to reach our network and, ultimately, to reach their final destinations.
In many of the foreign jurisdictions in which we conduct or plan to
conduct business, the primary provider of significant in-country transmission
facilities is the national telephone company. Accordingly, we may have to lease
transmission capacity at artificially high rates from a monopolistic provider,
and consequently, we may not be able to generate a profit on those calls. In
addition, national telephone companies may not be required by law to lease
necessary transmission lines to us or, if applicable law requires national
telephone companies to lease transmission facilities to us, we may encounter
delays in negotiating leases and interconnection agreements and commencing
operations. Additionally, disputes may result with respect to pricing terms and
billing.
In the United States, the providers of local telephone service are
generally the incumbent local telephone companies, including the regional Bell
operating companies. The permitted pricing of local transmission facilities that
we lease in the United States is subject to uncertainties. The Federal
Communications Commission's order requiring incumbent local telephone companies
to price those facilities at total element long-run incremental cost is
25
currently being reviewed by the United States Supreme Court, and, if that
standard is reversed, it could result in an increase in our cost of obtaining
incumbent local transmission facilities. In addition, the Federal Communications
Commission is in the process of re-examining the existing intercarrier
compensation system, a regime governing the flow of payments among
interconnected telecommunications carriers and networks. The Commission could
adopt an intercarrier compensation mechanism that could result in an increase in
the cost of the local transmission facilities necessary to complete our calls or
a decrease in the costs of such facilities to traditional long distance
telephone companies.
Our success depends on our ability to handle a large number of
simultaneous calls, which our systems may not be able to accommodate.
We expect the volume of simultaneous calls to increase significantly as
we expand our operations. Our network hardware and software may not be able to
accommodate this additional volume. If we fail to maintain an appropriate level
of operating performance, or if our service is disrupted, our reputation could
be hurt and we could lose customers.
Because we are unable to predict definitely the volume of usage and our
capacity needs, we may be forced to enter into disadvantageous contracts that
would reduce our operating margins.
In order to ensure that we are able to handle additional usage, we have
agreed to pay IDT a one-time fee of approximately $7.6 million for a 20-year
right to use part of a new high capacity network that is under construction. We
may have to enter into additional long-term agreements for leased capacity. To
the extent that we overestimate our call volume, we may be obligated to pay for
more transmission capacity than we actually use, resulting in costs without
corresponding revenue. Conversely, if we underestimate our capacity needs, we
may be required to obtain additional transmission capacity through more
expensive means or such capacity may not be available.
We may not be able to obtain sufficient funds to grow our business.
We intend to continue to grow our business. Due to our limited
operating history and the nature of our industry, our future capital needs are
difficult to predict. Therefore, we may require additional capital to fund some
or all of the following:
o unanticipated opportunities;
o strategic alliances;
o potential acquisitions;
o changing business conditions; and
o unanticipated competitive pressures.
Obtaining additional financing will be subject to a number of factors,
including market conditions, our operating performance and investor sentiment.
These factors may make the timing, amount, terms and conditions of additional
financings unattractive to us. If we are unable to raise additional capital, our
growth could be impeded.
Any damage to or failure of our systems or operations could result in
reductions in, or terminations of, our services.
26
Our success depends on our ability to provide efficient and
uninterrupted, high-quality services. Our systems and operations are vulnerable
to damage or interruption from natural disasters, power loss, telecommunication
failures, physical or electronic break-ins, sabotage, intentional acts of
vandalism and similar events that may be or may not be beyond our control. The
occurrence of any or all of these events could hurt our reputation and cause us
to lose customers.
Unauthorized use of our intellectual property by third parties may
damage our brand.
We regard our copyrights, service marks, trademarks, trade secrets and
other intellectual property as critical to our success. We rely on trademark and
copyright law, trade secret protection and confidentiality agreements with our
employees, customers, partners and others to protect our intellectual property
rights. Despite our precautions, it may be possible for third parties to obtain
and use our intellectual property without authorization. Furthermore, the laws
of some foreign countries may not protect intellectual property rights to the
same extent as do the laws of the United States. It may be difficult for us to
enforce certain of our intellectual property rights against third parties who
may have acquired intellectual property rights by filing unauthorized
applications in foreign countries to register the marks that we use because of
their familiarity with our worldwide operations. Since Internet related
industries such as ours are exposed to the intellectual property laws of
numerous foreign countries and trademark rights are territorial, there is
uncertainty in the enforceability and scope of protection of our intellectual
property. The unauthorized use of our intellectual property by third parties may
damage our brand.
Defending against intellectual property infringement claims could be
expensive and could disrupt our business.
We cannot be certain that our products and services do not or will not
infringe upon valid patents, trademarks, copyrights or other intellectual
property rights held or claimed by third parties. Multi-Tech, Inc. has filed a
lawsuit against us alleging that we infringe upon its patents. We are incurring
substantial expenses defending this claim. If Multi-Tech is successful, we may
be subject to significant monetary liability and our business may be materially
disrupted.
We may also be subject to other legal proceedings and claims from time
to time relating to the intellectual property of others in the ordinary course
of our business. We may incur substantial expenses in defending against those
third-party infringement claims, regardless of their merit. Successful
infringement claims against us may result in substantial monetary liability or
may materially disrupt the conduct of our business.
Risks Related to Our Relationship with AT&T/IDT/Liberty Media
In October 2001, AT&T, IDT Corporation and Liberty Media Corporation
formed a new a Delaware limited liability company which through a series of
transactions among AT&T, IDT and Liberty Media now holds an aggregate of 50
percent of our outstanding capital stock and 64 percent of the aggregate voting
power of our capital stock. IDT controls the right to vote the shares of Class A
common stock held by the LLC in most matters. This relationship contains certain
risks associated with it including the following:
We may experience conflicts of interest resulting from the new LLC's
power to elect the members of our board of directors.
The newly formed LLC, currently controls 64 percent of the aggregate
voting power of our capital stock, and has the power to nominate and elect the
members of our board of directors when such members become eligible for
re-election, so long as at least five members are not affiliated with us, IDT
27
or AT&T as required by our bylaws. This power may give rise to significant
influence and/or conflicts of interest with respect to certain decisions
involving business opportunities and similar matters that may arise in the
ordinary course of our business or the business of any of the owners of the LLC.
The holdings of the newly formed LLC may limit your ability to
influence the outcome of matters subject to a stockholder vote.
The holdings of the LLC will enable it to exert considerable influence
over us, including in the election of our directors, the appointment of
management and the approval of any other action requiring the approval of our
stockholders, including any amendments to our certificate of incorporation and
mergers or sales of our company or of all of our assets. In addition, we could
be prevented from entering into certain transactions that could be beneficial to
us and our stockholders. Third parties will likely be discouraged from making a
tender offer or bid to acquire us because of the LLC's stockholdings and voting
rights.
We have contracted with IDT for various services and for the use of its
telecommunications network, which contracts we may not be able to renew when
they expire.
In May 1999, we entered into agreements with IDT under which IDT
provided administrative and telecommunication services to us. Since these
agreements have expired, we will need to extend them, engage other entities to
perform these services or perform these services ourselves. We cannot assure you
that IDT will continue to provide these services. As a result, we may have to
purchase these services from third parties or devote resources to handle these
functions internally, which may cost us more than we paid IDT for the same
services.
There is uncertainty regarding AT&T licenses.
There is no commitment from AT&T to use our technology, and therefore
there is no assurance that AT&T will pay us any royalties, notwithstanding the
fact that its significant interest in us should give it an incentive to do so.
Our relationship may discourage others from seeking nonexclusive
licenses.
Our obligation to grant non-exclusive "most favored nation" licenses to
AT&T will preclude us from granting exclusive licenses to others and may
discourage others from seeking nonexclusive licenses, particularly if AT&T fails
to use our technology and AT&T's failure to use it is deemed to be a negative
reflection on the technology.
Risks Related to Our Industry
If the Internet does not continue to grow as a medium for voice
communications, our business will suffer.
The technology that allows voice communications over the Internet is
still in its early stages of development. Historically, the sound quality of
Internet calls was poor. As the industry has grown, sound quality has improved,
but the technology requires additional refinement. Additionally, the Internet's
capacity constraints may impede the acceptance of Internet telephony. Callers
could experience delays, errors in transmissions or other interruptions in
service. Making telephone calls over the Internet must also be accepted as an
alternative to traditional telephone service. Because the Internet telephony
market is new and evolving, predicting the size of this market and its growth
rate is difficult. If our market fails
28
to develop, then we will be unable to grow our customer base and our
opportunity for profitability will be harmed.
Our business will not grow without increased use of the Internet.
The use of the Internet as a commercial marketplace is at an early
stage of development. Demand and market acceptance for recently introduced
products and services over the Internet are still uncertain. We cannot predict
whether customers will be willing to shift their traditional activities online.
The Internet may not prove to be a viable commercial marketplace for a number of
reasons, including:
o concerns about security;
o Internet congestion;
o inconsistent service; and
o lack of cost-effective, high-speed access.
If the use of the Internet as a commercial marketplace does not continue to
grow, we may not be able to grow our customer base, which may prevent us from
achieving profitability.
Governmental regulations regarding the Internet may be passed, which
could impede our business.
The legal and regulatory environment that pertains to the Internet is
uncertain and is changing rapidly as use of the Internet increases. For example,
in the United States, the Federal Communications Commission could undertake an
examination of whether to impose surcharges or additional regulations upon
certain providers of Internet telephony.
In addition, regulatory treatment of Internet telephony outside the
United States varies from country to country. For example, access to certain
services may be negatively impacted by government regulation. There can be no
assurance that there will not be future interruptions in foreign countries or
that we will be able to return to the level of service we had in any such
countries prior to any interruptions. These actions and other similar actions in
foreign countries may adversely affect our continuing ability to offer services
in these and other countries, causing us to lose customers and revenue.
New regulations could increase our costs of doing business and prevent
us from delivering our products and services over the Internet, which could
adversely affect our customer base and our revenue. The growth of the Internet
may also be significantly slowed. This could delay growth in demand for our
products and services and limit the growth of our revenue. In addition to new
regulations being adopted, existing laws may be applied to the Internet. New and
existing laws may cover issues that include:
o sales and other taxes;
o interstate access charges;
o user privacy;
o pricing controls;
29
o characteristics and quality of products and services;
o consumer protection;
o contributions to the Universal Service Fund, which is funded
by telecommunications carriers for the purpose of supporting
local telephone service in rural and high cost areas;
o cross-border commerce;
o copyright, trademark and patent infringement; and
o other claims based on the nature and content of Internet
materials.
Our risk management practices may not be sufficient to protect us from
unauthorized transactions or thefts of services.
We may be the victim of fraud or theft of service. From time to time,
callers have obtained our services without rendering payment by unlawfully using
our access numbers and personal identification numbers. We attempt to manage
these theft and fraud risks through our internal controls and our monitoring and
blocking systems. If these efforts are not successful, the theft of our services
may cause our revenue to decline significantly.
ITEM 2. PROPERTIES
Our primary facility is our headquarters and executive offices located
on four floors at 520 Broad Street, Newark, New Jersey. We believe that our
facilities are suitable and adequate for our business for the foreseeable
future. A summary of our leased facilities is as follows:
Total
Domestic Office Locations Sq. Ft. Occupant Lease Expiration Date
------------------------- ------- -------- ---------------------
Newark, New Jersey 105,000 Net2Phone, 05/31/10
Headquarters
Hackensack, New Jersey 21,000 Net2Phone 06/30/04
Cust & Tech
Support
New York, New York 13,000 Net2Phone 11/30/08
Schaumburg, Illinois 2,537 Net2Phone 11/30/05
San Francisco, California 2,000 Net2Phone 10/31/01
Boston, Massachusetts 6,720 Net2Phone 05/31/05
Brick, New Jersey 14,663 Adir Laboratories 03/31/06
Boca Raton, Florida 51,740 Adir/Netspeak 08/09/10
*West Long Branch, 31,485 Net2Phone 09/30/07
New Jersey Laboratories
Piscataway, New Jersey 22,000 Net2Phone 05/19/02
Equipment
Atlanta, Georgia 241 Net2Phone 05/31/04
Equipment
30
Foreign Office Locations Total
and Subsidiaries Sq. Ft. Occupant Lease Expiration Date
------------------------ ------ ------- ---------------------
Kfar-Sava, Israel 1,012 Aplio 08/30/02
Warsaw, Poland 2,153 Net2Phone 08/31/02
Global
Jerusalem, Israel 1,800 Net2Phone MEA 07/14/02
Jing Guang Centre, China 826 NetSpeak 11/30/01
(Adr)
--------------------------------
* We currently lease approximately 7,900 sq.ft. in Lakewood, New
Jersey which lease we intend to terminate in favor of a larger
facility in West Long Branch, New Jersey better suited to our needs.
ITEM 3. LEGAL PROCEEDINGS
Multi-Tech
On February 15, 2000, Multi-Tech Systems, Inc. filed suit against us
and other companies in the United States Federal District Court in Minneapolis,
Minnesota. Multi-Tech alleges that "the defendant companies are infringing
because they are providing the end users with the software necessary to
simultaneously transmit voice and data on their computers in the form of making
a phone call over the Internet." We have defended the lawsuit vigorously. We
have filed an answer and discovery has now been completed. Trial of this matter
is tentatively scheduled for August 1, 2002. In the interim, it is likely that
various motions will be filed to limit the scope of the plaintiff's claims or to
dismiss the action in its entirety. We believe that the Multi-Tech claims are
without merit. However, should a judge issue an injunction against us requiring
that we cease distributing Multi-Tech's software or providing Multi-Tech's
software-based services, such an injunction could have a material adverse effect
on our business operations, financial condition, results of operations and cash
flows.
Aplio, S.A.
In connection with the acquisition of Aplio, S.A in July 2000, disputes
arose with certain selling shareholders with respect to out obligations under
the Stock Purchase Agreement dated as of June 16, 2000. We have now settled
all disputes by entering into agreements with various selling shareholders
providing for certain cash payments to be made on or before January 8, 2002 in
the aggregate amount of approximately $11 million and the deferral of payment
obligations totaling approximately $19.25 million until April 30, 2003. As part
of the arrangement, the selling shareholders waived their rights to receive $3
million in purchase price held back by us at closing to secure certain
indemnification obligations.
Class-Actions
Four substantially similiar class-action lawsuits were filed in the
United States District Court for the Southern District of New York on behalf of
all persons who acquired our stock between July 29, 1999 and December 6, 2000.
Net2Phone, certain of our executive officers, directors and underwriters
involved in our initial public offering are named as defendants in these
complaints. The complaints allege, in part, that certain underwriters of our
initial public offering violated federal securities laws by
31
failing to disclose that they had solicited and received undisclosed commissions
and allocated shares in our initial public offering to those investors in
exchange for their agreement to purchase our shares in the after-market at
pre-determined prices. The complaints also allege that, whether or not Net2Phone
and the named executives were aware of the underwriters' arrangements, Net2Phone
and the named executives have statutory liability under the federal securities
laws for issuing a registration statement in connection with our initial public
offering that failed to disclose that these allegedly undisclosed arrangements
existed. The suits against us are substantially the same as suits making the
same allegations that have been filed against more than 100 other companies that
had their initial public offerings at or about the same time. The deadline for
all defendants to respond to the complaints has been extended by the court to
which the various cases have been assigned. Our underwriting agreement with our
underwriters provide for indemnification of Net2Phone and its executives and
directors for liabilities arising out of misstatements in our registration
statement attributable to material non-disclosures by the underwriters. We
intend to pursue our indemnification claims against the underwriters. In
addition, we maintain directors and officers liability insurance coverage which
should substantially cover the costs of defending the various suits. However an
unfavorable decision in these cases could have a material adverse effect on our
business operations, financial condition, results of operations and cash flow.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to our stockholders during the fourth quarter of the
fiscal year ended July 31, 2001.
