ended January 31, 2003 we had significantly reduced our workforce and had scaled back certain low-margin services, including wholesale termination of telecommunications traffic.
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, and routing their calls through a local telephone company to reach their final destination. It also includes the cost of purchasing, storing and shipping VoIP devices. Most of these costs were incurred within the units that now comprise Net2Phone Global Services. Direct cost of revenue decreased 15.3% from $26.2 million for the six months ended January 31, 2003 to $22.2 million for the six months ended January 31, 2004. As a percentage of total revenue, these costs decreased from 55.7% for the six months ended January 31, 2003 to 55.2% for the six months ended January 31, 2004. While the dollar cost decrease is primarily attributable to lower revenue, we are also realizing cost reductions, despite a $0.6 million inventory obsolescence charge taken during the second quarter of fiscal 2004, from a more efficiently structured and utilized network, and from more aggressively priced termination contracts. Our decision to discontinue issuing new disposable calling cards during the second quarter of fiscal 2004 has allowed us to reduce higher direct costs associated with this service and to pursue other, more profitable service offerings.
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 force, advertising costs, travel, entertainment, referral fees and amounts paid in connection with revenue-sharing arrangements. Selling, general and administrative expense decreased 14.2% from $28.2 million for the six months ended January 31, 2003 to $24.2 million for the six months ended January 31, 2004 due to continuing cost management initiatives, elimination of certain expenses directly related to the restructurings of our operations and to an overall reduction in employee headcount. In addition, during the second quarter of fiscal 2004 we received a refund of $0.6 million for the overpayment of employer taxes, which has been reflected as a reduction in selling, general and administrative expenses. We expect to incur significant selling, general and administrative expense related to the future growth of our Net2Phone Cable Telephony business.
Depreciation and amortization. Depreciation and amortization increased 4.1% from $4.9 million for the six months ended January 31, 2003 to $5.1 million for the six months ended January 31, 2004, due to accelerated depreciation on certain capitalized software. As a percentage of total revenue, these costs increased from 10.4% for the six months ended January 31, 2003 to 12.7% for the six months ended January 31, 2004. This increase is due primarily to a 14.5% decrease in revenue during the first six months of fiscal 2004 as compared with revenue recorded during the first six months fiscal 2003.
Restructuring, severance, impairment and other items. Restructuring, severance, impairment and other items decreased from $5.9 million for the six months ended January 31, 2003 to $1.0 million for the six months ended January 31, 2004.
In the first half of fiscal 2002, both our Chief Executive Officer and Chief Financial Officer resigned as we began to implement an overall long term restructuring plan, which would scale down our operations, organize us to compete more
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efficiently, and allow us to redirect our focus and resources towards a more profitable business plan. During the two years since, we have executed our plan and implemented a series of strategic workforce reductions, sold business units and long-lived assets, as well as impaired such assets and goodwill. As we continue to execute our plan we are realizing lower costs and identifying more attractive revenue opportunities. While the majority of our restructuring costs were incurred during fiscal 2001 and 2002, we continued to incur these costs during fiscal 2003 and 2004. Those expenses within these charges that required cash outlays were funded through current operations.
During the six months ended January 31, 2004, we incurred a $0.5 million charge to exit our disposable calling card business, recorded executive separation charges of $0.4 million and employee separation costs of $0.1 million and recorded various impaired lease and settlement costs totaling $0.4 million. Partially offsetting these charges were net reserve reversals of $0.1 million, and a $0.3 million recovery of equipment that was previously written off.
During the six months ended January 31, 2003, we incurred significantly higher restructuring, severance, impairment and other charges of $5.9 million, as we implemented a restructuring plan to consolidate the development and support for our projects for both our core business and our broadband effort within one unit working on standards-based solutions that service the entire organization. These charges for the six months ended January 31, 2003 included $3.6 million in employee termination charges and $2.0 million in executive separation charges, as well as $1.8 million primarily related to impaired lease costs. We also incurred $1.9 million in impairment charges primarily related to the elimination of various equipment and network build-outs. We also recorded reserve adjustments of $3.4 million during the six months ended January 31, 2003. These adjustments resulted primarily from the reversal of previously recognized costs, which were obtained through settlement agreements with vendors and related to cancellation charges.
