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United States
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
-----------------
FORM 10-Q
(Mark one)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR
15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended October 31, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR
15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission file number 000-26763
NET2PHONE, INC.
(Exact Name of Registrant as Specified in Its Charter)
DELAWARE 22-3559037
(State or Other Jurisdiction of Incorporation (I.R.S. Employer
or Organization) Identification No.)
520 Broad Street, Newark, New Jersey 07102
(Address of Principal Executive Offices) (Zip Code)
(973) 438-3111
(Registrant's Telephone Number, Including Area Code)
---------------------------
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No ___
As of December 6, 2002, the registrant had outstanding 30,666,333
shares of common stock, $.01 par value and 28,986,750 shares of Class A stock,
$.01 par value.
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act) Yes X No ____
NET2PHONE, INC.
TABLE OF CONTENTS
Page No.
--------
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets as of October 31, 2002 and July 31, 2002..................... 3
Condensed Consolidated Statements of Operations for the three months ended
October 31, 2002 and 2001................................................................... 4
Condensed Consolidated Statement of Stockholders' Equity for the three months ended
October 31, 2002............................................................................... 5
Condensed Consolidated Statements of Cash Flows for the three months ended October 31, 2002
and 2001........................................................................................ 6
Notes to Condensed Consolidated Financial Statements............................................... 7
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations........................................................................................... 12
Item 3. Quantitative and Qualitative Disclosures About Market Risk.................................... 18
Item 4. Controls and Procedures....................................................................... 18
PART II. OTHER INFORMATION
Item 1. Legal Proceedings............................................................................. 19
Item 2. Changes in Securities and Use of Proceeds..................................................... 19
Item 3. Defaults Upon Senior Securities............................................................... 19
Item 4. Submission of Matters to a Vote of Security Holders........................................... 20
Item 5. Other Information............................................................................. 20
Item 6. Exhibits and Reports on Form 8-K.............................................................. 20
Signatures.............................................................................................. 21
Certifications.......................................................................................... 22
2
PART I--FINANCIAL INFORMATION
Item 1. Financial Statements
NET2PHONE, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
October 31, July 31,
(in thousands, except per share data) 2002 2002
-------------------------------
(unaudited) (note 1)
ASSETS:
Current assets:
Cash and cash equivalents........................................................... $ 74,503 $ 64,216
Marketable securities - current..................................................... 44,972 25,771
Notes receivable from employees - current........................................... 846 855
Due from IDT........................................................................ - 682
Other current assets................................................................ 12,580 15,690
-------------------------------
Total current assets........................................................... 132,901 107,214
Property and equipment, net.............................................................. 30,621 32,875
Marketable securities - long term........................................................ - 18,704
Notes receivable from employees - long term.............................................. 6,536 -
Other assets............................................................................. 6,141 12,903
-------------------------------
Total assets................................................................... $ 176,199 $ 171,696
===============================
LIABILITIES AND STOCKHOLDERS' EQUITY:
Current liabilities:
Accounts payable.................................................................... $ 5,988 $ 7,727
Accrued expenses.................................................................... 22,576 27,266
Capital lease obligations - short term.............................................. 3,188 3,003
Due to IDT.......................................................................... 640 -
Other current liabilities........................................................... 15,732 15,821
-------------------------------
Total current liabilities...................................................... 48,124 53,817
Other liabilities........................................................................ 2,860 1,973
Capital lease obligations - long term.................................................... 2,211 2,670
-------------------------------
Total liabilities.............................................................. 53,195 58,460
Minority interests....................................................................... 8,110 46,881
Redeemable common stock, $.01 par value; 294 and 294 shares outstanding.................. 10,006 9,753
Stockholders' equity:
Common stock, $.01 par value; 200,000 shares authorized including redeemable
shares; 33,879 and 33,871 shares issued .................................... 339 339
Class A stock, $.01 par value, 37,924 shares authorized;
28,987 and 28,995 shares issued.............................................. 290 290
Additional paid-in capital.......................................................... 884,465 885,165
Accumulated deficit................................................................. (728,854) (773,266)
Accumulated other comprehensive income ............................................. 740 240
Deferred compensation............................................................... (10,907) (12,919)
Loans to stockholders............................................................... (2,040) (2,040)
Treasury stock, at cost; 3,634 and 3,751 shares..................................... (39,145) (41,207)
-------------------------------
Total stockholders' equity ................................................... 104,888 56,602
-------------------------------
Total liabilities and stockholders' equity ................................... $ 176,199 $ 171,696
===============================
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
NET2PHONE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
Three months ended
(in thousands, except per share data) October 31,
--------------------------------------
2002 2001
--------------------------------------
Revenue............................................................................... $ 23,948 $ 42,891
Costs and expenses:
Direct cost of revenue........................................................... 13,942 24,079
Selling, general and administrative.............................................. 13,870 38,104
Depreciation and amortization.................................................... 2,480 6,739
Settlement of Cisco litigation,
restructuring, severance, impairment and other items........................... (53,257) 5,911
Acquired in-process research and development..................................... - 13,850
Non-cash compensation............................................................ 1,446 4,888
----------------------------------
Total costs and expenses............................................ (21,519) 93,571
----------------------------------
Income (loss) from operations......................................................... 45,467 (50,680)
Interest income, net.................................................................. 816 1,935
----------------------------------
Income (loss) before minority interests............................................... 46,283 (48,745)
Minority interests.................................................................... 159 (7,390)
----------------------------------
Net income (loss)..................................................................... 46,124 (41,355)
Redeemable common stock accretion..................................................... - (133)
----------------------------------
Net income available to common stockholders........................................... $ 46,124 $ (41,488)
==================================
Net income per common share-basic & diluted........................................... $ 0.77 $ (0.72)
==================================
Weighted average of number of common shares used in the calculation of
basic & diluted net income per common share:...................... 59,516 57,674
==================================
The accompanying notes are an integral part of these condensed
consolidated financial statements.
4
Net2Phone, Inc.
