SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1997
Commission File Number 000-29284
TELEGROUP, INC.
(Exact name of Registrant as specified in its charter)
Iowa 42-1344121
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2098 Nutmeg Avenue, Fairfield, Iowa 52556
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (515) 472-5000
Securities Registered Pursuant to Section 12(b) of the Act:
Title of Class Name of each exchange on which registered
-------------- -----------------------------------------
None Not Applicable
Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, no par value
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 such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [ x ] No [ ].
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K [ ].
The aggregate market value of the voting stock (which consists solely
of the shares of Common Stock) held by non-affiliates of the registrant as of
March 25, 1998, computed by reference to the closing sales price of the
registrant's Common Stock on the Nasdaq National Market on such date, was
approximately $8,756,546.
As of March 30, 1998, the registrant had 32,996,731 shares of Common
Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive Proxy Statement for the 1998
Annual Meeting of Shareholders are incorporated by reference into Part III
hereof, as specifically set forth in Part III.
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Telegroup, Inc.
1997 Annual Report on Form 10-K
Page
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Part I
Item 1. Business
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Submission of Matters to a Vote of Security Holders
Part II
Item 5. Market for the Registrant's Common Equity and
Related Shareholder Matters
Item 6. Selected Financial Data
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 8. Financial Statements and Supplementary Data
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosures
Part III
Item 10. Directors and Executive Officers of the Registrant
Item 11. Executive Compensation
Item 12. Security Ownership of Certain Beneficial Owners and Management
Item 13. Certain Relationships and Related Transactions
Part IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
Signatures
Exhibit Index
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NOTE ON FORWARD-LOOKING STATEMENTS
Certain statements contained in this Annual Report on Form 10-K (this
"Annual Report"), including, without limitation, statements containing the
words ''believes,'' ''anticipates,'' ''intends,'' ''expects'' and words of
similar import, constitute ''forward-looking statements.'' Such
forward-looking statements involve known and unknown risks, uncertainties and
other factors that may cause the actual results, performance or achievements
of Telegroup, Inc. ("Telegroup" or the "Company") or the global long distance
telecommunications industry to be materially different from any future
results, performance or achievements expressed or implied by such
forward-looking statements. Such factors include, among others, the following:
general economic and business conditions; prospects for the global long
distance telecommunications industry; competition; changes in business
strategy or development plans; the loss of key personnel; the availability of
capital and regulatory developments. Given these uncertainties, prospective
investors are cautioned not to place undue reliance on such forward-looking
statements. The Company disclaims any obligation to update any such factors or
to publicly announce the results of any revisions to any of the
forward-looking statements contained herein to reflect future events or
developments.
PART I
ITEM 1. BUSINESS
OVERVIEW
Telegroup is a rapidly growing global telecommunications company
providing high quality, competitively priced, international and domestic long
distance telecommunications services. The Company established an early
presence in key European, Asia-Pacific and Latin American markets in order to
capitalize on the market opportunity presented by full deregulation and the
telecommunications industry. The Company offers a broad range of
international, national, value-added wholesale and enhanced telecommunications
services to approximately 220,000 small and medium-sized business,
residential and wholesale customers (those that incurred charges in February
1998 and were invoiced) providing service to over 200 countries. Telegroup has
achieved its significant international market penetration by developing what
it believes to be one of the most comprehensive sales, marketing and customer
service organizations in the global telecommunications industry. The Company
operates a reliable, flexible, cost-effective, digital, facilities-based
network (the ''Telegroup Intelligent Global Network(R)'' or ''TIGN''). The
TIGN is one of the largest alternative global telecommunications networks and
consists of 21 Nortel DMS and Excel LNX switches, five enhanced services
platforms, 19,000 miles of owned and leased capacity on nine digital
fiber-optic cable links, leased parallel data capacity and the Company's
Network Operations Center in Iowa City, Iowa. Telegroup's revenues have
increased from $29.8 million in 1993 to $337.4 million in 1997. In 1993, the
Company had an operating loss of $0.5 million and a net loss of $0.7 million,
compared to an operating loss of $11.8 million and a net loss of $23.7 million
in 1997.
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The Company's goal is to become one of the largest global alternative
telecommunications providers in the world. Telegroup provides an extensive
range of telecommunications services on a global basis under the Telegroup(R)
Spectra, Telegroup Global Access(R) and other brand names. The Company's
services are typically priced competitively with the services of other
alternative telecommunications providers and below the prices offered by the
incumbent telecommunications operators ("ITOs"), which are often
government-owned or protected telephone companies. The Company began
operations in the United States and has since expanded its presence in key
North American, European, Asia-Pacific and Latin American countries in
anticipation of continued deregulation. While the Company offers a broad
range of telecommunications services, the services offered in a particular
market vary depending upon regulatory constraints and local market demands.