Settlement of Cisco Litigation. 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. 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 percent and 7.0 percent 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 a gain of $58.0 million during fiscal 2003 consisting of a $38.9 million reduction in minority interests as a result of the transfer of the ADIR shares, receipt of settlement proceeds of $19.5 million less compensation expense of $0.4 million. No income taxes have been provided for with respect to the gain as we have sufficient net operating loss carry forwards to offset the gain. In fiscal 2002, we recorded $1.6 million of legal and other expenses related to this settlement.
Non-cash compensation (attributable to selling, general and administrative). Non-cash compensation decreased 7.0% from $4.3 million for the six months ended January 31, 2003 to $4.0 million for the six months ended January 31, 2004 primarily due to a $2.6 million charge taken during the six months ended January 31, 2003 relating to the discount amortization of ADIR shares sold to Net2Phone and ADIR employees in fiscal 2001, which has been fully amortized during fiscal 2003 as a result of the termination of all ADIR employees. The $3.8 million of ADIR unamortized deferred compensation, which remained at the close of fiscal 2003, was written off as a component of other income, net during the first quarter of fiscal 2004 as a result of the termination of all ADIR employees. See ADIR Technologies, Inc. (note 11.) Net of this charge, non-cash compensation would have increased $2.3 million primarily due to a greater increase in our stock price at quarter end January 31, 2004, as compared with the changes in our stock price during the same period last year, and the impact it has on our variable repriced options’ charge for this period. As a percentage of total revenue, these costs increased from 9.1% for the six months ended January 31, 2003 to 10.0% for the six months ended January 31, 2004 primarily due to a 14.5% decrease in revenue during the six months ended January 31, 2004, as compared with the same period during fiscal 2003. 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, those repriced options that are vested and unexercised, must be marked-to-market each quarter. For the six months ended January 31, 2004 and 2003, we recorded charges of $3.2 million and $0.4 million, respectively, related to these repriced options. If our stock price increases, we will continue to incur charges over the vesting period with respect to repriced options, until those options are exercised.
Non-cash services. Expense related to the receipt of services to be paid for through the issuance of Class A shares of $2.3 million were recorded during the second quarter of fiscal 2004. This expense was recorded for the first time based on a binding memorandum of understanding executed on October 29, 2003 with IDT, whereby, in exchange for attractive pricing
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on local and inter-exchange network access, termination, origination and other related services, as compared to third party vendors, access to IDT’s facilities and other benefits, we have agreed to issue 6.9 million shares of our Class A Stock to IDT at the time we enter into a definitive agreement, with vesting retroactive to October 29, 2003. This charge represents the market value of 0.4 million Class A shares which were accrued during the second quarter ended January 31, 2004. It is anticipated that these shares will be issued upon execution of definitive agreements and subsequently released to IDT in equal annual installments over five years, with the first release scheduled for October 29, 2004. Until such release, these shares and others subsequently accrued will be marked-to-market as required by variable accounting rules. See Related Party Transactions (note 5).
Income (loss) from operations. Loss from operations was $18.6 million for the six months ended January 31, 2004 as compared to income from operations of $35.5 million for the six months ended January 31, 2003. This change is primarily due to the net gain of $58.0 million that we realized from the settlement of our Cisco litigation, which we recorded during the first quarter of fiscal 2003. Net of this one time gain, loss from operations, for the six months ended January 31, 2003 would have totaled $22.5 million, which when compared with our loss from operations during the six months ended January 31, 2004, would have reflected a reduction in our overall loss from operations of $3.9 million or 17.3%, despite new expenses that were incurred during fiscal 2004, such as non-cash services expense. This decrease is attributable to a $4.8 million decrease in restructuring expenses, and to our cost reduction programs, which have yielded a leaner, more efficient cost structure.
Interest income, net. Interest income consists primarily of interest earned on cash and cash equivalents, which is partially offset by interest expense incurred on long-term obligations. Interest income decreased 35.7% from $1.4 million for the six months ended January 31, 2003 to $0.9 million for the six months ended January 31, 2004. This decrease is primarily a result of the lower average cash balances held during the first four months of fiscal 2004 relative to the same period last year, and to incremental interest expense incurred through our Deutsche Bank obligation that was entered into during the third quarter of fiscal 2003 described below in “Liquidity and Capital Resources”.