PART II.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Market Information
Our stock is quoted on the Nasdaq National Market under the ticker
symbol "NTOP." The stock was initially offered to the public on July 29, 1999 at
$15.00 per share. There is no public market for our Class A common stock. The
following table sets forth for the periods indicated the high and low reported
closing sale prices per share for our stock as reported by Nasdaq.
Year Ended July 31, 2001 High Low
------------------------------ ------------- -------------
First Quarter........................... $ 33.813 $ 16.688
Second Quarter ......................... $ 20.250 $ 6.844
Third Quarter........................... $ 13.438 $ 7.375
Fourth Quarter ........................ $ 9.460 $ 4.100
Year Ended July 31, 2000 High Low
------------------------------ ------------- -------------
First Quarter........................... $ 92.625 $ 15.000
Second Quarter.......................... $ 76.500 $ 40.063
Third Quarter........................... $ 68.375 $ 34.375
Fourth Quarter.......................... $ 47.875 $ 22.500
-----------------------------
32
Holders
As of October 19, 2001, there were approximately 429 stockholders of
record of our Common Stock and 19 stockholders of record of our Class A Common
Stock, $.01 par value. On October 19, 2001, the last reported sale price of our
stock as reported by Nasdaq was $3.62.
Dividend Policy
We have not paid any dividends in the past and do not intend to pay
cash dividends on our capital stock for the foreseeable future. Instead, we
intend to retain all earnings, if any, for use in the operation and expansion of
our business.
[REMAINDER OF PAGE INTENTIONALLY LEFT BLANK]
33
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data should be read in conjunction with our
financial statements and related notes thereto and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" included in Item 7.
The data is derived from our financial statements.
Fiscal Year Ended July 31,
-------------------------------------------------------------------------------
Statement of Operations Data: 1997 1998 1999 2000 2001
----------------------------- ----------- ------------- ------------- ------------- -------------
Revenue:
Service $ - $ 10,490,972 $ 32,648,305 $ 61,253,096 $ 143,309,997
Product - 1,515,000 608,152 11,148,094 6,888,491
----------- ------------- ------------- ------------- -------------
Total revenue 2,652,303 12,005,972 33,256,457 72,401,190 150,198,488
----------- ------------- ------------- ------------- -------------
Costs and expenses:
Services cost of revenue - 6,576,523 17,554,074 34,700,401 102,805,831
Products cost of revenue - 272,236 263,936 6,286,392 5,605,022
----------- ------------- ------------- ------------- -------------
Total direct cost of revenue . 1,553,443 6,848,759 17,818,010 40,986,793 108,410,853
----------- ------------- ------------- ------------- -------------
Selling and marketing 76,724 2,887,766 8,828,167 68,677,169 83,843,970
General and administrative 2,599,283 5,087,628 10,836,072 36,321,177 84,158,715
Depreciation and amortization 120,500 726,508 2,316,545 6,804,412 23,349,538
Restructuring and other charges - - - - 70,100,860
Compensation charge from the
issuance of stock options - - 17,919,541 48,124,333 20,544,829
----------- ------------- ------------- ------------- -------------
Total costs and expenses 4,349,950 15,550,661 57,718,335 200,913,884 390,408,765
----------- ------------- ------------- ------------- -------------
Loss from operations (1,697,647) (3,544,689) (24,461,878) (128,512,694) (240,210,277)
Interest income (expense), net - - (243,314) 9,672,815 18,530,609
Loss on equity investments and other, net - - - 505,874 (146,972,698)
----------- ------------- ------------- ------------- -------------
Net loss before minority interests (1,697,647) (3,544,689) (24,705,192) (118,334,005) (368,652,366)
Minority interests - - - - (2,676,595)
----------- ------------- ------------- ------------- -------------
Net loss (1,697,647) (3,544,689) (24,705,192) (118,334,005) (365,975,771)
Redeemable preferred stock dividends - - (29,219,362) - -
Redeemable common stock accretion . - - - - (531,999)
----------- ------------- ------------- ------------- -------------
Net loss available to common
stockholders (1,697,647) $(3,544,689) $ (53,924,554) $(118,334,005) $(366,507,770)
----------- ------------- ------------- ------------- -------------
Net loss per common share - basic
and diluted $ (0.06) $ (0.12) $ (1.73) $ (2.29) $ (6.25)
----------- ------------- ------------- ------------- -------------
Weighted average number of common
shares used in calculation of
basic and diluted net loss per
common share 27,864,000 30,186,000 31,236,415 51,738,918 58,664,580
----------- ------------- ------------- ------------- -------------
Cash, cash equivalents, and
marketable securities $ - $ 10,074 $ 20,379,048 $ 249,294,250 $ 253,968,496
Working capital (deficit) (3,104,830) (11,149,553) 6,303,452 106,371,979 218,099,989
Total assets 916,025 6,975,108 50,816,891 411,728,433 411,403,084
Accounts payable to IDT 2,960,429 11,814,988 3,735,395 4,883,111 14,401,290
Loan payable to IDT - - 14,000,000 - -
Total stockholders' (deficit) equity (2,205,305) (5,649,994) (4,062,867) 331,886,546 273,828,532
-------------------------------------------------------------------
34
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our
financial statements and notes thereto included elsewhere in this report.
Overview
We began our operations in November 1995, launched our first Net2Phone
product in July 1996, and were established as a separate subsidiary of IDT in
October 1997. We have incurred net operating losses since inception and expect
to incur additional losses for the foreseeable future, primarily as a result of
increased sales and marketing efforts.
Sources of Revenue
During fiscal 2001, our revenues were derived from per-minute charges
we billed to our customers on a pre-paid basis and from the sale of internet
telephony equipment, such as YAP Gear and services primarily to resellers, IDT
and other carriers. We anticipate that revenue in fiscal 2002 from services will
increase in absolute terms as our products become more widely distributed. In
addition, we are selling Web-based advertising through our PC client, e-mail
properties acquired from Mail.com, as well as certain instant messenger services
to leverage our customer reach.
Approximately 83 percent of our revenue in fiscal 2001 was generated
from per-minute charges we charge our retail customers mostly on a prepaid basis
to use our services. During fiscal 2001, approximately 24 percent of our revenue
was derived from customers based outside of the United States. As of July 31,
2001, we served over 2,490,000 active customers. We recognize revenue as our
customers utilize the balances in their prepaid accounts by placing calls. As
such, we have deferred revenue for all unutilized balances in our active
customers' accounts.
35
Direct Cost of Revenue
Direct cost of revenue consists primarily of network costs associated
with carrying our customers' traffic on our network and leased networks, and
routing their calls through a local telephone company to reach their final
destination. These costs exclude depreciation and include:
o amounts paid to other carriers to terminate traffic on a
per-minute basis;
o the cost of leased routers and access servers;
o telecommunications costs, including the cost of local
telephone lines to carry subscriber calls to our network;
o the costs associated with leased lines connecting our network
directly to the Internet or to our operations centers and
connecting our operations centers to the Internet;
o Internet backbone costs, which are the amounts we pay to
connect to the Internet;
o service providers for capacity;
o costs associated with the manufacturing, purchasing and
licensing of equipment; and
o ad serving costs and e-mail box hosting fees.
We expect our direct cost of revenue to increase in absolute terms over
time to support our growing customer base. While some of these costs are fixed,
other costs vary on a per minute basis. Therefore, we anticipate volatility in
our direct cost of revenue as a percentage of revenue, particularly as we expand
our network and dynamically determine how we price our services. We try to
terminate calls on our own network whenever possible. When we cannot terminate
calls on our network, we terminate calls on the network of other suppliers,
including IDT. We expect to continue to utilize this process. We also expect the
percentage of our traffic that we terminate with IDT will decline in the future
as we expand our own network and establish additional carrier inter-connects.
Selling and Marketing. Selling and marketing includes the expenses
associated with acquiring customers, including commissions paid to our sales
partners, advertising costs, travel, entertainment, referral fees and amounts
paid to our strategic partners in connection with revenue-sharing arrangements.
We expended significant capital to build brand recognition. Most of our sales
and marketing expenses have gone toward securing significant and strategic
relationships with a variety of Internet companies. Many of these agreements
with Internet companies have since been restructured in a manner more favorable
to us, or in some cases, terminated.
General and Administrative. General and administrative expenses consist
of the salaries of our employees and associated benefits, and the cost of
insurance, legal, rent, utilities, shipping, consulting and other costs. A large
portion of our general and administrative expenses include operations and
customer support. These include the expenses associated with customer service
and technical support, and consist primarily of the salaries and employment
costs of the employees responsible for those efforts. We expect general and
administrative costs to decrease by operating more efficiently and by leveraging
our existing infrastructure to support our growth. Over time, we expect these
relatively fixed general and administrative expenses to decrease as a percentage
of revenue.
36
Depreciation and Amortization. Depreciation and amortization expenses
primarily relate to our software and hardware infrastructure. We depreciate our
network equipment over its estimated useful life ranging from five to fifteen
years using the straight-line method. We plan to acquire a domestic high
capacity network to provide additional capacity to handle the expected increase
in customer traffic as our business grows. In addition, we will be adding more
network hardware as traffic volumes justify. As a result, depreciation will
continue to increase capital expenditures for the deployment of our networks to
manage increased call volumes. Upon the adoption of SFAS No. 142, goodwill will
no longer be amortized.
Results of Operations
The following table sets forth certain items in our statement of
operations as a percentage of total revenue for the periods indicated:
Fiscal Year Ended July 31,
1999 2000 2001
-------- -------- --------
Percent
-----------------------------------------
Statement of Operations Data:
Revenue:
Service Revenue ............................................. 98.2 84.6 95.4
Product Revenue ............................................. 1.8 15.4 4.6
------ ------ ------
Total revenue ............................................. 100.0 100.0 100.0
------ ------ ------
Costs and expenses:
Service cost of revenue, excluding .......................... 52.8 47.9 68.5
depreciation
Product cost of revenue, excluding .......................... 0.8 8.7 3.7
------ ------ ------
depreciation
Total Direct Costs of revenue ............................ 53.6 56.6 72.2
Selling and marketing ....................................... 26.5 94.9 55.8
General and administrative .................................. 32.6 50.2 56.0
Depreciation and amortization ............................... 7.0 9.4 15.5
Restructuring costs and other charges ....................... -- -- 46.7
Compensation charge from the issuance of
stock options ............................................. 53.9 66.4 13.7
------ ------ ------
Total costs and expenses ................................ 173.6 277.5 259.9
------ ------ ------
Loss from operations ........................................... (73.6) (177.5) (159.9)
Interest expense ............................................... (1.3) (0.4) 0.0
Interest income ................................................ 0.6 13.8 12.3
Loss on equity investments and other, net ...................... -- 0.7 (97.9)
------ ------ ------
Net loss before Minority Interests ............................. (74.3) (163.4) (245.5)
Minority Interests ............................................. -- -- (1.8)
------ ------ ------
Net loss ....................................................... (74.3) (163.4) (243.7)
Redeemable preferred stock dividends ........................... (87.8) -- (.4)
------ ------ ------
Net loss available to common stockholders ................... (162.1) (163.4) (244.1)
------ ------ ------
Comparison of Fiscal Years Ended July 31, 2001 and 2000
Revenue. Our revenues are derived from per-minute charges we billed to
our customers on a pre-paid basis and from the sale of Internet telephony
equipment, such as YAP Gear and services provided to resellers, IDT and other
carriers. Revenue increased approximately 107 percent from $72.4 million for
fiscal 2000 to $150.2 million for fiscal 2001. The increase in revenue was
primarily due to an increase in billed minutes of use resulting from additional
marketing of our products and services. Specifically, revenue from services
increased approximately 134 percent from approximately $61.3 million for fiscal
2000 to approximately $143.3 million in revenue for fiscal 2001. Revenue from
products decreased
37
approximately 38 percent from approximately $11.1 million for fiscal 2000 to
approximately $6.9 million for fiscal 2001 as we discontinue certain selling
channels, primarily retail stores in the domestic market. We anticipate that in
fiscal 2001 services revenue will increase in absolute terms as our products and
services become more widely distributed.
Direct Cost of Revenue, Excluding Depreciation and Amortization. Our
direct cost of revenue consists primarily of network costs associated with
carrying our customers' traffic on our network and leased networks, routing
their calls through a local telephone company to reach their final destination
and wholesale cost of internet telephony devices and ad serving cost and e-mail
box hosting fees. Total direct cost of revenue, excluding depreciation and
amortization, increased by 165 percent from $41.0 million for fiscal 2000 to
$108.4 million in fiscal 2001. As a percentage of total revenue, these costs
increased from approximately 56.6 percent for fiscal 2000 to approximately 72.2
percent for fiscal 2001. This increase is primarily attributable to the impact
of our subsidization of free minutes to strategic partners such as Microsoft and
Yahoo! as well as monthly recurring costs from leased lines and other
connectivity in anticipation of increased traffic volumes from our various
distribution relationships. As a percentage of revenue, we expect direct cost of
revenue to decrease as a result of restructuring of these agreements in a manner
more favorable to us.
Selling and Marketing. Selling and marketing expenses consist primarily
of expenses associated with acquiring customers, including commissions paid to
our sales partners, advertising costs, referral fees and amounts paid to our
strategic partners, some of which contain revenue-sharing arrangements. Selling
and marketing expenses increased approximately 22 percent from approximately
$68.7 million for fiscal 2000 to approximately $83.8 million for fiscal 2001. As
a percentage of total revenue, these costs decreased from approximately 94.9
percent for fiscal 2000 to approximately 55.8 percent for fiscal 2001. In the
second quarter of fiscal 2001, we incurred a one-time non-recurring charge of
approximately $31 million related to the termination of certain marketing and
advertising agreements previously established with our strategic partners. In
fiscal year 2000, a similar one-time charge of $27.8 million was taken related
to these agreements.
General and Administrative. General and administrative expenses consist
of the salaries of our employees and associated benefits, and the cost of
insurance, legal, rent, utilities, shipping, consulting and other costs. General
and administrative expenses increased approximately 132 percent from
approximately $36.3 million for fiscal 2000 to approximately $84.2 million for
fiscal 2001. As a percentage of total revenue, these costs increased from
approximately 50.2 percent for fiscal 2000 to approximately 56.0 percent for
fiscal 2001. This increase was primarily attributable to the additional
organizational infrastructure and increase in personnel as we continued to build
our operations, product development, customer service, marketing and business
development functions and reflects the impact of acquisitions.
Depreciation and Amortization. Depreciation and amortization increased
approximately 243 percent from approximately $6.8 million for fiscal 2000 to
approximately $23.3 million for fiscal 2001. As a percentage of total revenue,
these costs increased to 15.5 percent in fiscal 2001 from 9.4 percent in fiscal
2000. In fiscal year 2001, amortization from Aplio was $5.4 million.
Depreciation will continue to increase as we increase capital expenditures for
the deployment of our networks both domestically and internationally to manage
increased call volumes. Upon the adoption of SFAS No. 142, goodwill will no
longer be amortized.
Restructuring costs and other charges. In the third quarter of Fiscal
2001, the Company decided to restructure the operations of its Aplio subsidiary.