Telegroup historically has offered traditional callback services. As major
markets have deregulated, the Company has migrated its traffic to conventional
''call-through'' service. The Company markets its call-through services under
the brand names Telegroup Spectra and Telegroup Global Access Direct.
Currently, the Company offers both international and national long distance
service, prepaid and postpaid calling cards, toll-free service and enhanced
services such as fax store and forward, fax-mail, voice-mail and conference
calling. The Company believes its broad array of basic and enhanced services
enables the Company to offer a comprehensive bundled solution to meet its
customers' telecommunications needs. The Company believes that the small and
medium-sized business segment offers a significant market opportunity for the
Company because it has been traditionally underserved by the ITOs and is
likely to be receptive to a competitively priced bundled service offering. The
Company also resells switched minutes and enhanced service platforms on a
wholesale basis to other telecommunications providers and carriers. See
''--Services.''
Telegroup's extensive sales, marketing and customer service organization
consists of a worldwide network of independent agents and an internal sales
force who market Telegroup's services and provide customer service, typically
in local languages and in accordance with the cultural norms of the countries
and regions in which they operate. The Company's local sales, marketing and
customer service organization permits the Company to continually monitor
changes in each market and quickly modify service and sales strategies in
response to changes in particular markets. In addition, the Company believes
that it can leverage its global sales and marketing organization to quickly
and efficiently market new and innovative service offerings. The Company has
over 1,500 independent agents worldwide with twenty-three Country Coordinators
responsible for coordinating Telegroup's operations, including sales,
marketing, customer service and independent agent support in 79 countries. In
addition, the Company has 32 internal sales personnel in the United States and
overseas sales offices. The Company believes that its comprehensive global
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sales, marketing and customer service organization will enable the Company to
increase its market share and position itself as one of the leading
international long distance providers in three of the largest international
telecommunications markets in the world(France, the Netherlands and
Switzerland. See ''--Sales, Marketing and Customer Service.''
The Telegroup Intelligent Global Network( includes a central Network
Operations Center (''Network Operations Center'') in Iowa City, Iowa, as well
as switches, owned and leased transmission capacity and a proprietary
distributed intelligent network architecture. The TIGN is designed to allow
customer-specific information, such as credit limits, language selection,
waiting voice-mail and faxes, and speed dial numbers to be distributed
efficiently over a parallel data network wherever Telegroup has installed a
TIGN switch. In addition, the open, programmable architecture of the TIGN
allows the Company to rapidly deploy new features, improve service quality,
and reduce costs through least cost routing. As of December 31, 1997, the TIGN
consisted of (i) the Network Operations Center, (ii) 21 Nortel DMS and Excel
LNX switches in New York City, Jersey City, London, Paris, Amsterdam, Zurich,
Copenhagen, Frankfurt, Hong Kong, Sydney, Tokyo and Milan, (iii) five enhanced
services platforms in New York, Hong Kong, London, Paris and Sydney, (iv)
owned and leased fiber-optic cable links connecting its New York and New
Jersey switches to its switches in London, Amsterdam, Sydney, Auckland and
Tokyo, and its London switches to its switches in Paris, Amsterdam and
Copenhagen, and (v) leased parallel data transmission capacity connecting
Telegroup's switches to each other and to the networks of other international
and national carriers. The Company believes the further development of the
TIGN by upgrading existing facilities and by adding switches and transmission
capacity including ownership of fiber optic cable is critical to becoming a
high quality, lost-cost telecommunications provider. By owning or controlling
key elements of its network, the Company is better able to control service
offerings, quality and transmission and other operating costs. In addition,
the Company is developing plans to introduce ATM technology into its network.
On July 14, 1997, the Company completed the initial public offering (the
''IPO'') of 4,000,000 shares of Common Stock, no par value (the ''Common
Stock''), at a price of $10.00 per share. The net proceeds to the Company from
the sale of the 4,000,000 shares was approximately $35.6 million after
deducting expenses and underwriting discounts. In addition, on August 12,
1997, the Company completed the sale of an additional 450,000 shares of Common
Stock pursuant to the exercise of the underwriters' overallotment option,
yielding net proceeds to the Company of approximately $4.2 million after
deducting underwriting discounts.