Other income, net. Other income includes the losses or gains resulting from non-operating transactions. Other income increased from a nominal gain recorded during the six months ended January 31, 2003 to $13.3 million recorded for the six months ended January 31, 2004. This increase is primarily attributable to the non-cash, non-recurring $12.2 million gain realized from the buyout of ADIR’s remaining minority interest holders during the first quarter of fiscal 2004, and to a lesser extent, to a $0.5 million recovery on a customer receivable and mark-to-market gains on Net2Phone shares held by Deutsche Bank, which may serve to reduce our overall debt obligation to Deutsche Bank.
Three Months Ended January 31, 2004 Compared to Three Months Ended January 31, 2003 |
Revenue. Our revenue is primarily derived from per-minute charges we billed to our customers on a pre-paid basis and from the sale of VoIP equipment and services to resellers, IDT and other carriers. Revenue decreased 14.3% from $23.1 million for the three months ended January 31, 2003 to $19.8 million for the three months ended January 31, 2004. A significant portion of the decrease in revenue was caused by a reduction in our sales of disposable calling cards, which generated low-margin revenue of $1.9 million during the three months ended January 31, 2003, compared to revenue of $0.3 million recorded during the three months ended January 31, 2004. The remaining decrease in revenue is primarily due to reduced revnues in our U.S. Consumer and International Communication Services divisions, which was driven by overall competitive market pricing pressures.
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, and routing their calls through a local telephone company to reach their final destination. It also includes the cost of purchasing, storing and shipping VoIP devices. Most of these costs were incurred within the units that now comprise Net2Phone Global Services. Direct cost of revenue decreased 8.9% from $12.3 million for the three months ended January 31, 2003 to $11.2 million for the three months ended January 31, 2004, despite a $0.6 million inventory obsolescence charge recorded during the second quarter of fiscal 2004, which was partially offset by a $0.4 million credit recorded, during the same period, in settlement of previously disputed carrier rates. As a percentage of total revenue, these costs increased from 53.3% for the three months ended January 31, 2003 to 56.7% for the three months ended January 31, 2004, primarily due to the inventory obsolescence charge. While the dollar cost decrease is primarily attributable to lower revenue, we are also realizing cost reductions from a more efficiently structured and utilized network and from more aggressively priced termination contracts. Our decision to discontinue issuing new disposable calling cards during the second quarter of fiscal 2004 has allowed us to reduce higher direct costs associated with this service and to pursue other, more profitable service offerings.
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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 force, advertising costs, travel, entertainment, referral fees and amounts paid in connection with revenue-sharing arrangements. Selling, general and administrative expense decreased 20.5% from $14.6 million for the three months ended January 31, 2003 to $11.6 million for the three months ended January 31, 2004 due to continuing cost management initiatives, elimination of certain expenses directly related to the restructurings of our operations, and to an overall reduction in employee headcount. In addition, during the second quarter of fiscal 2004 we received a refund of $0.6 million for the overpayment of employer taxes, which has been reflected as a reduction in selling, general and administrative expenses. We expect to incur significant selling, general and administrative expense related to anticipated future growth of our Net2Phone Cable Telephony business.
Depreciation and amortization. Depreciation and amortization increased 12.5% from $2.4 million for the three months ended January 31, 2003 to $2.7 million for the three months ended January 31, 2004. This increase is primarily attributable to accelerated depreciation on certain capitalized software. As a percentage of total revenue, these costs increased from 10.3% for the three months ended January 31, 2003 to 13.4% for the three months ended January 31, 2004, primarily due to a 14.3% reduction in revenue during the three months ended January 31, 2004 as compared with the same period during fiscal 2003.
Restructuring, severance, impairment and other items. Restructuring, severance, impairment and other items increased from $0.7 million for the three months ended January 31, 2003 to $0.8 million for the three months ended January 31, 2004.