In connection with this decision, the Company wrote-off substantially all of
Aplio's intangible and fixed assets as their values would not be recoverable,
resulting in a charge of approximately $33.6 million. In addition, the Company
accrued approximately $5.5 million for payments relating to the Aplio Settlement
Agreements. The Company recorded an additional charge of approximately $1.8
million in the fourth quarter of Fiscal 2001 related to possible Aplio employee
terminations. In addition, the Company wrote off certain advertising agreements
of approximately $14.6 million as well as intangible and fixed assets of $14.6
million, which were required based on the Company's review of its business plan,
as no future benefits are expected from these assets and commitments.
38
Non-Cash Compensation. We recognized significant charges relating to
non-cash executive compensation expense in fiscal 2001 and fiscal 2000 and will
recognize additional significant charges on an ongoing basis, in connection with
the grants of options to purchase shares of our common stock, modification of
our stock option plans and the sale of subsidiary restricted stock. As a
percentage of total revenue, non-cash compensation expense was 13.7 percent in
fiscal 2001 as compared to 66.4 percent in fiscal 2000.
Loss from Operations. Loss from operations was approximately $240.2
million for fiscal 2001 as compared to loss from operations of approximately
$128.5 million for fiscal 2000. Excluding the non-cash compensation charge, the
one-time non-recurring termination costs and restructuring costs and other
charges described above, our loss from operations for fiscal 2001 and fiscal
2000 would have been $118.6 million and $52.6 million, respectively. This change
is due to the increase in both selling and marketing expenses as well as general
and administrative expenses we incurred as we expanded our distribution
relationships, corporate infrastructure and human resources.
Interest Income, net. Interest income consists primarily of interest
earned on cash and cash equivalents. Interest income, net increased
approximately 91 percent from $9.7 million for fiscal 2000 to approximately
$18.5 million for fiscal 2001. The interest income resulted from the investment
of the proceeds of sales of our stock.
Loss on equity investments and other, net. During fiscal 2001, we
recorded a loss relating to a permanent write-down of our investment in shares
of Yahoo!, Inc. common stock, in addition, we recorded a loss relating to an
other-than-temporary decline in value for our equity investment in Webley and
WebDialogs, totaling approximately $17.7 million. This loss of approximtely
$136 million has been recorded as "other expense" in the accompanying
consolidated statement of operations. Off-setting the loss, in part, relating to
permanent write-down is a gain relating termination of derivative financial
instruments relating to our Yahoo! investment.
Comparison of Fiscal Years Ended July 31, 2000 and 1999
Revenue. Our revenues were derived from per-minute charges we billed to
our customers on a pre-paid basis and from the sale of internet telephony
equipment, such as YAP Gear and services to resellers, IDT and other carriers.
Revenue increased approximately 118 percent from $33.3 million for fiscal 1999
to $72.4 million for fiscal 2000. The increase in revenue was primarily due to
an increase in billed minutes of use resulting from additional marketing of our
products and services and the introduction of our YAP product line of internet
telephony devices. Specifically, revenue from services increased approximately
88 percent from approximately $32.6 million for fiscal 1999 to approximately
$61.3 million in revenue for fiscal 2000. Revenue from products increased
approximately 1,733 percent from approximately $0.6 million for fiscal 1999 to
approximately $11.1 million for fiscal 2000 primarily due to the introduction of
our line of YAP gear in the third and fourth quarters of 2000.
Direct Cost of Revenue, Excluding Depreciation and Amortization. Our
direct cost of revenue consists primarily of network costs associated with
carrying our customers' traffic on our network and leased networks, routing
their calls through a local telephone company to reach their final destination
and wholesale cost of internet telephony devices. Total direct cost of revenue,
excluding depreciation and amortization, increased by 130 percent from $17.8
million for fiscal 1999 to $41.0 million in fiscal 2000. As a percentage of
total revenue, these costs increased from approximately 53.6 percent for fiscal
1999 to
39
approximately 56.6 percent for fiscal 2000. This increase was primarily
attributable to monthly recurring costs from leased lines and other connectivity
in anticipation of increased traffic volumes from our various distribution
relationships.
Selling and Marketing. Selling and marketing expenses consisted
primarily of expenses associated with acquiring customers, including commissions
paid to our sales partners, advertising costs, referral fees and amounts paid to
our strategic partners, some of which contain revenue-sharing arrangements.
Selling and marketing expenses increased approximately 678 percent from
approximately $8.8 million for fiscal 1999 to approximately $68.7 million for
fiscal 2000. However, we incurred a one-time charge of $27.8 million in the
fourth quarter of fiscal 2000 which was associated with our termination of
certain marketing agreements with smaller Web properties, which had been
important in our initial stage of development as a way of promoting brand
awareness and consumer acceptance of our retail services, but have since been
rendered superfluous to our marketing plan. As a percentage of total revenue,
these costs increased from approximately 26.5 percent for fiscal 1999 to
approximately 94.9 percent for fiscal 2000. This increase primarily reflected
the increased marketing and advertising expenses associated with the agreements
established with priceline.com, Compuserve, Infospace.com, Yahoo!, Excite, Snap
and other strategic partners, as well as the $27.8 million one-time charge.
General and Administrative. General and administrative expenses
consisted of the salaries of our employees and associated benefits, and the cost
of insurance, legal, travel, entertainment, shipping, consulting, rent,
utilities and other cost. General and administrative expenses increased
approximately 235 percent from approximately $10.8 million for fiscal 1999 to
approximately $36.3 million for fiscal 2000. As a percentage of total revenue,
these costs increased from approximately 32.6 percent for fiscal 1999 to
approximately 50.2 percent for fiscal 2000. This increase was primarily
attributable to the additional organizational infrastructure and increase in
personnel as we continue to build our operations, customer service, marketing
and business development functions, the building of our Broadband and Enterprise
groups, and adding new office space.
Depreciation and Amortization. Depreciation and amortization increased
approximately 194 percent from approximately $2.3 million for fiscal 1999 to
approximately $6.8 million for fiscal 2000. As a percentage of total revenue,
these costs increased to 9.4 percent in fiscal 2000 from 7.0 percent in fiscal
1999.
Non-Cash Compensation. We recognized $48.1 million of non-cash
compensation expense in fiscal 2000 and 17.9 million in fiscal 1999. As a
percentage of total revenue, the compensation charge from issuance of stock
options was 66.4 percent in fiscal 2000 and 53.9 percent in fiscal 1999.
Loss from Operations. Loss from operations was approximately $128.5
million for fiscal 2000 as compared to loss from operations of approximately
$24.5 million for fiscal 1999. Excluding the non-cash compensation charge and
the one time costs described above, our loss from operations for fiscal 2000 and
fiscal 1999 would have been $52.6 million and $6.6 million, respectively. This
change was due to the substantial increase in both selling and marketing
expenses as well as general and administrative expenses we incurred as we
expanded our distribution relationships, corporate infrastructure and human
resources.
40
Quarterly Results of Operations
The following table sets forth certain quarterly financial data for the
eight quarters ended July 31, 2001. This quarterly information is unaudited,
has been prepared on the same basis as the annual financial statements, and, in
our opinion, reflects all adjustments (consisting only of normal recurring
accruals) necessary for a fair presentation of the information for periods
presented. Operating results for any quarter are not necessarily indicative of
results for any future period.
Quarter Ended
-------------------------------------------------------------
Oct. 31, Jan. 31, April 30, July 31,
1999 2000 2000 2000
----------- ----------- ----------- -----------
Revenue:
Service.............................. $12,379,956 $14,546,160 $16,157,012 $18,169,968
Product.............................. 756,962 925,651 2,712,789 6,752,692
----------- ----------- ----------- -----------
Total revenue......................... 13,136,918 15,471,811 18,869,801 24,922,660
Direct Cost of Revenue ................. 6,834,111 8,392,056 10,943,112 14,817,514
Selling and marketing................... 6,266,476 9,229,220 11,133,197 42,048,276(1)
General and administrative.............. 5,707,539 8,010,959 9,779,478 12,823,201
Depreciation and amortization........... 850,031 1,126,335 1,559,995 3,268,051(2)
Compensation charge from the 2,930,574 4,410,858 4,368,886 36,414,015
issuance of stock options..........
----------- ----------- ----------- -----------
Total costs and expenses.............. 22,588,731 31,169,428 37,784,668 109,371,057
Income (loss) from operations........... (9,451,813) (15,697,617) (18,914,867) (84,448,397)
Net interest expense.................... 1,086,543 2,555,193 3,148,803 3,388,150
----------- ----------- ----------- -----------
Net income (loss)....................... $ (8,365,270) $(13,142,424) $(15,766,064) $(81,060,247)
----------- ----------- ----------- -----------
As a Percentage of Revenue
------------------------------------------------------------
Revenue:
Service................................. 94.2% 94.0% 85.6% 72.9%
Product................................. 5.8 6.0 14.4 27.1
----------- ----------- ----------- ----------
Total revenue......................... 100.0 100.0 100.0 100.00
Direct Cost of Revenue ................. 52.0 54.3 58.0 59.5
Selling and marketing................... 47.7 59.7 59.0 168.7(1)
General and administrative.............. 43.4 51.8 51.8 51.5
Depreciation and amortization........... 6.5 7.3 8.3 13.1(2)
Compensation charge from the 22.3 28.5 23.2 146.1
issuance of stock options.......... ----------- ----------- ----------- ----------
Total costs and expenses.............. 171.9 201.6 200.3 438.9
Income (loss) from operations........... (71.9) (101.6) (100.3) (338.9)
----------- ----------- ----------- ----------
Net interest expense.................... 8.3 16.5 16.7 13.6
----------- ----------- ----------- ----------
Net income (loss)....................... (63.6%) (85.1)% (83.6)% (325.3)%
----------- ----------- ----------- ----------
(1) Includes approximately $28 million of costs incurred to terminate
advertising arrangements.
(2) Includes amortization of goodwill from the Aplio acquisition in the amount
of $941,019.
41
Quarter Ended
-------------------------------------------------------------
Oct. 31, Jan. 31, April 30, July 31,
2000 2001 2001 2001
----------- ----------- ----------- -----------
Revenue:
Service.............................. $26,940,727 $33,896,534 $39,940,437 $42,532,299
Product.............................. 3,868,343 756,873 674,017 1,589,258
----------- ----------- ----------- -----------
Total revenue......................... 30,809,070 34,653,407 40,614,454 44,121,557
Direct Cost of Revenue ................. 18,711,267 25,834,900 37,522,571 26,342,115
Selling and marketing................... 12,453,267 46,589,855 14,829,027 9,971,821
General and administrative.............. 17,516,403 20,131,213 21,654,863 24,856,237
Depreciation and amortization........... 5,653,628 6,630,235 5,082,920 5,982,755
Restructuring costs and other charges -- -- 66,500,044 3,600,815
Compensation charge from the
issuance of stock options.......... 4,769,904 5,205,852 5,151,264 5,417,809
----------- ----------- ----------- -----------
Total costs and expenses.............. 59,104,469 104,392,055 150,740,689 76,171,552
Income (loss) from operations........... (28,295,399) (69,738,648) (110,126,235) (32,049,995)
Net interest expense.................... 5,991,516 5,875,127 3,549,983 3,113,982
Loss on equity investments and other,
net.................................... 16,938,120 (112,856,355) (12,587,049) (38,467,414)
----------- ----------- ----------- -----------
Net loss before minority interests...... (5,365,763) (176,719,876) (119,163,301) (67,403,427)
Minority Interest....................... 193,284 (498,598) (283,476) (1,701,237)
----------- ----------- ----------- -----------
Net income (loss)....................... $ (5,172,479) $(176,221,278) $(118,879,825) $(65,702,190)
----------- ----------- ----------- -----------
As a Percentage of Revenue
------------------------------------------------------------
Revenue:
Service................................. 87.4% 97.8% 98.3% 96.4%
Product................................. 12.6 2.2 1.7 3.6
----------- ----------- ----------- ----------
Total revenue......................... 100.0 100.0 100.0 100.00
Direct Cost of Revenue ................. 60.7 74.6 92.4 59.7
Selling and marketing................... 40.4 134.4 36.5 22.6
General and administrative.............. 56.2 58.1 53.3 56.3
Depreciation and amortization........... 18.4 19.1 12.5 13.6
Restructuring costs and other charges -- -- 163.7 8.2
Compensation charge from the 15.5 15.0 12.7 12.3
issuance of stock options..........
----------- ----------- ----------- ----------
Total costs and expenses.............. 191.2 301.2 371.1 172.7
----------- ----------- ----------- ----------
Income (loss) from operations........... (91.2) (201.2) (271.1) (72.7)
Net interest expense.................... 19.4 17.0 8.7 7.1
Loss on equity investments and other,
net.................................... 55.0 (325.8) (31.0) (87.2)
----------- ----------- ----------- ----------
Net loss before minority interests...... (16.8) (510.0) (293.4) (152.8)
Minority Interest....................... -- (1.4) (.7) (3.9)
----------- ----------- ----------- ----------
Net income (loss)....................... (16.8)% $(508.6)% (292.7)% (148.9)%
----------- ----------- ----------- -----------
42
We have experienced growth in total revenue in each quarter since
inception, reflecting greater acceptance and usage of our products and services
by our expanded customer base. We expect our revenue to grow over time as use of
our service increases. We continue to explore and evaluate new lines of business
that are profitable.
As a result of our limited operating history and the emerging nature of
the markets in which we compete, we are unable to accurately forecast our
revenue and direct cost of revenue as they may be impacted by a variety of
factors. These factors include the level of use of the Internet as a
communications medium, capacity constraints, the amount and timing of our
capital expenditures, introduction of new services by us or our competitors,
price competition, technical difficulties or system downtime, and the
development of regulatory restrictions.
Liquidity and Capital Resources
As of July 31, 2001, we had cash, cash equivalents and marketable
securities of approximately $254 million and working capital of approximately
$218.1 million. We generated negative cash flow from operating activities of
approximately $115.1 million during the fiscal 2001, compared with negative cash
flow from operating activities of $72.1 million during fiscal 2000. The decrease
in cash flow from operating activities was primarily caused by an increase in
the net loss before depreciation and amortization, non-cash compensation
expense, an increase in prepaid and other assets, and the write down of equity
investments.
Net cash used in investing activities decreased from $160.4 million
during fiscal 2000, to $39.7 million for fiscal 2001. Capital expenditures
increased from approximately $47.4 million in fiscal 2000 to approximately $72.9
million in fiscal 2001, as we expanded our domestic and international network
infrastructure. In addition, the net cash from the proceeds from the sale of
marketable securities was approximately $180.2 million for fiscal 2001 as
compared to $49.4 million for fiscal 2000. In August 2000, we purchased 321,027
shares of common stock of Speechworks International, Inc. for approximately $4.0
million and acquired 994,299 shares of
43
Predictive Networks, Inc. Series C Convertible preferred stock for
approximately $3.0 million. In November 2000, we purchased 2,729,730 shares of
HeyAnita, Inc. Series B preferred stock for approximately $2.0 million. In
December 2000, we purchased 591,576 shares of LocatioNet Systems 2000 Ltd.
common stock for approximately $1.0 million and acquired 54,000 shares of
Millicom Italia common stock for approximately $2.0 million. In December 2000,
we acquired 4,432,665 shares of Alonet S.A. common stock for approximately
$3 million in cash and converted loans of $4 million due from Alonet S.A.
Net cash provided by financing activities increased from $270 million
during fiscal 2000, to approximately $291.9 million for fiscal 2001. We received
approximately $296 million in net proceeds related to the sale of common stock
to a subsidiary of AT&T in August 2000 and received approximately $48.2 million
in a private placement of preferred stock for Adir Technologies, Inc., a
subsidiary of Net2Phone. During fiscal 2001, the Board of Directors authorized a
new share buyback program through which the we may repurchase up to five million
shares of common stock in the open market. As of July 31, 2001, we had
repurchased 4,361,600 shares under this program, utilizing approximately $56.9
million in cash.