On August 14, 1997, the Company acquired 60% of the common stock of, and
a controlling interest in, PCS Telecom, Inc. (''PCS Telecom'') for
approximately $1.3 million in cash and 40,000 shares of unregistered Common
Stock. PCS Telecom is a developer and manufacturer of state of the art,
feature-rich, calling card platforms used by Telegroup and numerous other
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companies. PCS Telecom, which currently has 22 employees, has installed its
products both in international and domestic markets. Telegroup has purchased
these platforms as part of its global strategy of providing enhanced services
for the TIGN, and considers this acquisition to be a strategic purchase which
is intended to ensure stability of supply of platforms to establish
expeditiously an international facilities network for enhanced services.
On September 5, 1997, the Company prepaid in full all of its outstanding
$20 million in aggregate principal amount of 12% Senior Subordinated Notes due
2003 (the ''Senior Subordinated Notes'') at a redemption price equal to 107%
of the principal amount thereof, plus accrued interest. The Company financed
the prepayment of the Senior Subordinated Notes with a portion of the net
proceeds from the IPO and $8.5 million of borrowings under a $15 million
revolving credit facility with First Chicago NBD, Inc. (the ''Revolving Credit
Facility''). The Revolving Credit Facility expired on October 31, 1997. The
Company currently anticipates entering into a new credit facility for
available borrowings in an amount not expected to exceed $20 million with a
bank or other financial institution (the ''New Credit Facility''). There can
be no assurance that the Company will enter into the New Credit Facility.
On September 30, 1997, the Company consummated a private placement of
$25 million aggregate principal amount of Convertible Notes. The Convertible
Notes are eligible for resale under Rule 144A of the Securities Act. The net
proceeds to the Company from the issuance of the Convertible Notes were
approximately $24.1 million and approximately $15.0 million of such net
proceeds were used to repay all amounts outstanding under the Revolving Credit
Facility. Unless redeemed by the Company previously, the Convertible Notes
are convertible into Common Stock of the Company at the conversion price of
$12 per share.
On October 23, 1997, the Company consummated a private placement of $97
million aggregate principal amount at maturity of 10 1/2% Senior Discount
Notes due 2004 (the "Senior Discount Notes"), receiving gross proceeds of
approximately $72.1 million. The Senior Discount Notes were issued pursuant to
the terms of an indenture dated October 23, 1997 between the Company and State
Street Bank and Trust Company, as trustee. On March 4, 1998, all of the
privately placed Senior Discount Notes were exchanged for Senior Discount
Notes that are registered under the Securities Act.
On November 25, 1997, the Company acquired certain property and equipment
from Fastnet UK Limited (''Fastnet'') for approximately $240,000. Fastnet has
an agency agreement with the Company in which it coordinated retail sales and
provided customer service and other services to the Company's customers in the
United Kingdom. The Company intends to utilize the assets acquired to enhance
the operations of Telegroup UK Limited, a wholly-owned subsidiary of the
Company.
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In January 1998, the Company purchased the telephony portion of its
Country Coordinator in Japan, Kabushiki Kaisha Cosmo Kaihatsu, for cash in the
amount of approximately $450,000. Also, in January 1998, the Company acquired
the operations of its Australian and New Zealand Country Coordinators for
297,500 shares of the Company's Common Stock in an unregistered sale and
$150,000 in cash.
The Company announced on January 28, 1998, that it proposes to make a
tender offer for all of the shares of Newsnet ITN LTD. (''Newsnet'') at a
price of $0.60 per share. Prior to the announcement, the Company had acquired
2.35 million shares of Newsnet ordinary shares (representing approximately
9.9% of Newsnet's issued capital). The Company is also currently in
discussions with other Pacific Rim based telecommunications firms regarding
possible acquisition or strategic combination opportunities.
On February 27, 1998, the Company acquired 60% of the stock of RediCall
Pty Limited, an Australian company engaged in the wholesale distribution of
pre-paid telephone call cards. The Company paid $504,375 in cash and 6,677
shares of the Company's common stock.
CUSTOMERS
Telegroup's worldwide retail customer base is comprised of residential
customers and small to medium-sized businesses with monthly bills from $10 and
$5,000. Telegroup had approximately 211,000 active retail customers (those
that incurred charges in December 1997 and were invoiced), consisting of
approximately 54,000 U.S. domestic and approximately 157,000 international
customers. In addition, Telegroup markets its wholesale services to both
facilities-based carriers and switched-based long distance providers that
purchase the Company's service for resale to their own customers. As of March
15, 1998, Telegroup had 40 active domestic and international wholesale carrier
customers.