The following table summarizes the charges included in restructuring, severance, impairment and other items in the statements of operations:
| | | Three Months Ended January 31,
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| | | 2004 | | 2003 | |
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|
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| | | (in thousands) | |
| Exit and other costs | | $ | 700 | | $ | (113) | |
| Separation agreements of former CEO and CFO | | | 204 | | | 658 | |
| Workforce reductions | | | 61 | | | — | |
| Reserve adjustments | | | (132 | ) | | (250) | |
| Impairment charges, including recovery on assets held for sale | | | — | | | 408 | |
| | |
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| |
|
| |
| Total | | $ | 833 | | $ | 703 | |
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| |
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| |
During the three months ended January 31, 2004, we incurred $0.5 million of costs to exit our disposable calling card business. Remaining fiscal second quarter 2004 charges incurred include $0.2 million in impaired lease costs and $0.2 million in executive separation charges, which are partially offset by $0.1 million in net reversals of employee severance costs.
For the three months ended January 31, 2003, we incurred restructuring, severance, impairment and other charges of $0.7 million. These included the following: $0.4 million relating to a lease termination of one our New Jersey locations; $0.4 million for the write-off of capitalized software relating to the de-emphasis of our carrier services business; and $0.1 million in severance for a former employee of Net2Phone. As an offset to these items, we recorded a favorable mark-to-market adjustment of $0.6 million relating to the proceeds owed to former shareholders of an operation we purchased in fiscal 2000 and discontinued during fiscal 2001.
Non-cash compensation (attributable to selling, general and administrative). Non-cash compensation decreased 18.5% from $2.7 million for the three months ended January 31, 2003 to $2.2 million for the three months ended January 31, 2004 primarily due to a $1.3 million charge taken during the three months ended January 31, 2003, relating to the discount
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amortization of ADIR shares sold to Net2Phone and ADIR employees in fiscal 2001, which has been eliminated through the winding down of our ADIR subsidiary. The $3.8 million of ADIR unamortized deferred compensation, which remained at the close of fiscal 2003, was written off as a component of other income, net during the first quarter of fiscal 2004 as a result of the termination of all ADIR employees. See ADIR Technologies, Inc. (note 11.) This decrease was partially offset by a greater increase in our stock price at January 31, 2004, as compared with the change in our stock price during the same period end last year. 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, those repriced options that are vested and unexercised, must be marked-to-market each quarter. For the three months ended January 31, 2004 and 2003, we recorded a charge of $1.9 million and $1.0 million, respectively, of compensation expense related to these repriced options. If our stock price increases, we will continue to incur charges over the vesting period with respect to repriced options until those options are exercised. As a percentage of total revenue, Non-cash compensation costs decreased from 11.7% for the three months ended January 31, 2003 to 10.9% for the three months ended January 31, 2004 primarily due to the impact of the aforementioned fiscal second quarter ADIR charge.
Non-cash services. Expense related to the receipt of services to be paid for through the issuance of Class A shares of $2.3 million were recorded during fiscal second quarter 2004. This expense was recorded for the first time based on a binding memorandum of understanding executed on October 29, 2003 with IDT, whereby, in exchange for attractive pricing on local and inter-exchange network access, termination, origination and other related services, as compared to third party vendors, access to IDT’s facilities and other benefits, we have agreed to issue 6.9 million shares of our Class A Stock to IDT at the time we enter into a definitive agreement, with vesting retroactive to October 29, 2003. This charge represents the market value of 0.4 million Class A shares, which were accrued during the second quarter ended January 31, 2004. It is anticipated that these shares will be issued upon execution of a definitive agreement and subsequently released from escrow on October 29, 2004. Until such release, these shares and others subsequently accrued will be marked to market as required by variable accounting rules. See Related Party Transactions (note 5).
Income (loss) from operations. Loss from operations was $10.0 million for the three months ended January 31, 2003 as compared to $10.9 million for the three months ended January 31, 2004. This increase is primarily due to new non-cash services expense incurred for the first time during the three months ended January 31, 2004 and to an inventory obsolescence charge taken this quarter, net of cost savings realized in remaining direct and selling, general and administrative expenses.
Interest income, net. Interest income consists primarily of interest earned on cash and cash equivalents, which is partially offset by interest expense incurred on long-term obligations. Interest income increased 16.7% from $0.6 million for the three months ended January 31, 2003 to $0.7 million for the three months ended January 31, 2004. This increase is primarily a result of higher cash balances generated by the issuance of 14 million common shares on November 25, 2003.