We believe that, based upon our present business plan, our existing
cash resources will be sufficient to meet our currently anticipated working
capital and capital expenditure requirements for at least twelve months.
Effects of Inflation
Due to relatively low levels of inflation over the last several years,
inflation has not had a material effect on our results of operations.
Recent Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards (SFAS) No. 141, "Business Combinations," and
No. 142, "Goodwill and Other Intangible Assets."
SFAS No. 141 requires that the purchase method of accounting be used
for all business combinations initiated after June 30, 2001. Use of the
pooling-of-interests method is no longer permitted. SFAS No. 141 also includes
guidance on the initial recognition and measurement of goodwill and other
intangible assets acquired in a business combination that is completed after
June 30, 2001.
SFAS No. 142 no longer permits the amortization of goodwill and
indefinite-lived intangible assets. Instead, these assets must be reviewed
annually (or more frequently under certain conditions) for impairment in
accordance with this statement. This impairment test uses a fair value approach
rather than the undiscounted cash flows approach previously required by SFAS
No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed of." Intangible assets that do not have indefinite lives
will continue to be amortized over their useful lives and reviewed for
impairment in accordance with SFAS No. 121. We plan to early adopt SFAS No. 142
effective August 1, 2001 and do not expect the adoption to have a material
impact on our results of operations and financial condition.
Subsequent Events
On August 14, 2001, ADIR acquired all of the issued and outstanding
capital stock of NetSpeak Corporation ("NetSpeak"), a Florida corporation
through the merger of A Tech Merger Sub, Inc., a Florida corporation and
wholly-owned subsidiary of ADIR, with and into NetSpeak. As consideration ADIR,
paid an aggregate of $48.2 million for the acquisition. ADIR raised an aggregate
of $21 million from its existing shareholders specifically for the acquisition
of Netspeak.
In October 2001, IDT entered into an agreement to lead a consortium
that would concentrate ownership of approximately 50% in us and 64% voting
power. The consortium consists of IDT, Liberty Media Corporation ("Liberty"),
and AT&T. As part of the agreement, IDT and AT&T contributed their shares of our
Class A common stock (approximately 10.0 million and 18.9 million shares,
respectively) to a newly formed limited liability company (LLC). Liberty then
acquired a substantial portion of the LLC's units from AT&T, while IDT increased
its stake and AT&T retained a reduced but still significant interest. IDT will
be the managing member of the LLC. Immediately thereafter, Howard S. Jonas,
Chairman of IDT Corporation, became our Chief Executive Officer and four new
persons were added to our board of directors. It is too early at this time to
know whether any significant changes will be made in our current business
strategy as described above as a result of the concentration of majority voting
power in us into a single shareholder.
The events of September 11, 2001, additional threatened terrorist acts,
and the ongoing military action have created uncertainties in our industry as
well as domestic and international economies in general. These events, and
potential future terrorist acts, may result in reduced demand from our clients
for our services and products and may potentially have a material adverse effect
on our business,
44
financial condition and operating results. It is too soon, however, for us to
reasonably estimate the impact of these tragic events on our industry and our
future financial performance.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Securities and Exchange Commission's rule related to market risk
disclosure requires that we describe and quantify our potential losses from
market risk sensitive instruments attributable to reasonably possible market
changes. Market risk sensitive instruments include all financial or commodity
instruments and other financial instruments (such as investments and debt) that
are sensitive to future changes in interest rates, currency exchange rates,
commodity prices or other market factors. We are not exposed to market risks
from changes in foreign currency exchange rates or commodity prices. As of July
31, 2001, we do not hold derivative financial instruments nor do we hold
securities for trading or speculative purposes. We are exposed to changes in
interest rates primarily from our investments in cash equivalents. Under our
current policies, we do not use interest rate derivative instruments to manage
our exposure to interest rate changes.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Financial Statements filed as part of this Annual Report on Form
10-K are identified in the index to Consolidated Financial Statements on Page
F-1 hereto and are set forth on pages F-2 through F-25 hereto.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information under the captions "Board of Directors" and "Section 11(c)
Beneficial Ownership Reporting Compliance" in our Proxy Statement for the 2001
Annual Meeting of Stockholders (the "Proxy Statement") are incorporated herein
by reference. Certain information concerning our executive officers is set forth
in Part I of this Form 10-K under the caption "Executive Officers."
ITEM 11. EXECUTIVE COMPENSATION
Information set forth under the captions "Executive Compensation" and
"Board of Directors" in the Proxy Statement is incorporated herein by reference.
The sections captioned "Report of the Compensation Committee on Executive
Compensation" and "Stock Price Performance Graph" in the Proxy Statement are not
incorporated herein by reference.
45
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information set forth under the caption "Information Regarding
Beneficial Ownership of Principal Stockholders, Directors and Management" in the
Proxy Statement is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information set forth under the caption entitled "Certain Relationships
and Related Transactions" in the Proxy Statement is incorporated herein by
reference.
PART IV.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) (1) Financial Statements.
The Financial Statements filed as part of this Annual Report on Form
10-K are identified in the Index to Consolidated Financial Statements on page
F-1 hereto.
(2) Financial Statement Schedules.
Financial Statement Schedules have been omitted because the information
required to be set forth therein is not applicable or is shown on the financial
statements or notes thereto.
(3) Exhibits.
Exhibits listed in the accompanying Index of Exhibits are filed
herewith or are incorporated by reference to exhibits previously filed with the
Commission.
(b) Reports on Form 8-K.
(1) On June 21, 2001, we filed a Current Report on Form
8-K reporting under Item 5 the execution of a merger
agreement by and among Adir Technologies, Inc.,
Netspeak Corporation and a wholly-owned subsidiary of
ADIR.
(2) On July 16, 2001, we filed a Current Report on Form
8-K/A reporting under Item 2 and Item 7 certain
matters related to our acquisition of Aplio S.A.
(3) On August 16, 2001 we filed a Current Report on Form
8-K/A reporting under Item 2 and Item 7 certain
matters related to our acquisition of Aplio S.A.
(4) On August 27, 2001 we filed a Current Report on Form
8-K reporting under Item 2 the merger of a
wholly-owned subsidiary of Adir Technologies, Inc.
with and into Netspeak Corporation.
46
NET2PHONE, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULE
Report of Independent Auditors............................................ F-2
Consolidated Balance Sheets as of July 31, 2001 and 2000 ................. F-3
Consolidated Statements of Operations for the years ended July 31, 2001,
2000 and 1999........................................................... F-4
Consolidated Statements of Stockholders' Equity (Deficit) for the years
ended July 31, 2001, 2000 and 1999..................................... F-5
Consolidated Statements of Cash Flows for the years ended July 31, 2001,
2000 and 1999.......................................................... F-6
Notes to Consolidated Financial Statements............................... F-7
The following consolidated financial statement schedule of Net2Phone, Inc.
and Subsidiaries is included in Item 14(d):
Schedule II-Valuation and Qualifying Accounts.......................... F-24
F-1
The Board of Directors and Stockholders
Net2Phone, Inc.
We have audited the accompanying consolidated balance sheets of Net2Phone,
Inc. (the "Company") as of July 31, 2001 and 2000, and the related consolidated
statements of operations, stockholders' equity (deficit) and cash flows for each
of the three years in the period ended July 31, 2001. Our audits also included
the financial statement schedule listed in the index at item 14(a). These
financial statements and schedule are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. 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 financial statements referred to above present fairly,
in all material respects, the financial position of the Company at July 31, 2001
and 2000 and the results of its operations and its cash flows for each of the
three years in the period ended July 31, 2001, in conformity with accounting
principles generally accepted in the United States. Also, in our opinion, the
related financial statement schedule, when considered in relation to the basic
financial statements taken as a whole, presents fairly in all material respects
the information set forth therein.
/s/ ERNST & YOUNG LLP
New York, New York
October 23, 2001
F-2
NET2PHONE, INC.
CONSOLIDATED BALANCE SHEETS
July 31,
--------
2001 2000
---- ----
ASSETS:
Current assets:
Cash and cash equivalents ......................................................... $ 195,140,568 $ 57,874,228
Marketable securities - current ................................................... 58,827,928 59,142,518
Trade accounts receivable,
net of allowance for doubtful accounts of $1.9 million (2001) and $0 (2000) .. 12,385,119 9,754,931
Prepaid contract deposits ......................................................... 7,446,450 13,443,704
Inventory ......................................................................... 4,160,877 3,216,783
Prepaid expenses .................................................................. 4,178,798 7,020,970
Notes receivable .................................................................. 4,112,759 3,450,000
Other current assets .............................................................. 1,319,524 2,119,802
------------- -------------
Total current assets ......................................................... 287,572,023 156,022,936
Property and equipment, net ............................................................ 108,398,276 59,867,154
Investments ............................................................................ 8,591,164 19,845,349
Marketable securities - long term ...................................................... -- 132,277,504
Intangible assets, net ................................................................. 6,544,859 42,123,045
Other assets ........................................................................... 296,762 1,592,445
------------- -------------
Total assets ................................................................. $ 411,403,084 $ 411,728,433
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY:
Current liabilities:
Accounts payable .................................................................. $ 15,689,484 $ 19,783,115
Accrued expenses .................................................................. 20,268,212 17,230,019
Deferred revenue .................................................................. 7,516,066 5,010,951
Current portion of long-term obligations .......................................... 11,596,982 2,743,761
Due to IDT ........................................................................ 14,401,290 4,883,111
------------- -------------
Total current liabilities .................................................... 69,472,034 49,650,957
Accrued expenses ....................................................................... 366,667 4,300,000
Long-term obligations .................................................................. 8,349,253 5,203,340
------------- -------------
Total liabilities ............................................................ 78,187,954 59,154,297
Minority interests ..................................................................... 45,482,342 --
Redeemable common stock, $.01 par value; 410,595 and 582,749 shares outstanding ........ 13,904,256 20,687,590
Commitments and contingencies
Stockholders' equity :
Common stock, $.01 par value; 200,000,000 shares authorized including redeemable
shares; 29,146,499 and 21,605,133 shares issued and outstanding.................. 291,465 216,051
Class A stock, $.01 par value, 37,924,250 shares authorized;
32,315,500 and 33,916,750 shares issued and outstanding.......................... 323,155 339,167
Additional paid-in capital ........................................................ 883,140,001 555,364,405
Accumulated deficit ............................................................... (514,765,057) (148,789,291)
Accumulated other comprehensive gain (loss) ....................................... 149,685 (41,757,843)
Deferred compensation ............................................................. (34,885,132) (30,246,300)
Loans to stockholders ............................................................. (3,512,998) (3,239,643)
Treasury stock, at cost ........................................................... (56,912,587) --
------------- -------------
Total stockholders' equity .................................................. 273,828,532 331,886,546
------------- -------------
Total liabilities and stockholders' equity .................................. $ 411,403,084 $ 411,728,433
============= =============
See accompanying notes.
F-3
NET2PHONE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Year ended July 31,
-----------------------------------------------
2001 2000 1999
---- ---- ----
Revenue:
Service revenue ................................................ $ 143,309,997 $ 61,253,096 $ 32,648,305
Product revenue ................................................ 6,888,491 11,148,094 608,152
------------- ------------- -------------
Total revenue ........................................ 150,198,488 72,401,190 33,256,457
Costs and expenses:
Direct cost of revenue:
Service cost of revenue ................................... 102,805,831 34,700,401 17,554,074
Product cost of revenue ................................... 5,605,022 6,286,392 263,936
------------- ------------- -------------
Total direct cost of revenue ......................... 108,410,853 40,986,793 17,818,010
Selling and marketing .......................................... 83,843,970 68,677,169 8,828,167
General and administrative ..................................... 84,158,715 36,321,177 10,836,072
Depreciation and amortization .................................. 23,349,538 6,804,412 2,316,545
Restructuring and other charges ................................ 70,100,860 -- --
Non-cash compensation .......................................... 20,544,829 48,124,333 17,919,541
------------- ------------- -------------
Total costs and expenses ............................ 390,408,765 200,913,884 57,718,335
------------- ------------- -------------
Loss from operations ........................................... (240,210,277) (128,512,694) (24,461,878)
Interest income, net ........................................... 18,530,609 9,672,815 (243,314)
Loss on equity investments and other, net ...................... (146,972,698) 505,874 --
------------- ------------- -------------
Loss before minority interests ................................. (368,652,366) (118,334,005) (24,705,192)
Minority interests ............................................. (2,676,595) -- --
------------- ------------- -------------
Net loss ....................................................... (365,975,771) (118,334,005) (24,705,192)
Redeemable preferred stock dividends ........................... -- -- (29,219,362)
Redeemable common stock accretion .............................. (531,999) -- --
------------- ------------- -------------
Net loss available to common shareholders ...................... ($366,507,770) ($118,334,005) ($ 53,924,554)
============= ============= =============
Net loss per common share - basic and diluted .................. ($ 6.25) ($ 2.29) ($ 1.73)
============= ============= =============
Weighted average number of common shares used in the calculation
of basic and diluted net loss per common share.................. 58,664,580 51,738,918 31,236,415
============= ============= =============
See accompanying notes.
F-4
Net2Phone, Inc.