The following chart sets forth the Company's combined retail and
wholesale revenues for the year ended December 31, 1997 for each of the
Company's ten largest markets, determined by customers' billing addresses:
Year Ended
December 31, Percentage of
Country 1997 Revenues Revenues
------- -------- -------------
(millions)
United States $124.2 36.8%
Hong Kong 54.6 16.2
Netherlands 21.5 6.4
Australia 15.3 4.5
France 13.9 4.1
Switzerland 12.7 3.8
Germany 11.4 3.4
Sweden 8.7 2.6
Japan 7.0 2.1
Denmark 5.9 1.7
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For the year ended December 31, 1997, the Company's revenues from retail
and wholesale customers represented 67% and 33%, respectively, of the
Company's total revenues. This compared with 84% and 16%, respectively, for
the year ended December 31, 1996.
RETAIL CUSTOMERS. The Company's retail customer base is diversified
both geographically and by customer type. No single retail customer accounted
for more than 1% of the Company's total revenues for the years ended December
31, 1996 and 1997. The Company's sales and marketing efforts target
high-volume residential consumers and small and medium-sized businesses. The
Company believes that high-volume residential consumers are attracted to
Telegroup's services because of its significant price savings as compared to
first-tier carriers, its simplified price structure and its variety of service
offerings. The Company believes that small and medium-sized businesses are
attracted to Telegroup's services because of significant price savings
compared to first-tier carriers, and because of its personalized approach to
customer service and support, including its local presence, customized billing
and enhanced service offerings.
WHOLESALE CUSTOMERS. Telegroup's wholesale marketing targets second-
and third-tier international and telecommunications providers. The Company
currently provides wholesale services to a total of 40 customers of which 31
are U.S.-based providers, one is in Canada, and eight are international
providers. The Company believes that long distance services, when sold to
telecommunications carriers and other resellers, are generally a commodity
product with the purchase decision based primarily on price. Sales to these
other carriers and resellers help the Company maximize the use of its network
and thereby minimize fixed costs per minute of use.
China resumed sovereignty over Hong Kong as of July 1, 1997. For the
year ended December 31, 1997, one wholesale customer in Hong Kong accounted
for approximately 13% of the Company's total revenues (the "Hong Kong
Customer"). Substantially all of the services provided by the Company to this
customer consist of carrier-level, value-added call-reorigination services.
The initial term of the Company's agreement with the Hong Kong Customer
expires in October 1998, automatically renews for one year periods, and may be
terminated by the Hong Kong Customer if it determines in good faith that the
services provided pursuant to the agreement are no longer commercially viable
in Hong Kong. The Company recently renewed its Public Non-Exclusive
Telecommunications Services (''PNETS'') license which permits the provision of
personal identification number validation and call routing service and
facsimile communication service. In general, the PNETS has been interpreted
to permit the provision of call-reorigination services and/or if it is unable
to provide call-reorigination services in Hong Kong on either a retail or
wholesale basis. If the Company loses the license in the future, such action
could have a material adverse effect on the Company's business, financial
condition and results of operations. Similarly, a material reduction in the
level of services provided by the Company to the Hong Kong Customer or a
termination of the Company's agreement with the Hong Kong Customer could have
a material adverse effect on the Company's business, financial condition and
results of operations.
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Hong Kong Telecommunications International Limited ("HKTI") currently
holds an exclusive license until September 30, 2006 to provide a variety of
international services including the right to operate an international gateway
for the handling of all outgoing and incoming international calls. However,
the Hong Kong government has agreed to compensate HKTI in exchange for the
early termination of HKTI's exclusive license on January 1, 1999 to operate an
international gateway and on January 1, 2000 to provide international
circuits. The Hong Kong government intends to invite existing FTNS providers
to amend their licenses to permit the provision of international services and
facilities, and to establish a new license for other entities to provide
international services. The change in regulations may have a material adverse
impact on the carrier-level call-reorigination service provided by the
Company. However, the deregulation will enable the Company to provide a wide
range of international wholesale, retail and value-added telecommunications
services to new and existing customers in Hong Kong. The Company is currently
applying or intends to apply for the necessary licenses to continue operations
under the new regulations.
SALES, MARKETING AND CUSTOMER SERVICE
Telegroup's global sales, marketing and customer service organization
consists of Country Coordinators, independent agents and an internal sales
force who market Telegroup's services and provide customer service in local
languages and in accordance with the cultural norms of the countries in which
they operate. The Company's local sales, marketing and customer service
organization allows the Company to continually monitor changes in each market
and quickly modify service and sales procedures in response to market changes.
Since its inception, Telegroup's sales, marketing and customer service
strategy has been based on providing its network of agents and salespeople
with the systems, technology and infrastructure to attract and support
customers as efficiently as possible.