Other income, net. Other income includes the losses or gains resulting from non-operating transactions. Other income increased from a nominal loss recorded during the three months ended January 31, 2003 to $0.7 million of income recorded for the three months ended January 31, 2004. This increase is primarily attributable to a $0.5 million recovery of a customer receivable and to a lesser extent a mark-to-market credit on Net2Phone shares held by Deutsche Bank, which serve to reduce our overall debt obligation to Deutsche Bank.
Liquidity and Capital Resources |
Historically, we have satisfied our cash requirements through a combination of cash flow from operating activities, leases, and sales of equity securities. For the most part our cash requirements have been satisfied through our existing cash, cash equivalents and marketable securities balances.
The following table provides our cash flow data for the six months ended January 31, 2004 and 2003.
| | | Six Months Ended January 31,
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| | | 2004 | | 2003 | |
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| | | (in thousands) | |
| Net cash (used in) provided by operating activities | | $ | (13,089 | ) | $ | 6,400 | |
| Net cash used in investing activities | | | (35,914 | ) | | (4,771 | ) |
| Net cash provided by (used in) financing activities | | | 59,741 | | | (601 | ) |
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| Net increase in cash and cash equivalents | | $ | 10,738 | | $ | 1,028 | |
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As of January 31, 2004, we had total cash, cash equivalents, restricted cash, and marketable securities of $138.8 million and working capital of $107.4 million. Of the $138.8 million, $0.6 million in short term restricted cash and $25.2 million in long term restricted cash, cash equivalents, and marketable securities, was held as collateral for various letter of credit obligations, the majority of which related to our purchase of Aplio, S.A. from the stockholders of Aplio. On May 7, 2003, these obligations were assigned to Deutsche Bank AG London. Our payment obligations to Deutsche Bank are secured by standby letters of credit from a U.S. commercial bank, which are, in turn, collateralized by a $21.8 million money market account held by the bank. The letters of credit expire on August 4, 2006. Those restricted funds are classified as restricted cash, cash equivalents and marketable securities-long term on our balance sheet. Net cash provided by operating activities was $6.4 million during the six months ended January 31, 2003, compared with $13.1 million used in operating activities during the six months ended January 31, 2004. The decrease in cash flow provided by operating activities is primarily due to the receipt of $19.5 million in the first quarter of fiscal 2003 from the settlement of litigation with Cisco Systems. This decrease was partially offset by significantly reduced operating costs, and favorable changes in working capital as a result of the timing of receipts and disbursements.
Net cash used in investing activities was $4.8 million during the six months ended January 31, 2003, as compared to net cash used in investing activities of $35.9 million for the six months ended January 31, 2004. This increase in cash used in investing activities is primarily due to more cash being available subsequent to our issuance of 14 million common shares during the second quarter of fiscal 2004. Our capital expenditures decreased from $3.4 million for the six months ended January 31, 2003 to $2.9 million for the six months ended January 31, 2004 as Net2Phone Global Services has completed the majority of its expansion of our domestic and international network infrastructure. We anticipate that capital expenditures will significantly increase as Net2Phone Cable Telephony acquires fixed assets to build its infrastructure and deploy equipment related to contract obligations entered into with cable operators.
Net cash provided by (used in) financing activities increased from $(0.6) million for the six months ended January 31, 2003 to $59.7 million for the six months ended January 31, 2004. This change is due primarily to $58.7 million in net proceeds from the issuance of shares through an underwritten common stock offering at $4.50 per share on November 25, 2003. 10.5 million shares were issued to the public, an additional 1.0 million shares were issued as part of an over allotment option exercised by the underwriters, and an aggregate of 2.5 million shares were purchased by IDT Corporation and Liberty Media Corporation, our controlling shareholders. We intend to use the net proceeds from the common share issuance for general corporate purposes, capital expenditures, and working capital, including funding our Net2Phone Cable Telephony business. To a lesser extent, the increase in cash provided by financing activities during the six months ended January 31, 2004 was due to $5.3 million in proceeds generated by stock option exercises. We do not maintain an interest in any off balance sheet financing vehicles.