Condensed Consolidated Statement of Stockholders' Equity
Three months ended October 31, 2002
(unaudited)
(in thousands)
Accumulated
Common Stock Class A Stock Additional Other
------------------------------------------- Paid-In Accumulated Comprehensive
Shares Amount Shares Amount Capital (Deficit)/Profit Income (Loss)
--------- --------- -------- --------- --------- ---------------- -------------
Balance at July 31, 2002 33,871 $ 339 28,995 $ 290 $ 885,165 $ (773,266) $ 240
Net loss for the three months
ended October 31, 2002 - - - - - 46,124 -
Foreign currency translation - - - - - - -
Unrealized equity
securities gain, net - - - - - - 500
Comprehensive income
Treasury share funding
of 401K Plan - - - - - (1,712) -
Conversion of Class A
stock to common stock 8 - (8) - - - -
Exercise of stock options - - - 2 - -
Issuance of Restricted
Share grant to executive - - - - 394 - -
Forfeiture of stock options - - - - (289) - -
Repricing of stock options - - - - (807) - -
Amortization of deferred
compensation - - - - - - -
-------- -------- -------- -------- --------- ------------- -------------
Balance at October 31, 2002 33,879 $ 339 28,987 $ 290 $ 884,465 $ (728,854) $ 740
======== ======== ======== ======== ========= ============= =============
Treasury Stock Total
Deferred Loans to --------------------- Stockholders'
Compensation Stockholders Shares Amount Equity (Deficit)
------------ ------------- --------- ---------- ---------------
Balance at July 31, 2002 $ (12,919) $ (2,040) 3,751 $ (41,207) $ 56,602
Net loss for the three months
ended October 31, 2002 - - - - 46,124
Foreign currency translation - - - - -
Unrealized equity
securities gain, net - - - - 500
-----------
Comprehensive income 46,624
Treasury share funding
of 401K Plan - - (117) 2,062 350
Conversion of Class A
stock to common stock - - - - -
Exercise of stock options - - - - 2
Issuance of Restricted
Share grant to executive - - - - 394
Forfeiture of stock options 289 - - - -
Repricing of stock options 807 - - - -
Amortization of deferred
compensation 916 - - - 916
------------- ----------- --------- ------------ -----------
Balance at October 31, 2002 (10,907) $ (2,040) 3,634 $ (39,145) $ 104,888
============= =========== ========= ============ ===========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
NET2PHONE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Three Months Ended
(in thousands) October 31,
--------------------------------------
2002 2001
--------------------------------------
Operating activities:
Net income (loss).................................................................. $ 46,124 $ (41,355)
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization...................................................... 2,480 6,739
Non-cash compensation.............................................................. 1,446 4,888
Write-off of acquired in-process research and development.......................... - 13,850
Restructuring, severance, impairment, and other non-cash items..................... 5,172 -
Non-cash litigation settlement..................................................... (38,929) -
Minority interests................................................................. 159 (7,390)
Changes in assets and liabilities:
Accounts receivable............................................................. (1,034) 1,260
Other assets.................................................................... 3,070 (1,136)
Accounts payable and accrued expenses........................................... (6,964) (2,606)
Deferred revenue................................................................ (344) (2,271)
Net advances from (repayments to) IDT Corporation............................... 1,322 (13,604)
---------------------------------
Net cash provided by (used in) operating activities..................................... 12,502 (41,625)
Investing activities:
Purchases of property and equipment................................................ (2,069) (9,677)
Purchases of marketable securities................................................. (1,445) (20,000)
Proceeds from the sale of marketable securities.................................... 1,448 34,022
Acquisitions, net of cash acquired................................................. - (27,584)
Payments of long-term obligations.................................................. - (3,904)
Other.............................................................................. 110 (297)
---------------------------------
Net cash used in investing activities................................................... (1,956) (27,440)
Financing activities:
Proceeds from the issuance of subsidiary preferred stock........................... - 13,999
Payments of capital lease obligations.............................................. (266) -
Purchases of redeemable common stock............................................... - (3,306)
Repurchase of common stock......................................................... - (510)
Other.............................................................................. 7 4
---------------------------------
Net cash (used in) provided by financing activities..................................... (259) 10,187
Effect of exchange rate on cash......................................................... - 63
---------------------------------
Net increase (decrease) in cash and cash equivalents.................................... 10,287 (58,815)
Cash and cash equivalents at beginning of period........................................ 64,216 195,140
---------------------------------
Cash and cash equivalents at end of period.............................................. $ 74,503 $ 136,325
=================================
Supplemental disclosure of cash flow information:
Cash payments made for interest......................................................... $ 37 $ -
=================================
Cash payments made for income taxes..................................................... $ - $ -
=================================
Supplemental disclosure of non-cash investing activities:
Liabilities incurred to acquire fixed assets............................................ $ - $ 4,234
=================================
The accompanying notes are an integral part of these condensed
consolidated financial statements.
6
NET2PHONE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements
of Net2Phone, Inc. and its subsidiaries (collectively "the Company" or
"Net2Phone") have been prepared in accordance with accounting principles
generally accepted in the United States for interim financial information and
with the instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all of the information and footnotes required
by accounting principles generally accepted in the Unites States for annual
financial statements. In the opinion of management, all adjustments considered
necessary for a fair presentation, including normal recurring accruals and other
items, have been included. Certain reclassifications have been made to the prior
year's unaudited condensed consolidated financial statements to conform to the
current year's presentation. The results for the interim periods presented are
not necessarily indicative of the results that may be expected for any future
period. The balance sheet at July 31, 2002 has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by accounting principles generally accepted in the United
States for complete audited financial statements. For further information, refer
to the audited financial statements and notes thereto included in Net2Phone's
Annual Report on Form 10-K for the year ended July 31, 2002.
2. Recent Accounting Pronouncements
In June 2002, the FASB issued SFAS No. 146, Accounting for Costs
Associated with Exit or Disposal Activities ("SFAS 146"). SFAS 146 requires
companies to recognize costs associated with exit or disposal activities when
they are incurred rather than at the date of a commitment to an exit or disposal
plan. Previous accounting guidance was provided by Emerging Issues Task Force
("EITF") Issue No. 94-3, Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring) ("EITF 94-3"). SFAS 146 replaces EITF 94-3 and is to be
applied prospectively to exit or disposal activities initiated after December
31, 2002. The Company does not expect that the adoption of SFAS 146 will have a
material impact on its consolidated financial statements.
3. Earnings Per Share
The shares issuable upon the exercise of stock options and warrants are
excluded from the calculation of net income per share as their effect would be
antidilutive. Stock options for 10.5 million shares for the three months ended
October 31, 2002 were not included in the computation of diluted earnings per
share because the exercise price of the stock options was greater than the
average market price of the common stock.