Consolidated Statements of Stockholders' Equity (Deficit)
Years ended July 31, 1999, 2000, and 2001
Common Stock Class A Stock
--------------------------------------------------------------
Shares Amount Shares Amount
-------------- --------------- -------------- ------------
Balance at July 31, 1998 30,960,000 $ 100,100 -- $ --
Net loss for the year ended July 31, 1999 -- -- -- --
Comprehensive loss:
Issuance of warrants -- -- -- --
Exercise of stock options 1,345,218 13,452 -- --
Deferred compensation -- -- -- --
Capital contributions from IDT Corporation -- 209,500 -- --
Conversion of IDT Common stock to Class A stock (27,864,000) (278,640) 27,864,000 278,640
Conversion of Class A to Common Stock 241,911 2,420 (241,911) (2,420)
Exercise of warrants 136,648 1,366 -- --
Accretion of discount on Series A preferred stock
convertible to Class-A stock -- -- -- --
Amortization of deferred compensation -- -- -- --
-------------- --------------- -------------- ------------
Balance at July 31, 1999 4,819,777 48,198 27,622,089 276,220
Net loss for the year ended July 31, 2000 -- -- -- --
Foreign currency translation -- -- -- --
Unrealized equity securities loss, net -- -- -- --
Comprehensive loss:
Issuance of Common Stock in initial public offering 6,210,000 62,100 -- --
Conversion of Preferred Stock to Class A Stock -- -- 9,420,000 94,200
Conversion of Class A Stock to Common Stock 3,125,339 31,253 (3,125,339) (31,253)
Exercise of stock options 1,272,239 12,722 -- --
Amortization of deferred compensation -- -- -- --
Repayment of loans to stockholders -- -- -- --
Secondary equity offering 3,400,000 34,000 -- --
Issuance of common stock to Yahoo! Inc. 2,777,778 27,778 -- --
Deferred compensation from stock option grants and regrants -- --
-------------- --------------- -------------- ------------
Balance at July 31, 2000 21,605,133 216,051 33,916,750 339,167
Net loss for the year ended July 31, 2001 -- -- -- --
Foreign currency translation -- -- -- --
Unrealized equity securities loss, net -- -- -- --
Comprehensive loss
Issuance of Common Stock to AT&T -- -- 4,000,000 40,000
Repurchase of Common Stock -- -- -- --
Conversion of Class A stock to common stock 5,601,250 56,012 (5,601,250) (56,012)
Exercise of stock options 1,789,726 17,897 -- --
Repayment of loans to stockholders -- -- -- --
Release of escrow shares 150,390 1,505 -- --
Accretion of redeemable common stock -- -- -- --
Amortization of deferred compensation -- -- -- --
Deferred compensation -- -- -- --
-------------- --------------- -------------- ------------
Balance at July 31, 2001 29,146,499 $ 291,465 32,315,500 $ 323,155
============== =============== ============== ============
Accumulated
Additional Other
Paid-In Accumulated Comprehensive Deferred
Capital Deficit Income (Loss) Compensation
----------------- ------------------ ---------------- ----------------
Balance at July 31, 1998 $ -- $ (5,750,094) $ -- $ --
Net loss for the year ended July 31, 1999 -- (24,705,192) -- --
Comprehensive loss:
Issuance of warrants 2,100,000 -- -- --
Exercise of stock options 4,470,608 -- -- --
Deferred compensation 49,827,816 -- -- (49,827,816)
Capital contributions from IDT Corporation 4,420,338 -- -- --
Conversion of IDT Common stock to Class A stock -- -- -- --
Conversion of Class A to Common Stock -- -- -- --
Exercise of warrants 436,504 -- -- --
Accretion of discount on Series A preferred stock
convertible to Class-A stock (129,000) -- -- --
Amortization of deferred compensation -- -- -- 17,919,541
----------------- ------------------ --------------- ----------------
Balance at July 31, 1999 61,126,266 (30,455,286) -- (31,908,275)
Net loss for the year ended July 31, 2000 -- (118,334,005) -- --
Foreign currency translation -- -- 47,239 --
Unrealzed equity securities loss, net -- -- (41,805,082) --
Comprehensive loss:
Issuance of Common Stock in initial public offering 83,744,373 -- -- --
Conversion of Preferred Stock to Class A Stock 27,834,800 -- -- --
Conversion of Class A Stock to Common Stock -- -- -- --
Exercise of stock options 8,876,022 -- -- --
Amortization of deferred compensation -- -- -- 48,124,333
Repayment of loans to stockholders -- -- -- --
Secondary equity offering 177,348,364 -- -- --
Issuance of common stock to Yahoo! Inc. 149,972,222 -- -- --
Deferred compensation from stock option grants and regrants 46,462,358 -- -- (46,462,358)
----------------- ------------------ --------------- ----------------
Balance at July 31, 2000 555,364,405 (148,789,291) (41,757,843) (30,246,300)
Net loss for the year ended July 31, 2001 -- (365,975,766) -- --
Foreign currency translation -- -- 461,551 --
Unrealized equity securities loss, net -- -- 41,445,977 --
Comprehensive loss
Issuance of Common Stock to AT&T 295,943,720 -- -- --
Repurchase of Common Stock -- -- -- --
Conversion of Class A stock to common stock -- -- -- --
Exercise of stock options 7,180,214 -- -- --
Repayment of loans to stockholders -- -- -- --
Release of escrow shares -- -- -- --
Accretion of redeemable common stock (531,999) -- -- --
Amortization of deferred compensation -- -- -- 20,544,829
Deferred compensation 25,183,661 -- -- (25,183,661)
----------------- ------------------ --------------- ----------------
Balance at July 31, 2001 $ 883,140,001 $ (514,765,057) $ 149,685 $(34,885,132)
================= ================== =============== ================
Treasury Stock Total
Loans to --------------------------------- Stockholders'
Stockholders Shares Amount Equity (Deficit)
-------------- ------------ ------------------ -------------------
Balance at July 31, 1998 $ -- -- $ -- $ (5,649,994)
Net loss for the year ended July 31, 1999 -- -- -- (24,705,192)
-------------------
Comprehensive loss: (24,705,192)
Issuance of warrants -- -- -- 2,100,000
Exercise of stock options (3,149,990) -- -- 1,334,070
Deferred compensation -- -- -- --
Capital contributions from IDT Corporation -- -- -- 4,629,838
Conversion of IDT Common stock to Class A stock -- -- -- --
Conversion of Class A to Common Stock -- -- -- --
Exercise of warrants -- -- -- 437,870
Accretion of discount on Series A preferred stock
convertible to Class-A stock -- -- -- (129,000)
Amortization of deferred compensation -- -- -- 17,919,541
-------------- ------------ ------------------ -------------------
Balance at July 31, 1999 (3,149,990) -- -- (4,062,867)
Net loss for the year ended July 31, 2000 -- -- -- (118,334,005)
Foreign currency translation -- -- -- 47,239
Unrealzed equity securities loss, net -- -- -- (41,805,082)
-------------------
Comprehensive loss: (160,091,848)
Issuance of Common Stock in initial public offering -- -- -- 83,806,473
Conversion of Preferred Stock to Class A Stock -- -- -- 27,929,000
Conversion of Class A Stock to Common Stock -- -- -- --
Exercise of stock options (716,702) -- -- 8,172,042
Amortization of deferred compensation -- -- -- 48,124,333
Repayment of loans to stockholders 627,049 -- -- 627,049
Secondary equity offering -- -- -- 177,382,364
Issuance of common stock to Yahoo! Inc. -- -- -- 150,000,000
Deferred compensation from stock option grants and regrants -- -- -- --
-------------- ------------ ------------------ -------------------
Balance at July 31, 2000 (3,239,643) -- -- 331,886,546
Net loss for the year ended July 31, 2001 -- -- -- (365,975,766)
Foreign currency translation -- -- -- 461,551
Unrealized equity securities loss, net -- -- -- 41,445,977
-------------------
Comprehensive loss (324,068,238)
Issuance of Common Stock to AT&T -- -- -- 295,983,720
Repurchase of Common Stock -- 4,361,600 (56,912,587) (56,912,587)
Conversion of Class A stock to common stock -- -- -- --
Exercise of stock options (514,500) -- -- 6,683,612
Repayment of loans to stockholders 241,145 -- -- 241,145
Release of escrow shares -- -- -- 1,505
Accretion of redeemable common stock -- -- -- (531,999)
Amortization of deferred compensation -- -- -- 20,544,829
Deferred compensation -- -- -- --
-------------- ------------ ------------------ -------------------
Balance at July 31, 2001 $(3,512,998) 4,361,600 $ (56,912,587) $ 273,828,532
============== ============ ================== ===================
See accompanying notes.
F-5
NET2PHONE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year ended July 31,
-------------------
2001 2000 1999
---- ---- ----
Operating activities:
Net loss........................................................... ($365,975,771) ($118,334,005) ($24,705,192)
Adjustments to reconcile net loss to net cash used in operating
activities:
Depreciation and amortization...................................... 23,349,538 6,804,412 2,316,545
Amortization of discount on marketable securities.................. (31,072) (43,582) --
Amortization of deferred compensation 20,544,829 48,124,333 17,919,541
Write-down of equity investment.................................... 116,778,380 -- --
Write-down of assets............................................... 78,526,762 -- --
Gain on derivative instrument...................................... (5,235,240) (516,610) --
Minority interests................................................. (2,676,595) -- --
Changes in assets and liabilities:
Accounts receivable............................................. (2,643,586) (9,119,258) 933,939
Prepaid contract deposits....................................... 5,997,254 (7,281,620) (6,162,084)
Inventory....................................................... (979,327) (2,201,828) (540,000)
Prepaid expenses................................................ 2,992,729 (6,553,115) (459,918)
Other current assets............................................ 589,146 (804,674) --
Other assets.................................................... 778,930 (967,955) (17,239)
Accounts payable................................................ (3,931,429) 16,463,261 2,151,778
Accrued expenses................................................ 8,775,775 12,585,498 4,692,953
Deferred revenue................................................ 2,505,115 2,640,319 1,560,518
Net (repayments to) advances from IDT Corporation............... 5,518,179 (12,852,284) 5,920,407
------------- ------------- ------------
Net cash (used in) provided by operating activities..................... (115,116,383) (72,057,108) 3,611,248
Investing activities:
Purchases of property, plant & equipment .......................... (72,904,536) (47,386,058) (14,544,052)
Proceeds from derivative instrument ............................... 25,221,850 -- --
Purchases of marketable securities ................................ (142,199,630) (132,627,812) --
Payments of long-term obligations ................................. (2,094,468) -- --
Proceeds from the sale of marketable securities ................... 180,243,672 49,446,291 --
Purchase of trademark ............................................. -- -- (5,000,000)
Acquisitions, net of cash acquired ................................ (6,473,750) (6,563,576) --
Issuance of notes receivable ...................................... (7,316,049) (3,450,000) --
Investments ....................................................... (14,170,557) (19,845,349) --
------------- ------------- ------------
Net cash used in investing activities................................... (39,693,468) (160,426,504) (19,544,052)
Financing activities:
Proceeds from the issuance of common stock ........................ 295,983,720 261,188,838 --
Proceeds from the issuance of preferred stock .................... --
by ADIR Technologies ..................................... 48,158,937 --
Proceeds from the exercise of stock options ....................... 6,683,612 8,172,041 1,334,070
Proceeds from issuance of preferred stock and warrants ............ -- -- 29,900,000
Proceeds from exercise of warrants ................................ -- -- 437,870
Purchase of redeemable common stock ............................... (2,109,907) -- --
Proceeds from repayment of loans to stockholders................... 241,145 627,049 --
Repayments of borrowings........................................... (135,093) -- --
Capital contributions from IDT Corporation ........................ -- -- 4,629,838
Repurchase of common stock ........................................ (56,912,587) -- --
------------- ------------- ------------
Net cash provided by financing activities............................... 291,909,827 269,987,928 36,301,778
------------- ------------- ------------
Effect of exchange rate on cash......................................... 166,364 (9,136) --
------------- ------------- ------------
Net increase in cash and cash equivalents............................... 137,266,340 37,495,180 20,368,974
Cash and cash equivalents at beginning of period........................ 57,874,228 20,379,048 10,074
------------- ------------- ------------
Cash and cash equivalents at end of period.............................. $ 195,140,568 $ 57,874,228 $ 20,379,048
============= ============= ============
Supplemental disclosure of cash flow information:
Cash payments made for interest......................................... $ -- $ 558,335 $ --
============= ============= ============
Cash payments made for income taxes..................................... $ -- $ -- $ --
============= ============= ============
Supplemental disclosure of non-cash investing activities:
Redeemable common stock issued for an acquisition....................... $ -- $ 20,687,500 $ --
============= ============= ============
Common stock issued for marketable securities........................... $ -- $ 150,000,000 $ --
============= ============= ============
Supplemental disclosure of non-cash financing activities:
Conversion of preferred stock to Class A common stock................... $ -- $27,929,000 $ --
============= ============= ============
See accompanying notes.
F-6
Net2Phone, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
July 31, 2001
1. Description of Business and Basis of Presentation
The accompanying consolidated financial statements reflect the historical
financial information of Net2Phone, Inc. and Subsidiaries (collectively the
"Company"), which prior to August 2000 was a majority owned subsidiary of IDT
Corporation ("IDT"). The Company was incorporated in October 1997, to operate
and develop its Internet telephony business. Prior to such time, the Company's
business was conducted as a division of IDT. The incorporation of Net2Phone,
Inc. as a subsidiary of IDT was accounted for similar to a recapitalization. All
earnings per share calculations assume that such shares were outstanding for all
prior periods.
The Company's statements of operations include allocations of certain costs
and expenses from IDT. Although such allocations are not necessarily indicative
of the costs that would have been incurred if the Company operated as an
unaffiliated entity, management believes that the allocation methods are
reasonable.
On August 11, 2000, AT&T purchased four million newly-issued Class A shares
of the Company at a price of $75 per share. In addition, AT&T purchased 14.9
million Class A shares from IDT for $75 per share, giving the AT&T approximately
a 39 percent voting stake and approximately a 32 percent economic stake in the
Company.
On October 23, 2001, IDT entered into an agreement to lead a consortium
that would concentrate ownership of approximately 50% (64% of the voting power)
of the Company. See Note 21.
2. Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. Significant accounts have been eliminated in
consolidation.
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results may differ from those estimates.
Reclassifications
Certain prior year amounts have been reclassified to conform to the fiscal
2001 presentation.
Earnings (Loss) Per Share
Basic earnings (loss) per share is computed by dividing the net income
(loss) applicable to common shares by the weighted average of common shares
outstanding during the period. Diluted earnings (loss) per share adjusts basic
earnings (loss) per share for the effects of convertible securities, stock
options and other potentially dilutive financial instruments, only in the
periods in which such effect is dilutive. There were no dilutive securities in
any of the periods presented herein.
F-7
The shares issuable upon the exercise of stock options and warrants are
excluded from the calculation of net loss per share as their effect would be
antidilutive.
Foreign currency translation
The financial statements of the Company's foreign subsidiary has been
translated into U.S. dollars in accordance with SFAS No. 52, Foreign Currency
Translation. All balance sheet accounts have been translated using the average
exchange rates for the respective years. The gains or losses resulting from the
change in exchange rates have been reported as a component of accumulated other
comprehensive income (loss). Foreign currency translation gains and losses are
included in the results of operations as incurred.
Cash and Cash Equivalents
The Company considers all highly liquid investments with a maturity of
three months or less when purchased to be cash equivalents. Cash and cash
equivalents are carried at cost which approximates market value.
Inventory
Inventories are stated at the lower of cost or market. Cost is computed on
a specific identification basis.
Property and Equipment
Equipment and furniture and fixtures are recorded at cost and depreciated
using the straight-line method over the estimated useful lives of the assets,
which range from five to fifteen years.
Computer software is amortized using the straight-line method over the
shorter of five years or the term of the related agreement.
Software Development Costs
Costs for the internal development of new software products and substantial
enhancements to existing software products are expensed as incurred until
technological feasibility has been established, at which time any additional
costs would be capitalized. As the Company has completed its software
development concurrently with the establishment of technological feasibility, it
has not capitalized these costs. Software development costs are the Company's
only research and development expenditures. For the years ended July 31, 2001,
2000, and 1999, research and development costs totaled approximately
$10,360,000, $4,692,000, and $757,000, respectively.
Capitalized Internal Use Software Costs
The Company capitalizes certain costs incurred in connection with
developing or obtaining internal use software. These costs consist of payments
made to third parties and the salaries of employees working on such software
development. At July 31, 2001, 2000 and 1999, the Company has capitalized
approximately $17,672,000, $7,925,000, and $4,065,000, respectively, of internal
use software costs as computer software.
F-8
Long-Lived Assets
The Company reviews the impairment of long-lived assets and certain
identifiable intangibles whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. The analysis of the
recoverability utilizes undiscounted cash flows. The measurement of the loss, if
any, will be calculated as the amount by which the carrying amount of the asset
exceeds the fair value of the asset.
Revenue Recognition
Internet telephony service revenue is recognized as service is provided.
Revenue derived from equipment sales and from services provided to IDT is
recognized upon installation of the equipment and performance of the services,
respectively.
The sale of equipment with software necessary to provide the Company's
services is recognized when such products are delivered, collection of payments
are assured and there are no significant future obligations.
Pre-payments for communications services are deferred and recognized as
revenue as the communications services are provided.
Direct Cost of Revenue
Direct cost of revenue consists primarily of telecommunication costs,
connectivity costs, and the cost of equipment sold to customers. Direct cost of
revenue excludes depreciation and amortization.
Advertising Costs
The Company expenses the costs of advertising as incurred. The Company has
historically purchased banner advertising on other companies' web sites pursuant
to contracts which include the guarantee of (i) a minimum number of impressions,
(ii) the number of times that an advertisement appears in pages displayed to
users of the web site, or (iii) a minimum amount of revenue that will be
recognized by the Company from customers directed to the Company's Web site as a
direct result of the advertisement. The Company recognizes expense with respect
to such advertising ratably over the period in which the advertisement is
displayed. In addition, some agreements require additional payments as
additional impressions are delivered. Such payments are expensed when the
impressions are delivered. The Company has renegotiated, completed and/or
discontinued most of its on-line media expenditures.