We believe that, based upon our present business plans, 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 in the foreseeable future. We believe that as the expected growth in our Net2Phone Cable Telephony subsidiary accelerates or if we acquire the business or assets of another company, we may 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 anticipated expansion, 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 as of January 31, 2004.
Contractual Obligations | | Payments Due by Period
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| | | Total | | Less than 1 year | | 1-3 years | | 4-5 years | | After 5 years | |
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| Capital lease obligations | | $ | 821 | | $ | 821 | | $ | — | | $ | — | | $ | — | |
| Operating leases | | | 14,430 | | | 3,055 | | | 7,729 | | | 3,216 | | | 430 | |
| Other long term obligations | | | 15,508 | | | — | | | 15,508 | | | — | | | — | |
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| Total contractual obligations | | $ | 30,759 | | $ | 3,876 | | $ | 23,237 | | $ | 3,216 | | $ | 430 | |
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Other Commercial Commitments | | Payments Due by Period
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| | | Total | | Less than 1 year | | 1-3 years | | 4-5 years | | After 5 years | |
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| | | (in thousands) | |
| Standby letters of credit | | $ | 23,003 | | $ | 370 | | $ | 22,161 | | $ | 162 | | $ | 310 | |
| Guarantees | | | — | | | — | | | — | | | — | | | — | |
| Purchase commitments | | | 560 | | | 560 | | | | | | | | | | |
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| | | $ | 23,563 | | $ | 930 | | $ | 22,161 | | $ | 162 | | $ | 310 | |
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Other long term obligations include a $15.5 million debt obligation to Deutsche Bank which matures in 2006.
Related Party Transactions |
We continue to maintain significant business relationships with IDT Corporation and its affiliates (“IDT”), and IDT maintains a controlling ownership interest in us. In the three and six months ended January 31, 2004, we provided carrier services to IDT of $1.3 million and $2.6 million, respectively. In the three months and six months ended January 31, 2004, we purchased wholesale carrier services from IDT of $0.9 million and $1.9 million, respectively. In the three and six months ended January 31, 2003, we provided carrier services to IDT of $1.7 million and $2.8 million, respectively, and purchased wholesale carrier services from IDT of $2.8 million and $5.9 million, respectively.
During the second quarter of fiscal 2004, we executed an agreement with Union Telecard Alliance, LLC (“UTA”), a subsidiary of IDT, which ended UTA’s distribution of Net2Phone disposable calling cards effective December 31, 2003, and provided for an orderly wind-down over a two-year period of our disposable calling card business. This resulted in exit costs of $0.5 million to compensate UTA for estimated obligations associated with the Net2Phone disposable calling cards currently in the marketplace. These exit costs were recorded in restructuring, severance, impairment and other items during the three months ended January 31, 2004. Pursuant to the terms of our agreement with UTA, the parties will settle the aforementioned obligations over a two-year period ending December 31, 2005, through monthly reconciliations of on-going wind down activities, with final settlement to be completed by February 15, 2006. Consequently, we recorded nominal sales of disposable calling cards to IDT affiliates for the three and six months ended January 31, 2004. In the three and six months ended January 31, 2003, we sold disposable calling cards to IDT affiliates totaling $1.4 million and $3.5 million, respectively.
Our corporate headquarters and several other facilities are leased from IDT. In the three and six months ended January 31, 2004, we paid IDT $0.5 million and $1.0 million, respectively in facilities lease payments. In the three and six months ended January 31, 2003, we paid IDT $0.6 million and $1.2 million, respectively, in facilities lease payments.
On occasion, we have aggregated long distance minutes and other services purchases with IDT.
We outsource some of our administrative functions to IDT when we believe IDT can provide resources more efficiently and cost effectively than we could obtain from third party vendors or could do ourselves. These administrative functions include, but are not limited to, tax consulting services, payroll services and internal audit support services. IDT’s treasury function provides investment management services relating to our portfolio of marketable securities. During the fiscal second quarter of 2004, $11.5 million in securities were settled through IDT. On occasion, we provide services to IDT, based on the need for such services. Fees for services are negotiated on a cost recovery basis. During the three and six months ended January 31, 2004 we made payments totaling $0.08 million and $0.1 million, respectively, for such services. During the six months ended January 31, 2003, we made payments totaling $0.05 million for such services. No payments were made for these services during the three months ended January 31, 2003, as contract billing rates were in the process of being renegotiated at that time.