4. Related Party Transactions
IDT
In the three months ended October 31, 2002, we provided carrier
services to IDT of $1.1 million and sold disposable calling cards to IDT
affiliates totaling $2.0 million. In the three months ended October 31, 2002, we
purchased wholesale carrier services from IDT of $3.2 million.
Our corporate headquarters and several other facilities are leased from
IDT. In the three months ended October 31, 2002, we paid IDT $0.4 million in
facilities lease payments.
The due from (to) IDT balances represent net amounts due from (to) IDT
to (by) us principally for wholesale carrier services and facilities lease
payments. On October 31, 2002, we owed IDT $0.6 million. The average balance we
owed to IDT during the three months ended October 31, 2002 was $0.2 million.
7
5. Marketable Securities
Prior to August 1, 2002, we classified our investments in marketable
securities as held-to-maturity since we had the intent and ability to hold the
securities to maturity. During the first quarter of fiscal 2003, we elected to
have IDT's treasury function advise us regarding the management of our
marketable securities. As a result of this change, we reevaluated our prior
determination that our investments in marketable securities are
held-to-maturity, and concluded that they should be transferred to
available-for-sale to be consistent with the IDT treasury function's advice with
respect to management of these securities. Accordingly, effective October 31,
2002, held-to-maturity securities with an amortized cost of $44.5 million and
gross unrealized gains and losses of $0.5 million and $0, respectively, were
transferred to the available-for-sale category.
6. Other Comprehensive Income
The Company's other comprehensive income (loss) consists of the following:
Three Months Ended October 31,
------------------------------
2002 2001
--------- ---------
(in thousands)
Net income (loss) $ 46,124 $ (41,355)
--------- ---------
Other Comprehensive Income (Loss):
Foreign currency translation adjustments - (63)
Unrealized gain (losses) on available for sale 500 -
securities
--------- ---------
500 (63)
--------- ---------
Total comprehensive income (loss) $ 46,624 $ (41,418)
========= =========
The components of accumulated other comprehensive income (loss) are as
follows:
October 31, 2002 July 31, 2002
-------------------------------
(in thousands)
Foreign currency translation adjustments $ 599 $ 599
Unrealized gains (losses) on available for sale 141 (359)
securities ----------- ----------
$ 740 $ 240
=========== ==========
7. Option Repricing
On December 18, 2001, the Board of Directors approved the repricing of
options to purchase shares of Net2Phone's common stock, par value $0.01 per
share, outstanding under Net2Phone's 1999 Amended and Restated Stock Option and
Incentive Plan and granted on or before December 18, 2001. There were options to
purchase 6.4 million shares of common stock outstanding and eligible to be
repriced.
The exercise price per share of the repriced options ranged from $3.50
per share to $7.00 per share. The repriced options are subject to variable
accounting treatment and therefore must be marked-to-market each quarter. Based
on Net2Phone's stock price at October 31, 2002, we reversed $0.6 million of
compensation expense previously recorded as non-cash compensation. If our
share price increases, we will continue to incur charges over the vesting period
and with respect to repricings, until the options are exercised.
All of our non-cash compensation is attributable to selling, general
and administrative expense.
8
8. Legal Proceedings
Multi-Tech
On February 15, 2000, Multi-Tech Systems, Inc. filed suit against
Net2Phone and other companies in the United States Federal District Court in
Minneapolis, Minnesota. Multi-Tech alleged 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." On August 16, 2002, following an initial
hearing, the Court issued an order construing the claims of all the patents in
suit that we consider favorable to our non-infringement defenses. On October
31, 2002, the Court entered a consent judgment dismissing the patent
infringement claims asserted by Multi-Tech Systems, Inc. On November 19, 2002,
Multi-Tech filed an appeal with the United States Court of Appeals for the
Federal Circuit. We continue to defend the lawsuit vigorously.
Class-Actions
Four substantially similar 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 several hundred other companies that
executed 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. We recently have been able to secure
the voluntary dismissal of our executive officers from the lawsuits. In
addition, our underwriting agreement with our underwriters provides 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.
9
9. Settlement of Cisco Litigation, Restructuring, Severance,
Impairment and Other Items
The following table summarizes the charges included in settlement of
Cisco litigation, restructuring, severance, impairment and other items in the
statements of operations:
Three Months Ended October 31,
2002 2001
---------------------------------
(in thousands)
Settlement of Cisco litigation $ (58,429) $ -
Workforce reductions 3,649 -
Reserve adjustments (2,133) -
Exit costs 876 -
Impairment of long-lived assets 1,443 -
CEO & CFO separation agreements 1,337 5,911
---------------------------------
Total $ (53,257) $ 5,911
=================================
o Settlement of Cisco Litigation
On March 19, 2002 we filed suit in the United States District Court for
the District of New Jersey against Cisco Systems, Inc. and a Cisco executive who
had been a member of the board of directors of ADIR Technologies, Inc., a
majority-owned subsidiary of the Company. The suit arose out of the
relationships that had been created in connection with Cisco's and Net2Phone's
original investments in ADIR and out of ADIR's subsequent purchase of NetSpeak,
Inc. in August 2001. In July 2002, Net2Phone and ADIR agreed to settle the suit.
The parties settled the suit and all related claims against Cisco and the Cisco
executive in exchange for: (i) the transfer, during the first quarter of fiscal
2003, to Net2Phone of Cisco's and Softbank Asia Infrastructure Fund's respective
11.5% and 7.0% interests in ADIR, and (ii) the payment by Cisco, during such
quarter, of $19.5 million to Net2Phone and ADIR. As a result of this settlement,
we recognized for the quarter ended October 31, 2002, a gain of $58.4 million
consisting of a $38.9 million reduction in Minority interests as a result of the
transfer of the ADIR shares and receipt of settlement proceeds of $19.5 million
less the $1.6 million of legal and other expenses related to the settlement that
were recorded in fiscal 2002.
o First Quarter 2003 Restructuring
On October 24, 2002, we announced that we are consolidating the
development and support of our products for both our core business and our
broadband effort within one unit working on standards-based solutions that will
service the entire organization. This consolidation will reduce our staff by
approximately 20%, or about 63 employees. As a result of this restructuring,
there was a charge of $3.6 million related to terminated employees, $0.9 million
related to the reduction of operations at various locations, and $1.4 million
related to elimination of various equipment and network build-outs. As of
October 31, 2002, no significant involuntary termination benefits have been paid
and charged against the liability.