In one case, the Company entered into an agreement with no specified term
of years. In this case, the Company amortizes as expense the lesser of (i) the
number of impressions to date/minimum guaranteed impressions, or (ii) revenue to
date/minimum guaranteed revenue as a percentage of the total payments.
For the years ended July 31, 2001, 2000 and 1999 advertising expense
totaled approximately $55,149,000, $28,525,000, and $6,590,000 respectively.
In addition, the Company incurred approximately $45.9 million in fiscal
2001 and $28 million in fiscal 2000 of costs to terminate advertising
arrangements. In fiscal 2001, $31.4 million of these costs are included in
selling and marketing and $14.5 million are included in restructuring and other
charges in the accompanying statement of operations. In fiscal 2000, these costs
were included in selling and marketing.
Income Taxes
The Company accounts for income taxes using the liability method. Under
this method, deferred tax assets and liabilities are determined based on
differences between the financial reporting and tax bases of assets and
liabilities.
F-9
Stock Based Compensation
The Company accounts for stock options issued to employees using the
intrinsic value method prescribed in Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees, and related interpretations.
Compensation expense for stock options issued to employees is measured as the
excess of the quoted market price of the Company's stock at the date of grant
over the amount an employee must pay to acquire the stock. Stock options issued
to employees of IDT are accounted for in accordance with Financial Accounting
Standards Board Statement ("SFAS") No. 123, Accounting for Stock-Based
Compensation. Compensation expense for stock options issued to employees of IDT
is measured based on the fair value of the stock options on the grant date
estimated using the Black-Scholes option pricing model.
The Company applies the disclosure-only provisions of SFAS No. 123 with
respect to stock options issued to the Company's employees.
Current Vulnerability Due to Certain Concentrations
Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of cash, cash equivalents,
marketable securities and trade receivables. Concentrations of credit risk with
respect to trade receivables are limited due to the large number of customers
comprising the Company's customer base.
Management regularly monitors the creditworthiness of its domestic and
international customers and believes that it has adequately provided for any
exposure to potential credit losses.
Segment Disclosures
SFAS No. 131, Disclosure about Segments of an Enterprise and Related
Information requires use of the "management approach" model for segment
reporting. The management approach model is based on the way a company's
management organizes segments within the company for making operating decisions
and assessing performance. Reportable segments are based on products and
services, geography, legal structure, management structure, or any other manner
in which management disaggregate a company. The Company operates in one segment.
Recent Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (SFAS) No. 141, "Business Combinations," and No.
142, "Goodwill and Other Intangible Assets."
SFAS No. 141 requires that the purchase method of accounting be used for all
business combinations initiated after June 30, 2001. Use of the
pooling-of-interests method is no longer permitted. SFAS No. 141 also includes
guidance on the initial recognition and measurement of goodwill and other
intangible assets acquired in a business combination that is completed after
June 30, 2001.
SFAS No. 142 no longer permits the amortization of goodwill and indefinite-lived
intangible assets. Instead, these assets must be reviewed annually (or more
frequently under certain conditions) for impairment in accordance with this
statement. This impairment test uses a fair value approach rather than the
undiscounted cash flows approach previously required by SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed of." Intangible assets that do not have indefinite lives will
continue to be amortized over their useful lives and reviewed for impairment in
accordance with SFAS No. 121. We plan to early adopt SFAS No. 142 effective
August 1, 2001 and do not expect the adoption to have a material impact on our
results of operations and financial condition.
F-10
3. Financial Instruments
Effective August 1, 1999 the Company adopted FASB Statement No. 133,
Accounting for Derivative Instruments and Hedging Activities ("FAS 133"). FAS
133 requires that all derivative financial instruments, such as interest rate
swap contracts and foreign exchange contracts, be recognized in the financial
statements and measured at fair value regardless of the purpose or intent for
holding them. Changes in the fair value of derivative financial instruments are
either recognized periodically in income or shareholders' equity (as a component
of comprehensive income), depending on whether the derivative is being used to
hedge changes in fair value or cash flows. For the years ended July 31, 2001 and
2000, the Company recorded a gain of approximately $5.2 million and $500,000,
respectively, related to its derivative instruments.
The carrying value of the Company's financial instruments approximates fair
value, except for differences with respect to $8.6 million at July 31, 2001 and
$19.8 million at July 31, 2000 of certain equity investments included in
investments, which are reflected at their carrying value because quoted market
prices do not exist. The fair value of financial instruments is generally
determined by reference to market values resulting from trading on a national
securities exchange or in an over-the-counter market. In cases where quoted
market prices are not available, such as for derivative financial instruments,
fair value is based on estimates using present value or other valuation
techniques.
4. ADIR Technologies, Inc.
In the first quarter of Fiscal 2001, ADIR Technologies, Inc., ("ADIR") a
subsidiary of Net2Phone, designated 135,000 shares of its preferred stock as
Series A and sold 13,277 of such shares to Cisco Systems, Softbank and IDT in a
private placement transaction for aggregate gross proceeds of approximately
$23,234,750. In addition, ADIR sold 18,525 shares of its common stock in Fiscal
2001 to employees of Net2Phone and ADIR in exchange for promissory notes of
approximately $3.2 million.
In the fourth quarter of Fiscal 2001, ADIR raised an additional $25 million
in exchange for 9,905 shares of its Series B preferred stock from its previous
investors, Cisco Systems and Softbank.
On August 14, 2001, ADIR acquired all of the issued and outstanding capital
stock of NetSpeak Corporation, a Florida corporation ("Netspeak"). Netspeak,
founded in 1995, is also a leading Cisco Service ProviderSolutions Ecosystem
partner, and has over 30 service provider customers using its suite of VOIP
infrastructure and application software today. The total aggregate consideration
paid for the acquisition was $48 million. The Company is in the pocess of
obtaining a valuation to determine the allocation of the purchase price. ADIR
raised an aggregate of $21 million from its existing shareholders specifically
for the acquisition of Netspeak.
5. Aplio Acquisition
On July 7, 2000, the Company acquired all of the outstanding capital stock
of Aplio, S.A ("Aplio") a company located in France with technology that enables
Voice Over Internet Protocol ("VOIP") devices. Consideration consisted of $2.9
million in cash at closing and 582,749 shares of the Company's redeemable common
stock which were valued at $35.50 and are redeemable at $36.947 per share,
promissory notes aggregating $6.5 million, $1.4 million in acquisition related
costs and $4.8 million in cash to be paid within eighteen months of the closing
of the transaction. In addition, the Company was required to pay two contingent
cash payments of $2,778,230 each on July 7, 2001 and July 7, 2002 and a third
payment of $2,500,000 July 7, 2003. As collateral for the first two contingent
payments, the company placed 150,329 shares of its common stock in escrow.
Certain of the selling shareholders also were given the right to require the
Company to repurchase their shares on various dates prior to January 31, 2002.
As of July 31, 2001, $4.6 million remains outstanding on the promissory notes.
F-11
The aggregate purchase price of $36.2 million plus the fair value of net
liabilities assumed of $2.7 million totaled approximately $38.9 million which
was allocated as follows: approximately $17.7 million to goodwill, $13.9 million
to technology, $2.3 million to trademark, $4.5 million to patents and $500,000
to workforce.
This acquisition was accounted for as a purchase, and accordingly, the net
assets and results of operations of the acquired business have been included in
the consolidated financial statements from July 7, 2000, the date of
acquisition.
As of June 7, 2001, the Company entered into a Settlement Agreement
with certain former Aplio shareholders pursuant to which the Company redeemed
116,549 shares for a total of $4,306,136, of which $1 million was paid before
July 31, 2001, and the balance was paid in August 2001. On April 30, 2003, the
Company has the option of redeeming the remaining 294,046 shares of the
Company's stock owned by these same shareholders for $10,864,000 or simply
paying the excess, if any, of $36.947 per share over the market value of the
shares at that time. In exchange, these shareholders waived their rights to
receive $2 million held back by the Company at the closing to secure certain
indemnification obligations.
As of July 31, 2001, the Company entered into Settlement Agreements with
three other former shareholders of Aplio pursuant to which the Company agreed to
pay to such shareholders the aggregate sum of $6,563,380 in two installments on
August 31, 2001 and January 8, 2002. In addition, the Company agreed to pay such
shareholders on April 30, 2003 the aggregate sum of $8,349,253, reduced by the
market value at that time of the 291,279 shares (including the 150,329 shares
released to such shareholders from escrow) of the Company's stock owned by such
shareholders. In exchange, these shareholders waived their rights to receive $1
million held back by the Company at the closing to secure certain
indemnification obligations.
In the third quarter of Fiscal 2001, the Company decided to discontinue
Aplio's operations. See Note 20.
6. Intangible Assets
Intangible assets and related amortization periods consist of the following:
July 31, July 31,
2001 2000 Period (mos.)
---- ---- ------------
Goodwill.................. $2,163,447 $ 17,485,441 60
Customer Lists............ 3,000,000 -- 60
Technology................ 1,000,000 13,900,000 35
Trademark................. 983,991 7,300,000 36
Patent ................. -- 4,500,000 35
Workforce................. -- 500,000 34
---------- ------------
7,147,438 43,685,441
Accumulated amortization.. (602,579) (1,562,396)
---------- ------------
Intangible assets, net.... $6,544,859 $ 42,123,045
========== ============
The excess of the cost over the fair value of tangible net assets of
purchased businesses is recorded as intangible assets and is amortized on a
straight-line basis. Costs associated with obtaining the right to use trademarks
owned by third parties are capitalized and amortized on a straight-line basis
over the term of the trademark. The Company examines the carrying value of its
intangible assets to determine whether there are any impairment losses. If
indicators of impairment were present in intangible assets used in operations,
and future cash flows were not expected to be sufficient to cover the assets'
carrying amount, an impairment loss would be charged to expense in the period
identified.
F-12
In connection with the decision to discontinue Aplio's operations in the
third quarter of Fiscal 2001 (see Note 20), the Company wrote off unamortized
goodwill, technology, trademark, patents and workforce of $15.6 million, $10.1
million, $1.9 million, $3.6 million and $435,000, respectively.
In connection with the adoption of SFAS No. 142, effective August 1,
2001 the Company will no longer amortize goodwill. However, the unamortized
goodwill balance will be subject to annual impairment testing.
7. Marketable Securities
Marketable securities consist of equity securities, U.S. Government Agency
Obligations and commercial paper. Debt securities with original maturities of
greater than three months at the time of purchase are classified as marketable
securities and are carried at amortized cost and interest on these securities is
included in interest income as earned. The following is a summary of the
marketable securities at July 31, 2001:
Gross Gross
Carrying Unrealized Unrealized Fair
Amount Gains Losses Value
------ ----- ------ -----
Short term:
Held-to-maturity securities
U.S. Government Agency Obligations ...... $ 23,000,000 $ -- $ -- $23,000,000
Corporate notes ....................... 17,974,587 135,013 -- 18,109,600
------------ ------------- --------------- -----------
$ 40,974,587 135,013 $41,109,600
------------ ------------- --------------- -----------
Available-for-sale securities
Yahoo! common stock ................... 14,209,684
Speechworks common stock ............... 3,643,657
------------
17,853,341
------------
$ 58,827,928
============
The following is a summary of the marketable securities at July 31, 2000:
Gross Gross
Carrying Unrealized Unrealized
Amount Gains Losses Fair Value
------------ ---------- ---------- -----------
Short-term:
Held-to-maturity securities
U.S. Government Agency
Obligations..................... $ 9,500,000 $1,775 $(12,500) $ 9,489,275
Commercial paper.................. 49,642,518 17 (45,568) 49,596,967
------------ ------ -------- -----------
Total Short-Term: 59,142,518 1,792 (58,068) 59,086,242
------------ ------ -------- -----------
Long-term:
Held-to-maturity securities
U.S. Government Agency
Obligations..................... 5,000,000 -- (21,200) $ 4,978,800
Commercial paper.................. 17,942,877 -- (37,877) 17,905,000
------------ ------ -------- -----------
22,942,877 $ -- $(59,077) $22,883,800
====== ======== ===========
Available-for-sale securities
WebEx common stock................ 5,331,518
Yahoo! common stock............... 104,003,109
------------
109,334,627
------------
Total Long-Term: $132,277,504
============
F-13
In March 2000, the Company acquired 806,452 shares of Yahoo! Inc. in
exchange for 2,777,778 shares of the Company's common stock at a then equivalent
market value of approximately $150,000,000. During Fiscal 2001, the Company
recorded a loss relating to an other than temporary decline in the market value
of its Yahoo! shares. This loss of approximately $136 million has been recorded
as other expense in the accompanying condensed consolidated statement of
operations. At July 31, 2001, the carrying value of the Yahoo! shares
approximates their market value, with no unrealized gains or losses recorded in
other comprehensive income.
In January 2000, the Company purchased 240,000 shares of Series A Preferred
Stock at $3.00 per share in WebEx, a provider of online meetings on the Web. In
March 2000, the Company purchased 14,640 shares of Series D Preferred Stock at
$12.50 per share. WebEx completed its initial public offering in July 2000.
During Fiscal 2001, all shares of Preferred Stock were sold for net proceeds of
$3.3 million resulting in a gain of $2.4 million.
In August 2000, the Company purchased 321,027 shares of common stock at
$12.46 per share of Speechworks, International, Inc. ("Speechworks").
Speechworks completed its initial public offering in August 2000 and as of July
31, 2001 the market value of Speechworks shares was $3,643,657. The unrealized
loss of $356,339 has been recorded as a component of other comprehensive income
in the accompanying statement of stockholder's equity.
8. Property and Equipment
Property and equipment consists of the following:
July 31
------------------------------
2001 2000
----------- -----------
Equipment...................... $ 90,983,234 $43,421,399
Computer software.............. 31,397,724 21,289,136
Furniture and fixtures......... 10,929,592 4,211,906
------------ -----------
133,310,550 68,922,441
Accumulated depreciation and
amortization................. (24,912,274) (9,055,287)
------------ -----------
Property and equipment, net.... $108,398,276 $59,867,154
============ ===========
Depreciation and amortization of fixed assets for the years ended July 31, 2001,
2000 and 1999 was approximately $17.1 million, $5.5 million and $2.1 million,
respectively.
9. Investments
In February 2000, the Company acquired 1,696,667 shares of WebDialogs
Series D Convertible Preferred stock at $5.893 per share. WebDialogs is an
e-commerce enabler that focuses on collaborative browsing applications. During
the fourth quarter of fiscal 2001, the Company recorded a loss relating to an
other-than-temporary decline in value of its investment, resulting in a charge
to other expense of approximately $10 million.
F-14
In April 2000, the Company acquired 38,352 shares of Webley Systems, Inc.
Series B Preferred stock at $195.56 per share. Webley is a unified
communications and messaging provider. During the fourth quarter of fiscal 2001,
the Company recorded a loss relating to an other-than- temporary decline in
value of its investment, resulting in a charge to other expense of approximately
$7.6 million.
In December 2000, the Company acquired 2,859,569 shares at $1.3988 and
1,573,096 shares at $1.907 of Alonet S.A. ("Alonet") common stock and converted
loans of $4 million into common stock of Alonet. During the third quarter of
fiscal 2001, Alonet ceased operations and the Company wrote-off the investment,
resulting in a loss of $10.3 million.