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The due from (to) IDT balances represent net amounts due from (to) IDT to (by) us principally for wholesale carrier services, sales of disposable cards, and facilities lease payments. At January 31, 2004 and July 31, 2003 we owed IDT $0.8 million and $1.1 million, respectively. The average balance we owed to IDT during the three and six months ended January 31, 2004 was $0.6 million and $0.5 million, respectively, compared with averages of $2.6 million and $1.2 million, respectively that was owed to IDT for the three and six months ended January 31, 2003.
During the three and six months ended January 31, 2004, IDT reimbursed Net2Phone Cable Telephony for project support services totaling $0.05 million and $0.1 million, respectively, while, in turn, incurring $0.04 million and $0.08 million, respectively, in carrier service charges from IDT relating to our cable telephony service offering for Liberty Cablevision of Puerto Rico. During the quarter ended January 31, 2004 Net2Phone Cable Telephony initiated nominal billing to IDT’s United Kingdom Global Limited subsidiary. No similar services were provided during the three and six months ended January 31, 2003.
On October 29, 2003, we entered into a binding memorandum of understanding (“MOU”) with IDT, which requires us to issue 6.9 million shares of Class A stock to IDT at the time the parties execute definitive telecommunications services and related agreements with IDT. Once issued, the shares will be held in escrow to secure IDT’s performance obligations under the telecommunications services agreement and will be released to IDT in equal annual installments over five years, with the first release scheduled for October 29, 2004. During the second quarter of fiscal 2004, IDT provided telecommunication services to us under the terms of the MOU. The shares are subject to variable accounting treatment and, therefore, must be marked-to-market each quarter. Consequently, we recorded a charge of $2.3 million to non-cash services related to this agreement during the three and six months ended January 31, 2004, which represents the fair value of the 0.4 million shares that IDT earned during the three months ended January 31, 2004. In accordance with EITF Topic D-90, Grantor Balance Sheet Presentation of Unvested, Forfeitable Equity Instruments Granted to a Nonemployee, the 0.4 million shares have been included in the total number of Class A stock shares reported as issued and outstanding as of January 31, 2004 in our condensed consolidated financial statements, although such shares have not yet been issued to IDT. No definitive agreement has been executed as of January 31, 2004. The parties’ efforts to establish detailed terms and conditions continue. We continue to anticipate that a definitive agreement will be executed.
The MOU memorializes IDT’s agreement to provide Net2Phone Cable Telephony, directly or through its subsidiaries, with local and inter-exchange network access, termination, origination and other related services, drawing on its resources as a licensed local, long distance and international telecommunications provider. IDT is a competitive local exchange carrier and an inter-exchange carrier and its network includes switching facilities in many U.S. cities and additional points of presence in various countries, allowing us to co-locate our equipment and interconnect to IDT’s network at those points. We believe that this agreement through the provision of carrier services, sales and marketing assistance and an agreement by IDT not to compete in the cable telephony market enables us to improve the time-to-market, stability, scalability and security of our cable telephony services and allows us to more quickly attract and add customers. IDT provides Net2Phone Cable Telephony with these services at its incremental cost plus a five percent margin, which we believe is more favorable than what we would be able to receive from third parties. In exchange for such attractive pricing, access to IDT’s facilities and other benefits, we have agreed to issue 6.9 million shares of our Class A stock to IDT at the time we enter into the definitive agreement, with vesting retroactive to October 29, 2003.
Pursuant to an employment agreement with our then General Counsel dated January 8, 2001, we guaranteed that the value (as defined in the agreement) of 150,000 options to purchase our common stock held by our General Counsel would be at least $1.6 million on January 7, 2004. To the extent the value of such options was less than $1.6 million, we would pay our then General Counsel the difference in cash. On January 7, 2004, the value of the 150,000 options was $0.7 million. As required by the agreement, we paid $0.9 million to our then General Counsel at that time. We had amortized the $1.6 million guaranteed option value over the three-year term of the agreement, less the intrinsic value of the stock options as of each closing date. Consequently, we reduced non-cash compensation by $0.2 million for the three and six months ended January 31, 2004, and we recorded non-cash compensation expense of $0.1 million and $0.3 million for the three and six months ended January 31, 2003, respectively, related to this agreement.