o Reserve Adjustments
During the three months ended April 30, 2002, we recognized a charge of
$4.7 million related to the elimination of specific connectivity and network
related costs. During the three months ended October 31, 2002, we reversed $2.9
million of those previously recognized charges as a result of successful
settlement negotiations with vendors regarding cancellation charges and $0.3
million of previously recognized severance expense as a result of the subsequent
retention of several individuals whose employment had been terminated. We also
recognized, during the first quarter of fiscal 2003, an additional $0.5 million
charge relating to the sale of our web-based banner advertising business in
fiscal 2002 and a $0.5 million charge relating to the proceeds owed to former
shareholders of an operation we purchased in fiscal 2000 and discontinued during
fiscal 2001.
10
o Separation Agreements
In October 2001, Howard Balter resigned as our Chief Executive Officer.
Pursuant to an agreement between Mr. Balter and the Company, Mr. Balter waived
various rights under his employment agreement, entered into a 30 month
restrictive non-compete covenant and agreed to provide consulting services for a
15 month period, all in exchange for settlement of various loans from the
Company and the guarantee of continued benefits for a similar period. In
addition, Mr. Balter's options were repriced at the conclusion of the first
three months of the consultancy period. Mr. Balter waived all rights to assert
any claims against Net2Phone and ADIR relating to his employment agreement with
Net2Phone. The aggregate principal amount of Mr. Balter's borrowing from
Net2Phone and ADIR was $4.4 million. In addition, Net2Phone had guaranteed the
repayment of a bank loan to Mr. Balter in the principal sum of $5.0 million.
Net2Phone repaid the bank loan and forgave $2.0 million of the other
indebtedness after the completion of the first three months of Mr. Balter's
consulting arrangement and agreed to forgive the balance after the completion of
the entire consulting period. As a result of this agreement, there was a charge
of $0.9 million for the three months ended October 31, 2002. There will be
future charges of approximately $1.1 million relating to this separation
agreement.
In January 2002, Ilan Slasky tendered his resignation as our Chief
Financial Officer. Mr. Slasky's resignation became effective upon his
successor's assumption of the responsibility in March 2002. Pursuant to an
agreement between Mr. Slasky and the Company, Mr. Slasky waived all of his
rights under his employment agreement, entered into a 2 year restrictive
non-compete covenant and agreed to provide consulting services for a 4 year
period, all in exchange for settlement of various loans with the Company and the
guarantee of continued benefits for a similar period. In addition, Mr. Slasky's
options were repriced on January 31, 2002. The aggregate principal sum of Mr.
Slasky's borrowings from Net2Phone was $1.5 million. Net2Phone agreed to forgive
the loans in four equal installments upon the completion of each of the four
years of his consulting arrangement. As a result of this agreement, there was a
charge of $0.2 million for the three months ended October 31, 2002. There will
be future charges of approximately $1.6 million relating to this separation
agreement. In connection with the termination of his employment, Mr. Slasky sold
500 shares of ADIR stock to IDT Corporation. IDT then transferred the ADIR
shares to us for 273,798 shares of Net2Phone common stock valued at $1,423,750
or $5.20 per share, the closing price of the stock on January 24, 2002. Under
certain circumstances, Net2Phone is required to guarantee to IDT that the shares
still owned by it on January 31, 2007 will have a market value of at least $5.20
per share on that date. During the three months ended October 31, 2002, we
recorded a mark-to-market adjustment of $0.2 million relating to this guarantee.
11
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion of our financial condition and results of
operations should be read in conjunction with the Management's Discussion and
Analysis of Financial Condition and Results of Operations and the Consolidated
Financial Statements and the Notes thereto included in our Annual Report on Form
10-K for the year ended July 31, 2002. This quarterly report on Form 10-Q
contains forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange
Act of 1934, as amended. These forward-looking statements involve risks and
uncertainties and actual results could differ materially from those discussed in
the forward-looking statements. For this purpose, any statements contained in
this Form 10-Q that are not statements of historical fact may be deemed to be
forward-looking statements. Factors which may affect our results include, but
are not limited to, our ability to expand our customer base and to develop
additional and leverage our existing distribution channels for our products and
solutions, dependence on strategic and channel partners including their ability
to distribute our products and meet or renew their financial commitments, our
ability to address international markets, the effectiveness of our sales and
marketing activities, the acceptance of our products in the marketplace, the
timing and scope of deployments of our products by customers, fluctuations in
customer sales cycles, our customers' ability to obtain additional funding,
technical difficulties with respect to our products or products in development,
the need for ongoing product development in an environment of rapid
technological change, the emergence of new competitors in the marketplace, our
ability to compete successfully against established competitors with greater
resources, the uncertainty of future governmental regulation, our ability to
manage growth and obtain patent protection and additional funds, general
economic conditions and other risks discussed in this report and in our other
filings with the Securities and Exchange Commission. All forward-looking
statements and risk factors included in this report are made as of the date
hereof, based on information available to us as of the date thereof, and we
assume no obligation to update any forward-looking statement or risk factors.
Company Overview
We are a provider of Voice over Internet Protocol, or VoIP, telephony
products and services. We began operations in 1995 as a division of IDT
Corporation, and were incorporated in Delaware as a separate subsidiary of IDT
in October 1997. We utilize our VoIP technology to transmit digital voice
communications over the Internet and other data networks. We introduced our
flagship product, the personal computer to telephone, or PC-to-phone, service,
in 1996, which allows our end users to transmit voice communications over data
networks, such as the Internet, to standard phones on public switched telephone
networks. Since we introduced our PC-to-phone service, we have used our VoIP
technology and our ability to bridge VoIP networks with switched networks to
allow end users to send voice communications over the Internet via telephone,
computer or other calling device virtually anywhere in the world. Since 1996, we
have grown our VoIP services to the extent that, based on our market share, we
believe we are the largest retailer of VoIP services worldwide.