In April 2001, the Company made an initial capital contribution of
$4,000,000 for 5% ownership in a newly formed entity, IDT Telecom, LLC. This
investment is being accounted for using the cost method.
Also during the fourth quarter of fiscal 2001, the Company recorded a loss
relating to an other-than-temporary decline in value for several other of its
cost method investments, resulting in a charge to other expense of approximately
$4.3 million.
The Company has invested in minority holdings of several other technology
companies. Such investments are recorded at cost and amounted to approximately
$4.6 million at July 31, 2001 and $2.1 million at July 31, 2000.
10. Long-term Obligations
At July 31, 2001, long-term obligations are comprised of the following:
Future payments to Aplio Shareholders (note 5).................... $14,912,633
Promissory notes payable to Aplio Shareholders (note 5)........... 4,576,215
French government loan............................................ 457,387
-----------
19,946,235
Less: Current portion............................................ (11,596,982)
-----------
$ 8,349,253
===========
The promissory notes were issued in connection with the Aplio acquisition
(note 5) and bear interest at an annual rate of 6.53%. The Company is required
to pay the remaining principal balance of the promissory note of $4,576,215 plus
all accrued and unpaid interest on January 31, 2002.
The Companies long-term obligation of $8,349,253 is due April 30, 3003.
11. Loss Per Share
The following table sets forth the computation of basic and diluted loss
per share:
Year ended July 31
--------------------------------------------------
2001 2000 1999
------------ ----------- ----------
Numerator:
Net loss $(365,975,771) $(118,334,005) $(24,705,192)
Redeemable common stock accretion (531,999) -- --
Redeemable preferred stock dividends -- -- (29,219,362)
------------- ------------- ------------
Numerator for basic and diluted loss per common
share-net loss available for common stockholders $(366,507,770) $(118,334,005) $(53,924,554)
============= ============= ============
Denominator:
Denominator for basic and dilutive loss per
common share-weighted average shares 58,664,580 51,738,918 31,236,415
============= ============= ============
Basic and diluted loss per share $ (6.25) $ (2.29) $ (1.73)
============= ============= ============
F-15
The following securities have been excluded from the dilutive per share
computation as they are antidilutive:
Year ended July 31
---------------------------------------------------
2001 2000 1999
----------- ---------- -----------
Redeemable preferred stock.............. -- -- 9,420,000
Stock options........................... 12,069,098 8,450,984 7,445,900
12. Stock Repurchase Program
In October 2000, the Board of Directors authorized a new share buyback
program through which the Company may repurchase up to five million shares of
common stock in the open market. As of July 31, 2001, the Company had
repurchased 4,361,600 shares under this program.
13. Related Party Transactions
In May 1999, the Company and IDT entered into an
Internet/telecommunications agreement whereby the Company has agreed to pay IDT
up to $110,000 per month for connectivity, the use of certain computer software
and equipment owned or leased by IDT and to provide a platform for IDT's
Internet services for a monthly per customer charge. In connection with such
agreement, IDT has also granted the Company an indefeasible right, for a period
of 20 years, to use a certain telecommunications network as it is completed and
delivered for up to approximately $7.6 million.
In May 1999, the Company and IDT entered into two one-year services
agreements whereby the Company agreed to pay IDT for certain administrative,
customer support and other services that IDT provides to it at the cost of such
services plus 20%. Also, in conjunction with such agreements, the Company has
agreed to provide IDT with certain support services for the cost of such
services plus 20% for a period of two years.
In May 1999, the Company and IDT entered into a joint marketing agreement
whereby the companies have agreed to jointly advertise and market their
products. The agreement continues for a term of one year and is automatically
renewable for an additional one year unless terminated by either party. In
conjunction with such agreement, a commission will be earned by each company for
new customers generated by the other company as a result of such programs.
In March 1999, the Company entered into a lease agreement with a
company owned by the Chairman, Chief Executive Officer and Treasurer of IDT.
Pursuant to such lease agreement, the Company is required to make equal monthly
rental payments aggregating $101,000 through February 2002.
In June 2000, the Company entered into lease agreement with IDT for
office space. Pursuant to such agreement, the Company is required to make
monthly rental payments of $255,000 through May 2010.
The accompanying financial statements for periods prior to the signing
of the aforementioned agreements include charges by IDT to the Company for the
aforementioned services. Such charges were based principally upon the Company's
allocable portion of IDT's costs for such services. The ratios used to allocate
these costs were the Company's total payroll and the Company's total revenue to
IDT's total payroll and revenue, depending on the type of services provided. The
allocated costs approximate the amounts that would have been charged under the
inter-company agreements if they had been in effect during such periods.
F-16
For the years ended July 31, 2001, 2000 and 1999, the Company recognized
revenue for services provided to IDT of approximately $21,900,000, $11,225,000,
and $2,578,000, respectively.
At July 31, 2001 and 2000, the due to IDT balance represents the net
amounts owed to IDT as a result of the services provided by IDT to the Company
principally for wholesale carrier telecommunication services. The average
balance owed to IDT during the years ended July 31, 2001 and 2000, was
approximately $9,642,201 and $11,309,000 respectively.
The activity in the Due to IDT account was as follows:
Year ended July 31
--------------------------------------------------------
2001 2000 1999
---------------- -------------- --------------
Opening Balance ............................................... $ 4,883,111 $ 17,735,395 $ 11,814,988
Expenses paid by IDT on behalf of the Company, net of
cash received ............................................... 6,974,128 15,896,162 18,550,915
Net charges to the Company for services provided by
IDT ......................................................... 51,460,583 18,815,668 8,380,656
Revenue recognized by the Company for services
provided to IDT ............................................. (21,900,438) (11,224,814) (2,578,000)
Revenue recognized by the Company for sales to IDT ............ (31,619,815) (7,844,575) --
Cash Received from IDT ........................................ 29,144,240 5,874,000 --
Capital contribution to (from)IDT ............................. 4,000,000 -- (4,629,838)
Repayments .................................................... (28,540,519) (34,368,725) (13,803,326)
------------ ------------ ------------
Ending Balance ................................................ $ 14,401,290 $ 4,883,111 $ 17,735,395
============ ============ ============
14. Income Taxes
The Company filed a consolidated Federal income tax return with IDT through
May 13, 1999 and has entered into a tax sharing agreement with IDT. Pursuant to
such tax sharing agreement, the Company would, while included in the IDT
consolidated tax return, be reimbursed for the use of its tax losses to the
extent IDT realizes a tax reduction from the use of such tax losses. In May 1999
IDT's ownership interest in the Company fell below 80% and as a result the
Company is no longer a part of the IDT consolidated Federal tax group.
Significant components of the Company's deferred tax assets and liabilities
consists of the following:
July 31
--------------------------------
2001 2000
------------- -------------
Deferred tax asset:
Net operating loss carryforward ............................ $ 159,736,632 $ 37,508,601
Compensation charge from issuance of stock options ......... 2,561,271 756,858
Restructuring costs ........................................ 12,318,797 --
Contribution carryover ..................................... 88,559 --
Deferred tax liabilities:
Depreciation ............................................... (6,891,642) (4,526,380)
Other ...................................................... (304,060) --
------------- -------------
Net deferred tax asset ..................................... 167,509,557 33,739,079
Valuation allowance ........................................ (167,509,557) (33,739,079)
------------- -------------
Total deferred tax assets ..................................... $ -- $ --
============= =============
F-17
The net deferred tax assets have been fully offset by a valuation allowance
due to the uncertainty of the realization of the assets.
At July 31, 2001, the Company had net operating loss carryforwards for
federal income tax purposes of approximately $419.0 million expiring in years
through 2020 and for state income tax purposes of approximately $427.0 million
expiring in years through 2007. These net operating loss carryforwards may be
limited to future taxable earnings of the Company.
Year ended July 31
---------------------------------------------------
2001 2000 1999
------------- ----------- -------------
Tax at effective rate .......................................... $(128,091,520) (41,416,902) $ (8,646,817)
Non-deductible expenses ........................................ 15,127,050 3,787,484 4,597,338
Benefits used by IDT for which the Company received no
compensation ................................................. -- -- 1,017,088
Losses for which no benefit is provided ........................ 112,964,470 37,629,418 3,032,391
------------- ------------- -------------
Tax provision .................................................. $ -- $ -- $ --
============= ============= =============
15. Stockholders' Equity (Deficit)
Initial Public Offering
On August 3, 1999, the Company completed an initial public offering (the
"IPO") of 6,210,000 shares of common stock at an initial public offering price
of $15.00 per share, resulting in net proceeds of approximately $83.8 million.
Second Public Offering
On December 1, 1999, the Company completed a public offering of
7,245,000 shares of common stock at a price of $55.00 per share. 3,845,000
shares were sold by selling stockholders and 3,400,000 shares were sold by
Net2Phone. Net proceeds to Net2Phone, after deducting underwriting discounts and
commissions and offering expenses were approximately $177.4 million.
Series A Stock
On May 13, 1999, the Company designated 3,150,000 shares of its preferred
stock as Series A ("Series A Stock") and sold 3,140,000 of such shares to
unrelated third parties in a private placement transaction for aggregate gross
proceeds of $31,400,000.
The Series A Stock entitled its holders to a non-cumulative dividend of 8%
per annum on the original issue price. Each share of Series A Stock was
convertible into three shares of Class A stock at the option of the holder. The
Series A Stock was redeemable at the option of the holder, beginning May 2006,
over a period of 3 years.
The Series A Stock contained beneficial conversion features. The total value
of the beneficial conversion feature approximated $75 million. For accounting
purposes the value of the beneficial conversion features was limited to the
amount of proceeds allocated to the Series A Stock. The Company recorded an
increase in net loss available to common stockholders on the date of issuance of
the Series A Stock in the amount of approximately $29.2 million.
In connection with the sale of Series A Stock, the Company granted warrants
to purchase 272,400 shares of common stock at an exercise price of $3.33 per
share from the date of issuance through May 13, 2004 to the Series A Stock
investors and placement agent. The warrants contained a provision whereby they
were automatically terminated upon an initial public offering of the Company's
stock. In July 1999, 136,648 warrants were exercised. The remaining warrants
expired unexercised upon the Company's IPO in August 1999. The fair value of the
warrants on the date of issuance was $2.1 million. This was computed using the
Black Scholes model with the following assumptions: the fair value of the common
stock equal to $11.00 per share, the risk free interest rate of 4.79%,
volatility factor of 84%, an expected life of 6 months, and a dividend yield of
0%.
F-18
The fair value of the warrants was recorded as an increase to additional
paid-in capital and a decrease to the carrying value of the Series A Stock. The
decrease in the carrying value of the Series A Stock was accreted with a
reduction of additional paid-in capital over the period to the initial
redemption date in May 2006. In connection with the Company's IPO, the Series A
convertible preferred stock was converted into Class A stock. In August 1999
upon the consummation of the IPO the balance of the unamortized discount was
written off.
Stock Options
In April 1999, the Company adopted a stock option and incentive plan, as
amended (the "Plan"). Pursuant to the Plan, the Company's officers, employees
and non-employee directors, as well as those of IDT, are eligible to receive
awards of incentives and non-qualified stock options, stock appreciation rights,
limited stock appreciation rights and restricted stock. There are currently
14,940,000 shares of common stock authorized for issuance under the plan.
The Compensation Committee of the Board of Directors is responsible for
determining the type of award, when and to whom awards are granted, the number
of shares and terms of the awards and the exercise price. The options are
exercisable for a period not to exceed ten years from the date of the grant.
Vesting periods range from immediately to four years.
In the fourth quarter of fiscal 1999, the Company granted options to
purchase 8,821,500 shares of common stock at exercise prices ranging from $3.33
to $15.00 per share to employees of the Company and employees of IDT. The
options generally vest over periods up to four years and expire ten years from
the date of grant. In connection with the exercise of such options, the Company
extended $3,149,900 of recourse loans to employees. In order to obtain the
loans, optionees agreed to the cancellation of 23,382 outstanding options.
During the quarter ended July 31, 2000, stock options issued to certain
officers and employees of the Company were accelerated in accordance with the
original stock option awards and as a result the Company recorded approximately
$12.5 million in compensation charges as a result of the acceleration. During
the quarter ended July 31, 2000, stock options issued to certain officers and
employees of IDT were modified and as a result, the Company recorded $18.3
million in compensation charges.
In fiscal 2001 and 2000, the Company recorded compensation expense of $16.2
million and $48.1 million, respectively, from the issuance of stock options.
Deferred compensation at July 31, 2001 resulting from the issuance of stock
options of approximately $19.7 million is being charged to expense over the
vesting period of the stock options as follows: fiscal 2002, $13.3 million;
fiscal 2003, $3.2 million; fiscal 2004, $2 million; and fiscal 2005, $1.1
million.
F-19
A summary of stock option activity under the Company's stock option plan is
as follows:
Weighted Average
Shares Exercise Price
----------- ----------------
Outstanding at July 31, 1998 ................... -- --
Granted ........................................ 8,821,500 $ 7.18
Exercised ...................................... (1,345,218) 3.33
Cancelled ...................................... (23,382) 3.33
Forfeited ...................................... (7,000) 3.33
----------
Outstanding at July 31, 1999 ................... 7,445,900 $ 7.90
Granted ........................................ 2,371,689 $ 35.73
Exercised ...................................... (1,177,429) 7.55
Cancelled ...................................... (182,351) 26.83
Forfeited ...................................... (6,825) 14.49
----------
Outstanding at July 31, 2000 ................... 8,450,984 $ 15.77
Granted ........................................ 6,159,000 $ 16.19
Exercised ...................................... (1,814,815) 3.96
Cancelled ...................................... (638,434) 23.40
Forfeited ...................................... (87,637) 26.06
----------
Outstanding at July 31, 2001 ................... 12,069,098 $ 17.25
========== =========
The following table summarizes the status of the stock options outstanding
and exercisable at July 31, 2001:
Stock Options Outstanding Stock Options Exercisable
----------------------------------------------------------- ---------------------------------
Weighted
Remaining Weighted Weighted
Contractual Life Average Number of Average
Range of Exercise Prices Number of Options (in years) Exercise Price Options Exercise Price
---------------------------------------------------------------------------------------------------------------------------------
$3.33 1,782,585 7.80 $ 3.33 1,476,885 $3.33
$6.12 - $8.12 2,347,200 9.50 $ 6.98 191,583 $6.87
$9.87 - $11.00 490,000 3.60 $ 10.72 358,000 $10.94
$15.00 - $21.56 2,826,105 8.40 $ 15.61 1,673,992 $15.09
$24.50 - $35.00 3,937,583 9.20 $ 26.59 602,903 $29.95
$42.25 - $55.56 685,625 8.30 $ 46.41 362,717 $47.41
----------------- ---------------
12,069,098 4,666,080
================= ===============
F-20
The weighted average fair value of options granted was $13.63 and $27.01
for the years ended July 31, 2001 and 2000. Pro forma information regarding net
loss and loss per share has been determined as if the Company had accounted for
employee stock options under the fair value method. The fair value of the stock
options was estimated at the date of grant using the Black-Scholes option
pricing model with the following assumptions for vested and non-vested options:
Assumptions July 31, 2001 July 31, 2000
----------- ------------- -------------
Average risk-free interest rate............................................... 5.71% 5.60%
Dividend yield................................................................ ---- ----
Volatility factor of the expected market price of the Company's common stock.. 120% 89%
Average life.................................................................. 5 years 5 years
The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because the Company's employee stock options have characteristics
that are significantly different from those of traded options, and because
changes in the subjective input assumptions can materially affect the fair value
estimate, in management's opinion, the existing models do not necessarily
provide a reliable single measure of the fair value of its employee stock
options.