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Due to relatively low levels of inflation over the last several years, inflation has not had a material effect on our results of operations.
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 materially 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-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this Quarterly Report. Based on such evaluation, such officers have concluded that, as of such date, our disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to Net2Phone (and its consolidated subsidiaries) required to be included in our reports filed or submitted under the Exchange Act.
Changes in Internal Control over Financial Reporting. There were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II—OTHER INFORMATION
Item 1. Legal Proceedings |
On February 15, 2000, Multi-Tech Systems, Inc. (“Multi-Tech”), filed suit against Net2Phone and other companies in the United States Federal District Court in Minneapolis, Minnesota. Multi-Tech alleged “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 the suit in a way 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. On November 19, 2002, Multi-Tech filed an appeal with the United States Court of Appeals for the Federal Circuit. On February 3, 2004, the Court of Appeals for the Federal Circuit affirmed the decision of the District Court in favor of Net2Phone. On February 16, 2004, Multi-Tech filed a Petition for a Rehearing of this decision with the Court of Appeals.
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 were 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
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arrangements existed. The suits against us are substantially the same as suits asserting the same allegations that have been filed against several hundred other companies that closed their initial public offerings at or about the same time that we did. The court to which the various cases have been assigned has extended the deadline for all defendants to respond to the complaints. We have been able to secure the voluntary dismissal of the claims against those executive officers and directors named in 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 matters could have a material adverse effect on our business operations, financial condition and results of operations.
Item 2. Changes in Securities and Use of Proceeds |
Item 3. Defaults Upon Senior Securities |
Item 4. Submission of Matters to a Vote of Security Holders |
We held our Annual Meeting of Stockholders on December 18, 2003. At this meeting, the stockholders voted in favor of the following items listed in the Proxy Statement dated November 21, 2003:
| | (1) | Election of Directors: |
| | | |
Nominee | | | For | | | Withheld | |
| |
|
| |
|
| |
| Howard S. Jonas | | | 80,506,659 | | | 3,796,467 | |
| Stephen M. Greenberg | | | 80,561,779 | | | 3,738,347 | |
| James R. Mellor | | | 82,170,483 | | | 2,132,643 | |
| Anthony G. Werner | | | 80,532,403 | | | 3,803,123 | |
| | | | | | | | |
| | | |
| | (2) | Approval of an amendment to the Net2Phone, Inc. 1999 Amended and Restated Stock Option and Incentive Plan to increase the number of shares reserved for issuance thereunder by 2,000,000 shares to an aggregate of 18,940,000 shares. |
| | | |
For | | | Against | | | Abstain | | | Non-Votes | |
| |
|
| |
|
| |
|
| |
| 61,212,154 | | | 6,318,009 | | | 1,852,855 | | | 14,920,108 | |
| | | |
| | (3) | Ratification of the selection of Ernst & Young, LLP as our independent auditors for the fiscal year ending July 31, 2004: |
| | | |
For | | | Against | | | Abstain | |
| |
|
| |
|
| |
| 83,984,042 | | | 279,881 | | | 39,203 | |
| |
Item 5. Other Information |
Item 6. Exhibits and Reports on Form 8-K |
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Exhibit No. | | Description | |
| |
| |
| 10.1 | | Memorandum of Understanding Re: Continuing Employment Agreement, effective January 8, 2004, between the Company and Bruce Shoulson. | |
| 10.2 | | Agreement, dated January 30, 2004, between the Company and Union Telecard Alliance, LLC. | |
| 31.1 | | Certification of the Chief Executive Officer, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
| 31.2 | | Certification of the Chief Financial Officer, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
| 32 | | 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. | |
We furnished a report on Form 8-K dated December 10, 2003 reporting under Item 12 our press release regarding our earnings for the quarter ended October 31, 2003.
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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.
| Date: March 16, 2004 | By: /s/ Stephen M. Greenberg
Stephen M. Greenberg
Chief Executive Officer |
| | |
| Date: March 16, 2004 | By: /s/ Arthur Dubroff
Arthur Dubroff
Chief Financial Officer |
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QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
TRANSITION REPORT PURSUANT TO SECTION 13 OR