The majority of our revenue comes from the sale of voice minutes over
our data networks. Currently, we market our products and services through three
units, each focused on a different market for those minutes: (1) International
Communications Services; (2) Domestic Retail Services; and (3) Broadband
Telephony Solutions. The International Communications Services group, or ICS, is
responsible for the sale of international long distance solutions utilizing VoIP
technology. ICS, in turn, is comprised of three divisions: (a) Channel Sales and
Distribution; (b) Carrier Services; and (c) Direct to Consumer Services. Our
Domestic Retail Services group sells VoIP minutes via both disposable and
rechargeable calling cards primarily to U.S. consumers. Finally, our Broadband
Telephony Solutions group is able to provide cable operators with a fully
outsourced end-to-end telecommunications solution utilizing existing high speed
cable data networks and the "last mile" access into consumers' homes provided by
the cable operator via cable modems.
Critical Accounting Policies
Our consolidated financial statements have been prepared in accordance
with generally accepted accounting principles. These generally accepted
accounting principles require management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of net sales and expenses during the reporting period. We
continually evaluate our estimates, including those related to revenue
recognition, bad debts, intangible assets, income taxes, fixed assets, access
line costs, restructuring, contingencies and litigation. We base our estimates
on historical experience and on various other assumptions that are believed to
be reasonable under the facts and circumstances. Actual results may differ from
these estimates under different assumptions or conditions.
We believe the following critical accounting policies impact our most
difficult, subjective and complex judgments used in the preparation of our
consolidated financial statements, often as a result of the need to make
estimates about the effect of matters that are inherently uncertain. For a more
detailed discussion of these and other accounting policies, please see Note 2 of
the Notes to consolidated financial statements included in our Annual Report on
Form 10-K for the year ended July 31, 2002.
12
Revenue Recognition. Our primary source of revenue is communication
services revenue from the sale of minutes over our voice over Internet protocol,
or VoIP, network. We sell these minutes, or access to these minutes, through our
various businesses, including our international communications services group
and our domestic retail services group. Our international communications service
revenue is recognized as service is provided, that is, as minutes are used. Our
retail sales revenue, which consists primarily of pre-paid calling card revenue,
is also recognized as our service is provided, that is, as minutes are used, or
when service fees are charged. We also recognize revenue from pre-payments for
our services after we conduct evaluations of outstanding remaining pre-payment
balances and determine, based on historical data, that such balances are not
likely to be utilized. The sale of equipment with software necessary to provide
our services is recognized when such products are delivered, collection of
payments is assured and there are no significant future obligations. To date, we
have recognized no revenue from our broadband business.
Impairment of Long-Lived Assets. The recoverability of long-lived
assets and certain identifiable intangible assets are evaluated when events or
changes in circumstances indicate that the carrying amount of the assets may not
be recoverable. An impairment loss will be recognized when estimated future
undiscounted cash flows expected to result from the use of the asset and its
eventual disposition are less than its carrying amount, with the loss measured
based on discounted expected cash flows. Goodwill and indefinite-lived
intangible assets are tested for impairment annually, or upon an indication that
their value may be impaired.
Expense Recognition versus Capitalized Costs. Purchases that provide
benefit to future periods and have useful lives greater than one year are
capitalized. All other purchases are expensed in the period the underlying goods
and/or services are received.
Specifically:
o 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.
o Computer software is amortized using the straight-line method
over the shorter of five years or the term of the related
agreement.
o Software development 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 we have completed our software
development concurrently with the establishment of
technological feasibility, we have not capitalized these
costs. We capitalize 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.
Three Months Ended October 31, 2002 Compared to Three Months Ended October 31,
2001
Results of Operations
Revenue. Our revenues are primarily derived from per-minute charges we
billed to our customers on a pre-paid basis and from the sale of Internet
telephony equipment and services to resellers, IDT and other carriers. Revenue
decreased 44% from $42.9 million for the three months ended October 31, 2001 to
$23.9 million for the three months ended October 31, 2002. The decrease in
revenue was primarily driven by the restructurings of operations announced
during fiscal 2002 and in October 2002. We, purposefully, de-emphasized seeking
revenue from relatively low-margin services such as disposable calling cards in
favor of building up activities to generate revenue in relatively high-margin
services such as International Communications Services during the upcoming
periods.
Direct Cost of Revenue. 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 costs of internet telephony devices.
Direct cost of revenue decreased 42% from $24.1 million for the three months
ended October 31, 2001 to $13.9 million for the three months ended October 31,
2002. As a percentage of total revenue, these costs increased from 56.1% for the
three months ended October 31, 2001 to 58.2% for the three months ended October
31, 2002. The increase was a result of a reduction in overall pricing levels
from a year ago.
13
Selling, General and Administrative. Selling, general and
administrative expense consists of salaries of our employees and associated
benefits, and the cost of insurance, legal, rent, utilities and other services,
expenses associated with acquiring customers, including commissions paid to our
sales personnel, advertising costs, travel, entertainment, referral fees and
amounts paid to our strategic partners, some based upon revenue-sharing
arrangements. Selling, general and administrative expense decreased 64% from
$38.1 million for the three months ended October 31, 2001 to $13.9 million for
the three months ended October 31, 2002 due to continuing cost management
initiatives and elimination of certain expenses directly related to the
restructurings of our operations that were announced during fiscal 2002. We
anticipate selling, general and administrative expense, excluding Settlement of
Cisco litigation, restructuring, severance, impairment and other items, will
continue to decrease in the remainder of fiscal 2003 due to the restructurings
of our operations that were announced in fiscal 2002 and October 2002.
Depreciation and Amortization. Depreciation and amortization decreased
63% from approximately $6.7 million for the three months ended October 31, 2001
to $2.5 million for the three months ended October 31, 2002. As a percentage of
total revenues, these costs decreased from 15.7% for the three months ended
October 31, 2001 to approximately 10.4% for the three months ended October 31,
2002. Depreciation and amortization declined as a result of the impairment
charge for long-lived assets recognized during the quarter ended April 30, 2002
which reduced the carrying value of such assets.
Settlement of Cisco litigation, restructuring, severance, impairment
and other items.