For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period.
The Company's pro forma information is as follows:
For the year ended July 31,
-------------------------------------------------
2001 2000 1999
---- ---- ----
Pro forma net loss available to common stockholders $430,493,643 $ 146,364,946 $ 66,050,383
Pro forma net loss per common share $ 7.34 $ 2.83 $ 2.11
Increase in Authorized Shares
The Company designated 15,000,000 shares of its capital stock as Class A
stock. The holders of Class A stock are identical to those of common stock
except for voting and conversion rights and restrictions on transferability. The
Class A stock is entitled to two votes per share.
On July 6, 2000 the Company's shareholders gave approval to issue
4,000,000 newly-authorized shares of Class A common stock to AT&T for an
aggregate purchase price of $300,000,000. This transaction was consummated in
August 2000.
16. 401(K) Plan
In October 1999, the Company established a 401(k) Plan (the "Plan")
which permits employees to make contributions to the Plan on a pre-tax salary
reduction basis in accordance with the Internal Revenue Code. All full-time
employees are eligible to participate in the Plan after completing three months
of service. Eligible employees may contribute up to 15% of their annual
compensation, subject to IRS limitations. The Company matches a discretionary
amount of the employees' contributions. The Company contributed approximately
$990,000 and $200,000 for the years ended July 31, 2001 and 2000, respectively
and bore the administrative cost of the Plan.
F-21
17. Commitments
Leases
Future minimum rental payments at July 31, 2001 under agreements classified as
operating leases with noncancelable terms in excess of one year, are as follows:
Fiscal 2002 $ 6,535,378
Fiscal 2003 6,106,485
Fiscal 2004 6,067,092
Fiscal 2005 6,032,635
Fiscal 2006 5,715,517
Thereafter 19,131,794
-----------
Total $49,588,901
===========
Rent expense for the year ended July 31, 2001, July 31, 2000 and July 31, 1999
was $5.3 million, $1.4 million, and $409,000, respectively.
Letters of Credit
As of July 31, 2001, the Company has letters of credit outstanding totaling
$22.2 million, of which $21.7 million expires during fiscal 2002 and the
remainder expire in 2005 and 2009.
18. Customer and Geographical Area
Revenues from customers outside the United States represented
approximately 24%, 34% and 62% of total revenues during the years ended July 31,
2001, 2000 and 1999, respectively. No single geographic area accounted for more
than 10% of total revenue during the years ended July 31, 2001, 2000 and 1999.
No customer accounted for more than 10% of revenue during the years ended July
31, 2001, 2000 and 1999.
19. Legal Proceedings
Multi-Tech
On February 15, 2000, Multi-Tech Systems, Inc. filed suit against us
and other companies in the United States Federal District Court in Minneapolis,
Minnesota. Multi-Tech alleges that "the defendant companies are infringing
because they are providing the end users with the software necessary to
simultaneously transmit voice and data on their computers in the form of making
a phone call over the Internet." We have defended the lawsuit vigorously. We
have filed an answer and discovery has now been completed. Trial of this matter
is tentatively scheduled for August 1, 2002. In the interim, it is likely that
various motions will be filed to limit the scope of the plaintiff's claims or to
dismiss the action in its entirety. We believe that the Multi-Tech claims are
without merit. However, should a judge issue an injunction against us requiring
that we cease distributing Multi-Tech's software or providing Multi-Tech's
software-based services, such an injunction could have a material adverse effect
on our business operations, financial condition, results of operations and cash
flows.
Aplio, S.A.
In connection with the acquisition of Aplio, S.A in July 2000, disputes
arose with certain selling shareholders with respect to out obligations under
the Stock Purchase Agreement dated as of June 16, 2000. We have now settled all
disputes by entering into agreements with various selling shareholders providing
for certain cash payments to be made on or before January 8, 2002 in the
aggregate amount of approximately $11 million and the deferral of payment
obligations totaling approximately $19.,25 million until April 30, 2003. As part
of the arrangement, the selling shareholders waived their rights to receive $3
million in purchase price held back by us at closing to secure certain
indemnification obligations.
F-22
Class-Actions
Four substantially similiar class-action lawsuits were filed in the
United States District Court for the Southern District of New York on behalf of
all persons who acquired our stock between July 29, 1999 and December 6, 2000.
Net2Phone, certain of our executive officers, directors and underwriters
involved in our initial public offering are named as defendants in these
complaints. The complaints allege, in part, that certain underwriters of our
initial public offering violated federal securities laws by failing to disclose
that they had solicited and received undisclosed commissions and allocated
shares in our initial public offering to those investors in exchange for their
agreement to purchase our shares in the after-market at pre-determined prices.
The complaints also allege that, whether or not Net2Phone and the named
executives were aware of the underwriters' arrangements, Net2Phone and the named
executives have statutory liability under the federal securities laws for
issuing a registration statement in connection with our initial public offering
that failed to disclose that these allegedly undisclosed arrangements existed.
The suits against us are substantially the same as suits making the same
allegations that have been filed against more than 100 other companies that had
their initial public offerings at or about the same time. The deadline for all
defendants to respond to the complaints has been extended by the court to which
the various cases have been assigned. Our underwriting agreement with our
underwriters provide for indemnification of Net2Phone and its executives and
directors for liabilities arising out of misstatements in our registration
statement attributable to material non-disclosures by the underwriters. We
intend to pursue our indemnification claims against the underwriters. In
addition, we maintain directors and officers liability insurance coverage which
should substantially cover the costs of defending the various suits. However an
unfavorable decision in these areas could have a material adverse effect on our
business operations, financial condition, results of operations and cash flows.
20. Restructuring Costs and Other Charges
In the third quarter of Fiscal 2001, the Company decided to restructure
the operations of its Aplio subsidiary. In connection with this decision, the
Company wrote-off substantially all of Aplio's intangible and fixed assets as
their values would not be recoverable, resulting in a charge of approximately
$33.6 million. In addition, the Company accrued approximately $5.5 million for
payments relating to the Aplio Settlement Agreements (see Note 5). The Company
recorded an additional charge of approximately $1.8 million in the fourth
quarter of Fiscal 2001 related to Aplio employee terminations.
In addition, the Company wrote off certain advertising agreements of
approximately $14.6 million as well as intangible and fixed assets of
approximately $14.6 million, which were required based on the Company's review
of its business plan, as no future benefits are expected from these assets and
commitments.
21. Subsequent events
On October 23, 2001 IDT entered into an agreement to lead a consortium
that would concentrate ownership of approximately 50% (but representing 64% of
the voting power) of the Company. The consortium consists of IDT, Liberty Media
Corporation ("Liberty"), and AT&T Corporation ("AT&T"), resulting in significant
economic stakes in the Company for all three parties. As part of the agreement,
IDT and AT&T contributed their shares of Net2Phone (approximately 10.0 million
and 18.9 million shares, respectively) to a newly formed Limited Liability
Company (LLC). Liberty then acquired a substantial portion of the LLC's units
from AT&T, while IDT increased its stake and AT&T retained a significant
interest. IDT controls the right to vote the shares of Class A common stock held
by the LLC in most matters.
F-23
Net2Phone, Inc.
Schedule II - Valuation and Qualifying Accounts
For the Years Ended July 31, 2001, 2000 and 1999
(Dollars in Thousands)
Balance at Charged to Deductions Balance at End
Beginning Expenses Note (a) of Period
of Period
-------------------------------------------------------------------------------------------------------
Allowance For Uncollectible
Accounts Receivable:
Year 2001 $0 $3,577 $(1,677) $1,900
Year 2000 $0 $0 $0 $0
Year 1999 $0 $0 $0 $0
(a) Amounts written off as uncollectible.
F-24
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: October 29, 2001
Net2Phone, Inc.
By /s/ Howard S. Jonas
----------------------------------
Howard S. Jonas
Chief Executive Officer
Pursuant to the requirements of the Securities and Exchange Act of
1934, this report has been signed below by the following persons on behalf of
the registrant and in the capacities indicated on this 29 day of October, 2001.
/s/ Clifford M. Sobel Chairman of the Board
----------------------------------
Clifford M. Sobel
/s/ Howard S. Jonas
---------------------------------- Chief Executive Officer and Director
Howard S. Jonas (Principal Executive Officer
/s/ Ilan M. Slasky Chief Financial Officer (Chief Accounting
---------------------------------- Officer)
Ilan M. Slasky
/s/ James R. Mellor Director
----------------------------------
James R. Mellor
/s/ James A. Courter
---------------------------------- Director
James A. Courter
/s/ Stephen M. Greenberg President and Director
----------------------------------
Stephen M. Greenberg
/s/ Michael Fischberger Director
----------------------------------
Michael Fischberger
/s/ Gary E. Rieschel Director
----------------------------------
Gary E. Rieschel
/s/ Anthony G. Werner Director
----------------------------------
Anthony G. Werner
/s/ Daniel H. Schulman Director
----------------------------------
Daniel H. Schulman
/s/ Harry C. McPherson, Jr. Director
----------------------------------
Harry C. McPherson, Jr.
/s/ Joyce J. Mason Director
----------------------------------
Joyce Mason
/s/ Stephen R. Brown Director
----------------------------------
Stephen R. Brown
/s/ Jesse P. King Director
----------------------------------
Jesse P. King
INDEX TO EXHIBITS
The following exhibits are filed herewith or are incorporated by
reference to exhibits previously filed with the Commission.
Exhibit
No. Description
------- -----------
3.1 Amended and Restated Certificate of Incorporation (Incorporated by
reference from our registration statement on Form S-1 (Registration
No. 333-59751)).
3.2 Amended and Restated Bylaws (Incorporated by reference from our
Current Report on Form 8-K filed on August 21, 2000).
3.3 Certificate of Amendment to the Restated Certificate of
Incorporation of the Registrant (Incorporated by reference from our
registration statement on Form S-1 (Registration No. 333-59751)).
3.4 Certificate of Amendment to the Restated Certificate of
Incorporation of the Registrant(Incorporated by reference from our
registration statement on Form S-1 (Registration No. 333-59751)).
3.5 Certificate of Amendment to the Amended and Restated Certificate of
Incorporation (Incorporated by reference from our Annual Report on
Form 10-K for the fiscal year ended July 31,2000) .
4.1 Specimen Common Stock Certificate of the Registrant (Incorporated by
reference from our registration statement on Form S-1 (Registration
No. 333-59751)).
10.3 Bundling and Distribution Services Agreement, dated as of January
31, 1999, by and between NetScape Communications Corporation and the
Registrant (Incorporated by reference from our Current Report on
Form 8-K filed on August 21, 2000).
10.4 General License Terms & Conditions, dated as of January 31, 1999, by
and between Netscape Communications Corporation and the Registrant.
10.5 Trademark License Agreement, dated as of January 31, 1999, by and
between Netscape Communications Corporation and the Registrant
Assignment.
10.6 Internet/Telecommunications Agreement, dated as of May 7, 1999, by
and between IDT and the Registrant.
10.7 Joint Marketing Agreement, dated as of May 7, 1999, by and between
IDT and the Registrant.
10.8 IDT Services Agreement, dated as of May 7, 1999, by and between IDT
and the Registrant.
10.9 Net2Phone Services Agreement, dated as of May 7, 1999, by and
between IDT and the Registrant.
10.10 Assignment Agreement, dated as of May 7, 1999, by and between IDT
and the Registrant.
10.11 Tax Sharing and Indemnification Agreement, dated as of May 7, 1999,
by and between IDT and the Registrant (Incorporated by reference
from our registration statement on Form S-1 (Registration No.
333-59751)).
Exhibit
No. Description
-------- -----------
10.12 Separation Agreement, dated as of May 7, 1999, by and between IDT
and the Registrant (Incorporated by reference from our registration
statement on Form S-1 (Registration No. 333-59751)).
10.13 The Registrant's Amended and Restated 1999 Stock Option and
Incentive Plan (Incorporated by reference from our Proxy Statement
dated June 6, 2000).
10.14 Series A Subscription Agreement, dated as of May 13, 1999, by and
between the Investors listed therein and the Registrant
(Incorporated by reference from our registration statement on Form
S-1 (Registration No. 333-59751)).
10.15 Series A Preferred Shareholder Registration Rights Agreement, dated
as of May 13, 1999, by and between the Investors listed therein and
the Registrant (Incorporated by reference from our registration
statement on Form S-1 (Registration No. 333-59751)).
10.16 Form of Warrant to Purchase Common Stock (Incorporated by reference
from our registration statement on Form S-1 (Registration No.
333-59751)).
10.17 Promissory Note of Registrant to IDT, dated as of May 12,
1999(Incorporated by reference from our registration statement on
Form S-1 (Registration No. 333-59751)) .
10.18 Form of Loan Agreement between the Registrant and each of its
executive officers(Incorporated by reference from our registration
statement on Form S-1 (Registration No. 333-59751)) .
10.19 Form of Stock Option Agreement for Executive Officers (Incorporated
by reference from our registration statement on Form S-1
(Registration No. 333-59751)).
10.20# IP Telephony Services Distribution and Interactive Marketing
Agreement, dated as of July 15, 1999, by and between ICQ, Inc. and
the Registrant (Incorporated by reference from our registration
statement on Form S-1 (Registration No. 333-59751)).
10.21# Stock Subscription Warrant, dated July 15, 1999, by and between
America Online, Inc. and the Registrant (Incorporated by reference
from our registration statement on Form S-1 (Registration No.
333-59751)).
10.22 Stock Purchase Agreement, dated as of June 16, 2000, by and between
Registrant and the shareholders of Aplio named therein (Incorporated
by reference from our Current Report on Form 8-K filed on July 24,
2000)
10.23 Subscription Agreement, dated as of August 11, 2000, by and between
AT&T Corp. and the Registrant (Incorporated by reference from our
Current Report on Form 8-K filed on August 21, 2000)
10.24 Registration Rights Agreement, dated as of August 11, 2000, by and
AT&T Corp. and the Registrant (Incorporated by reference from our
Current Report on Form 8-K filed on August 21, 2000)
10.25 Employment Agreement executed by the Registrant and Clifford M.
Sobel (Incorporated by reference from our Annual Report on Form
10-K/A for the fiscal year ended July 31, 2000).
10.26 Employment Agreement executed by the Registrant and Stephen M.
Greenberg (Incorporated by reference from our Annual Report on Form
10-K/A for the fiscal year ended July 31, 2000).
10.27 Employment Agreement executed by the Registrant and Howard S. Balter
(Incorporated by reference from our Annual Report on Form 10-K/A for
the fiscal year ended July 31, 2000).
Exhibit
No. Description
-------- -----------
10.28 Employment Agreement executed by the Registrant and Ilan Slasky
(Incorporated by reference from our Annual Report on Form 10-K/A for
the fiscal year ended July 31, 2000).
10.29 Lease for premises located at 520 Broad Street, Newark, New Jersey
(Incorporated by reference from our Annual Report on Form 10-K for
the fiscal year ended July 31, 2000).
10.30 Form of Promissory Note between Adir Technologies, Inc. and certain
executive officers of the Registrant (Incorporated by reference from
our Annual Report on Form 10-K for the fiscal year ended July 31,
2000)
10.31 Agreement and Plan of Merger, dated as of June 11, 2001, by and
among Adir Technologies, Inc., A Tech Merger Sub, Inc. and Netspeak
(Incorporated by reference from our Current Report on Form 8-K filed
on June 21, 2001)
11.1 Statement of Computation of Per Share Earning: See Note 5 to
Financial Statements on page F-12 of this report.
21.1* Subsidiaries
23.1* Consent of Ernst & Young LLP.
-------------------
* Filed herewith
# Confidential treatment granted as to parts of this document.