The following table summarizes the charges included in Settlement of
Cisco litigation, restructuring, severance, impairment and other items in the
statements of operations:
Three Months Ended October 31,
2002 2001
---------------------------------
(in thousands)
Settlement of Cisco litigation $ (58,429) $ -
Workforce reductions 3,649 -
Reserve adjustments (2,133) -
Exit costs 876 -
Impairment of long-lived assets 1,443 -
CEO & CFO separation agreements 1,337 5,911
---------------------------------
Total $ (53,257) $ 5,911
=================================
o Settlement of Cisco Litigation
On March 19, 2002 we filed suit in the United States District Court for
the District of New Jersey against Cisco Systems, Inc. and a Cisco executive who
had been a member of the board of directors of ADIR Technologies, Inc., our
majority-owned subsidiary. The suit arose out of the relationships that had been
created in connection with Cisco's and Net2Phone's original investments in ADIR
and out of ADIR's subsequent purchase of NetSpeak, Inc. in August 2001. In July
2002, Net2Phone and ADIR agreed to settle the suit. The parties settled the suit
and all related claims against Cisco and the Cisco executive in exchange for:
(i) the transfer, during the first quarter of fiscal 2003, to Net2Phone of
Cisco's and Softbank Asia Infrastructure Fund's respective 11.5% and 7.0%
interests in ADIR, and (ii) the payment by Cisco, during such quarter, of $19.5
million to Net2Phone and ADIR. As a result of this settlement, we recognized for
the quarter ended October 31, 2002, a gain of $58.4 million consisting of a
$38.9 million reduction in Minority interests as a result of the transfer of the
ADIR shares and receipt of settlement proceeds of $19.5 million less the $1.6
million of legal and other expenses related to the settlement that were recorded
in fiscal 2002.
o First Quarter 2003 Restructuring
On October 24, 2002, we announced that we are consolidating the
development and support of our products for both our core business and our
broadband effort within one unit working on standards-based solutions that will
service the entire organization. This consolidation will reduce our staff by
approximately 20%, or about 63 employees. As a result of this restructuring,
there was a charge of $3.6 million related to terminated employees, $0.9 million
related to the reduction of operations at various locations, and $1.4 million
related to elimination of various equipment and network build-outs. As of
October 31, 2002, no significant involuntary termination benefits have been paid
and charged against the liability.
14
o Reserve Adjustments
During the three months ended April 30, 2002, we recognized a charge of
$4.7 million related to the elimination of specific connectivity and network
related costs. During the three months ended October 31, 2002, we reversed $2.9
million of those previously recognized charges as a result of successful
settlement negotiations with vendors regarding cancellation charges and $0.3
million of previously recognized severance expense as a result of the subsequent
retention, during the first quarter of fiscal 2003, of several individuals whose
employment had been terminated. We also recognized an additional $0.5 million
charge relating to the sale of our web-based banner advertising business in
fiscal 2002 and a $0.5 million charge relating to the proceeds owed to former
shareholders of an operation we purchased in fiscal 2000 and discontinued during
fiscal 2001.
o Separation Agreements
In October 2001, Howard Balter resigned as our Chief Executive Officer.
Pursuant to an agreement between Mr. Balter and the Company, Mr. Balter waived
various rights under his employment agreement, entered into a 30 month
restrictive non-compete covenant and agreed to provide consulting services for a
15 month period, all in exchange for settlement of various loans from the
Company and the guarantee of continued benefits for a similar period. In
addition, Mr. Balter's options were repriced at the conclusion of the first
three months of the consultancy period. Mr. Balter waived all rights to assert
any claims against Net2Phone and ADIR relating to his employment agreement with
Net2Phone. The aggregate principal amount of Mr. Balter's borrowing from
Net2Phone and ADIR was $4.4 million. In addition, Net2Phone had guaranteed the
repayment of a bank loan to Mr. Balter in the principal sum of $5.0 million.
Net2Phone repaid the bank loan and forgave $2.0 million of the other
indebtedness after the completion of the first three months of Mr. Balter's
consulting arrangement and agreed to forgive the balance after the completion of
the entire consulting period. As a result of this agreement, there was a charge
of $0.9 million for the three months ended October 31, 2002. There will be
future charges of approximately $1.1 million relating to this separation
agreement.
In January 2002, Ilan Slasky tendered his resignation as our Chief
Financial Officer. Mr. Slasky's resignation became effective upon his
successor's assumption of the responsibility in March 2002. Pursuant to an
agreement between Mr. Slasky and the Company, Mr. Slasky waived all of his
rights under his employment agreement, entered into a 2 year restrictive
non-compete covenant and agreed to provide consulting services for a 4 year
period, all in exchange for settlement of various loans with the Company and the
guarantee of continued benefits for a similar period. In addition, Mr. Slasky's
options were repriced on January 31, 2002. The aggregate principal sum of Mr.
Slasky's borrowings from Net2Phone was $1.5 million. Net2Phone agreed to forgive
the loans in four equal installments upon the completion of each of the four
years of his consulting arrangement. As a result of this agreement, there was a
charge of $0.2 million for the three months ended October 31, 2002. There will
be future charges of approximately $1.6 million relating to this separation
agreement. In connection with the termination of his employment, Mr. Slasky sold
500 shares of ADIR stock to IDT Corporation. IDT then transferred the ADIR
shares to us for 273,798 shares of Net2Phone common stock valued at $1,423,750
or $5.20 per share, the closing price of the stock on January 24, 2002. Under
certain circumstances, Net2Phone is required to guarantee to IDT that the shares
still owned by it on January 31, 2007 will have a market value of at least $5.20
per share on that date. During the three months ended October 31, 2002, we
recorded a mark-to-market adjustment of $0.2 million relating to this guarantee.
Acquired in-process research and development. For the three months
ended October 31, 2001, purchased in-process research and development ("IPR&D")
represents the value assigned in a purchase business combination to research and
development projects of the acquired business that had commenced but had not yet
been completed at the date of acquisition and which have no alternative future
use. In accordance with SFAS No. 2, Accounting for Research and Development
Costs, as clarified by FASB Interpretation No. 4, amounts assigned to IPR&D
meeting the above stated criteria must be charged to expense as part of the
allocation of the purchase price of the business combination. Accordingly,
charges totaling $13.9 million were recorded during fiscal 2002 as part of the
allocation of the purchase price related to the acquisition of NetSpeak by ADIR,
our majority-owned subsidiary.
The IPR&D relates primarily to advanced telephony software products for
Internet protocol ("IP") networks. The Route Server Infrastructure product
provides real-time IP address resolution ensuring high performance, scalability
and reliability. The Route Server Virtual Private Network ("VPN") product
integrated with the infrastructure product creates a solution that enables
service providers to address the long distance service market. The Residential
Cable Solution products provide routing and call management for end-user cable
subscribers.
The valuation of the IPR&D included both cost and income valuation
approaches, and utilized replacement cost and discounted cash flow methodologies
for various aspects of the analysis. The calculations were based on estimates of
operating earnings, capital charges, and working capital requirements to support
the cash flows attributed to the technologies. Discount rates reflecting the
stage of development, complexity and the risk associated with each technology
were used to value IPR&D. The fair value total of $13.9 million has been
assigned as follows: Route Server Infrastructure product -- $10.3 million; Route
Server VPN product -- $2.9 million, Residential Cable Solution products -- $0.7
million. Development of the Route Server Infrastructure and Route Server VPN
products were completed during the second quarter of fiscal 2002. Effective
February 14, 2002, further research and development of the Residential Cable
Solution products were suspended while we reevaluate the business prospects
of ADIR.
15
Non-cash Compensation. Non-cash compensation charges decreased 70% from
$4.9 million for the three months ended October 31, 2001 to $1.5 million for the
three months ended October 31, 2002. As a percentage of total revenue, these
costs decreased from 11.4% for the three months ended October 31, 2001 to 6.0%
for the three months ended October 31, 2002. This decrease was mainly caused
because many options granted below fair market value became fully vested during
fiscal 2002. In addition, due to our various restructurings, previously granted
options have been forfeited. On December 18, 2001, the Board of Directors
approved the repricing of options outstanding under Net2Phone's 1999 Amended and
Restated Stock Option and Incentive Plan. The repriced options are subject to
variable accounting treatment and therefore must be marked-to-market each
quarter. Based on our stock price at October 31, 2002, we reversed $0.6
million of compensation expense previously recorded from non-cash compensation.
If our stock price increases, we will continue to incur charges over the vesting
period and with respect to repricings, until the options are exercised.
Income from Operations. Loss from operations was $50.7 million for the
three months ended October 31, 2001 as compared to income from operations of
$45.5 million for the three months ended October 31, 2002. The decrease in loss
from operations is primarily due to the gain from the settlement of the Cisco
litigation, lower selling, general and administrative expense and the write-off
of acquired in-process research and development during the three months ended
October 31, 2001. Excluding non-cash compensation, acquired in-process research
and development and the Settlement of Cisco litigation, restructuring,
severance, impairment and other items described above, our loss from operations
for the three months ended October 31, 2002 would have been $6.3 million
compared to $26.0 million for the three months ended October 31, 2001. This
decrease is a result of our continuous cost management initiatives and
elimination of certain expenses directly related to the restructurings of our
operations that were announced in fiscal 2002 and October 2002.
Interest Income, net. Interest income consists primarily of interest earned
on cash and cash equivalents. Interest income decreased 58% from $1.9 million
for the three months ended October 31, 2001 to $0.8 million for the three months
ended October 31, 2002. The reduction primarily results from lower cash balances
and interest rate reductions. We anticipate reduced interest income from
interest bearing accounts due to lower interest rates and cash balances.
Related Party Transactions
In the three months ended October 31, 2002, we provided carrier
services to IDT Corporation, our controlling shareholder, of $1.1 million and
sold disposable calling cards to IDT affiliates totaling $2.0 million. In the
three months ended October 31, 2002, we purchased wholesale carrier services
from IDT of $3.2 million.
Our corporate headquarters and several other facilities are leased from
IDT. In the three months ended October 31, 2002, we paid IDT $0.4 million in
facilities lease payments.
The due from (to) IDT balances represent net amounts due from (to) IDT
to (by) us principally for wholesale carrier services and facilities lease
payments. On October 31, 2002, we owed IDT $0.6 million. The average balance we
owed to IDT during the three months ended October 31, 2002 was $0.2 million.
Liquidity and Capital Resources
Historically, we have developed our cash resources through a
combination of cash flow from operating activities, and sales of equity
securities and borrowings from third parties. Historically, our cash
requirements have been satisfied primarily through our existing cash, cash
equivalents and marketable securities balances.
The following table provides our cash flow data for the three months ended
October 31, 2002 and 2001.
Three Months Ended October 31,
------------------------------
2002 2001
------------------------------
(in thousands)
Net cash provided by (used in) operating
activities $ 12,502 $ (41,625)
Net cash used in investing
activities............................... (1,956) (27,440)
Net cash (used in) provided by financing
activities............................... (259) 10,187
Effect of exchange rate on cash............ - 63
---------- ---------
Net increase (decrease) in cash
and cash equivalents $ 10,287 $ (58,815)
---------- ---------
Operating activities
As of October 31, 2002, we had cash, cash equivalents and marketable
securities of approximately $119.5 million and working capital of approximately
$84.8 million. We generated positive cash flow from operating activities of
$12.5 million during the three months ended October 31, 2002, compared with
negative cash flow from operating activities of $41.6 million during the three
months ended October 31, 2001. The increase in cash flow from operating
activities is primarily due to receipt of $19.5 million from the settlement of
litigation with Cisco Systems, significantly reduced operating costs, and
favorable changes in working capital as a result of the timing of receipts and
disbursements.
16
Investing activities
Net cash used in investing activities decreased from $27.4 million
during the three months ended October 31, 2001, to $2.0 million for the three
months ended October 31, 2002. Our capital expenditures decreased from $9.7
million during the three months ended October 31, 2001 to $2.1 million for the
three months ended October 31, 2002, as we completed the majority of the
expansion of our domestic and international network infrastucture during fiscal
2002. The net cash from the proceeds from the sale of marketable securities
decreased from $34.0 million during the three months ended October 31, 2001 to
$1.5 million for the three months ended October 31, 2002. During the three
months ended October 31, 2001, we used $27.6 million for the acquistion of
Netspeak by ADIR.
Financing activities
Net cash used in financing activities was $0.3 million during the three
months ended October 31, 2002 compared to net cash provided of $10.2 million
during the three months ended October 31, 2001. During the three months ended
October 31, 2001, we received $14.0 million in a private placement of shares of
preferrred stock for ADIR.
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, and to fund any potential
operating cash flow deficits for at least the next twelve months. If our growth
exceeds current expectations or if we acquire the business or assets of another
company, or if our operating cash flow deficit exceeds our expectations to the
point that we cannot meet our working capital and capital expenditure
requirements, we will need to raise additional capital from equity or debt
sources. There can be no assurance that we will be able to raise such capital on
favorable terms or at all. If we are unable to obtain such additional capital,
we may be required to reduce the scope of our activities, which could have a
material effect on our business, financial condition, or results of operations.
Contractual Obligations and Commercial Commitments
The following table provides a summary of our contractual obligations and
commercial commitments.
Contractual Obligations Payments Due by Period
------------------------------------------------------------------ ---------------
Total Less than 1 year 1-3 years 4-5 years After 5 years
(in thousands)
Capital lease obligations $ 5,399 $ 3,188 $ 2,211 $ -- $ --
Operating leases 28,519 3,179 12,592 12,748 --
Other long term obligations 17,886 17,886 -- -- -
------------ ----------------- ---------------- --------------- ---------------
Total contractual obligations $ 51,804 $ 24,253 $ 14,803 $ 12,748 $ --
============================================== ================= ================ =============== ===============
Other Commercial Commitments Payments Due by Period
----------------------------------------------------------------------------------
Total Less than 1 year 1-3 years 4-5 years After 5 years
(in thousands)
Standby letters of credit $ 22,990 $ 20,079 $ 2,377 $ 161 $ 373
------------ ------------------ ----------------- --------------- ---------------
Total other commercial
commitments $ 22,990 $ 20,079 $ 2,377 $ 161 $ 373
============================================== ================= ================ =============== ===============
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.
Recently Issued Accounting Standards
In June 2002, the FASB issued SFAS No. 146, Accounting for Costs
Associated with Exit or Disposal Activities ("SFAS 146"). SFAS 146 requires
companies to recognize costs associated with exit or disposal activities when
they are incurred rather than at the date of a commitment to an exit or disposal
plan. Previous accounting guidance was provided by Emerging Issues Task Force
("EITF") Issue No. 94-3, Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring) ("EITF 94-3"). SFAS 146 replaces EITF 94-3 and is to be
applied prospectively to exit or disposal activities initiated after December
31, 2002. We do not expect that the adoption of SFAS 146 will have a material
impact on our consolidated financial statements.
17
Item 3. 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. 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 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures. Our Chief Executive
Officer and Chief Financial Officer have evaluated the effectiveness of our
disclosure controls and procedures (as such term is defined in Rules 13a-14(c)
and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the
"Exchange Act")) as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"). Based on such evaluation, such
officers have concluded that, as of the Evaluation Date, our disclosure controls
and procedures are effective in alerting them on a timely basis to material
information relating to Net2Phone (including its consolidated subsidiaries)
required to be included in our reports filed or submitted under the Exchange
Act.
Changes in Internal Controls. Since the Evaluation Date, there have not
been any significant changes in our internal controls or in other factors that
could significantly affect such controls.
18
PART II--OTHER INFORMATION
Item 1. Legal Proceedings
Multi-Tech
On February 15, 2000, Multi-Tech Systems, Inc. filed suit against
Net2Phone and other companies in the United States Federal District Court in
Minneapolis, Minnesota. Multi-Tech alleged 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." On August 16, 2002, following an initial
hearing, the Court issued an order construing the claims of all the patents in
suit favorably to our non-infringement defenses. On October 31, 2002, the Court
entered a consent judgment dismissing the patent infringement claims asserted by
Multi-Tech Systems, Inc. On November 19, 2002, Multi-Tech filed an appeal with
the United States Court of Appeals for the Federal Circuit. We continue to
defend this lawsuit vigorously.
Class-Actions
Four substantially similar 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 several hundred other companies that
executed 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. We recently have been able to
secure the voluntary dismissal of our executive officers from the lawsuits. In
addition, our underwriting agreement with our underwriters provides 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.
Cisco Systems
In August 2002, Net2Phone and its ADIR subsidiary consummated the
settlement of their lawsuit in the United States District Court for the District
of New Jersey against Cisco and a Cisco executive who had been a member of the
board of directors of ADIR Technologies, Inc., our majority-owned subsidiary.
The suit arose out of the relationships that had been created in connection with
Cisco's and Net2Phone's original investments in ADIR and out of ADIR's
subsequent purchase of NetSpeak, Inc. in August 2001. In July 2002, Net2Phone
and ADIR agreed to settle the suit. The parties settled the suit and all related
claims against Cisco and the Cisco executive in exchange for: (i) the transfer,
during the first quarter of fiscal 2003, to Net2Phone of Cisco's and Softbank
Asia Infrastructure Fund's respective 11.5% and 7.0% interests in ADIR, and (ii)
the payment by Cisco, during such quarter, of $19.5 million to Net2Phone and
ADIR. As a result of this settlement, the Company recognized, for the quarter
ended October 31, 2002, a gain of $58.4 million consisting of a $38.9 million
reduction in Minority interests as a result of the transfer of the ADIR shares
and receipt of settlement proceeds of $19.5 million.
Item 2. Changes in Securities and Use of Proceeds
Not applicable.
Item 3. Defaults Upon Senior Securities
Not applicable.
19
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
Item 5. Other Information
Not applicable.
Item 6. Exhibits and Reports on Form 8-K
a) Exhibits.
Exhibit No. Description
- ---------- -----------
10.1 Employment Agreement by and between the Registrant and Arthur
Dubroff, dated as of November 20, 2002.
99.1 Certification of the Chief Executive Officer and Chief Financial
Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
b) Reports on Form 8-K.
None.
20
SIGNATURES
Pursuant to the requirements 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.
NET2PHONE, INC.
Date: December 16, 2002 By: /s/ Stephen M. Greenberg
----------------------------
Stephen M. Greenberg
Chief Executive Officer
Date: December 16, 2002 By: /s/ Arthur Dubroff
-----------------------------
Arthur Dubroff
Chief Financial Officer
21
CERTIFICATIONS
I, Stephen M. Greenberg, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Net2Phone, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: December 16, 2002
/s/ Stephen M. Greenberg
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Stephen M. Greenberg
Chief Executive Officer
22
CERTIFICATIONS
I, Arthur Dubroff, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Net2Phone, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: December 16, 2002
/s/ Arthur Dubroff
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Arthur Dubroff
Chief Financial Officer
23