GLOBAL INDEPENDENT AGENT NETWORK. Telegroup's international market
penetration has resulted primarily from the sales activities of independent
agents compensated on a commission-only basis. As of March 15, 1998, Telegroup
had over 1,500 independent agents located worldwide. The use of independent
agents has allowed the Company to limit marketing expenses and customer
acquisition costs.
The Company's agreements with its independent agents typically provide
for a two-year term and require the agents to offer the Company's services at
rates prescribed by the Company and to abide by the Company's marketing and
sales policies and rules. Independent agent compensation is paid directly by
the Company and is based exclusively upon payment for the Company's services
by customers obtained for Telegroup by the independent agents. The commission
paid to independent agents ranges between five to twelve percent of revenues
received by the Company and varies depending on individual contracts, the
exclusivity of the agent and the type of service sold. Independent agents are
responsible for up to 40% of bad debt attributable to customers they enroll.
The Company's agreements with its independent agents typically provide that
the agents have no authority to bind Telegroup or to enter into any contract
on the Company's behalf.
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COUNTRY COORDINATORS. In significant international markets, Telegroup
appoints Country Coordinators. Country Coordinators are typically
self-financed, independent agents, with contracts that bind them exclusively
to Telegroup. Country Coordinators also have additional duties beyond
marketing Telegroup services, including the responsibility in a country or
region to coordinate the activities of Telegroup independent agents, including
training and recruitment, customer service and collections. Currently,
Telegroup has 23 Country Coordinators who are responsible for sales,
marketing, customer service and collections in 79 countries. Telegroup has
begun to vertically integrate its sales, marketing and customer service
operations by opening offices in Germany and the U.K. which provide the
services of a Country Coordinator and acquired the business operations of its
Country Coordinators in France, Japan, New Zealand and Australia.
Country Coordinators offer the Company's services at rates prescribed by
the Company, and enforce standards for all advertising, promotional, and
customer training materials relating to Telegroup's services that are used or
distributed in the applicable country or region. Country Coordinators review
all proposed marketing or advertising material submitted to them by the
independent agents operating in their country or region and ensure such
agents' compliance with the Company's standards and policies. The Company's
agreements with its independent Country Coordinators typically have a two-year
term and include an exclusivity provision restricting the Country
Coordinator's ability to offer competing telecommunication services. Such
agreements typically entitle the Country Coordinator to an override based on a
percentage of revenues collected by Telegroup from customers within the
Country Coordinator's country or region, as well as a commission similar to
the commission paid to independent agents with respect to customers obtained
directly by the Country Coordinator. The Company's agreements with its Country
Coordinators typically provide that the agents have no right to enter into any
contract on Telegroup's behalf or to bind Telegroup in any manner not
expressly authorized in writing.
INTERNAL SALES. In early 1993, Telegroup began the development of an
internal sales force which, as of March 15, 1998, numbered 39 persons,
including 32 in the U.S., three in Australia, and one each in New Zealand,
Japan, Germany, and Brazil. The internal sales department, which is fully
dedicated to marketing Telegroup's services, provides increased control over
existing customers and enables the Company to quickly test new products and
implement special marketing campaigns. For the year ended December 31, 1997,
Telegroup's internal sales department was responsible for generating 100% of
the Company's wholesale revenue and approximately 27.4% of the Company's
revenues from U.S. retail customers, with the balance being generated by
independent agents in the U.S. Internal sales representatives are compensated
by means of a base salary and a commission which varies depending upon the
type of services sold.
THE INTERNET. In March 1995, Telegroup implemented an aggressive
program to use the World Wide Web as a marketing, order entry, and information
distribution tool. The Company currently processes approximately 90% of orders
submitted by its independent agents through its Web-based RepLink order entry
system. RepLink allows for customer provisioning in approximately 30 minutes
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and provides agents with real-time access to customer information. In
addition, the Company's World Wide Web site provides a central source of
information about Telegroup, easily accessible to Telegroup's agents and
prospective customers around the world. The Company is currently developing a
customer service interface called CustomerLink to provide information and
services such as invoices, call-back requests, and maintenance of speed dial
lists over the Internet.
CUSTOMER SERVICE. Telegroup is committed to providing its customers
with high-quality customer service, provided in the local language and in
accordance with local cultural norms. As of December 31, 1997, Telegroup
directly provided customer service to customers in 108 countries, 24 hours a
day, 365 days a year, from its headquarters in Fairfield, Iowa. In addition,
Telegroup currently has seven Telegroup-owned offices and 23 Country
Coordinators, each of whom maintains a customer service office. These offices
provide customer support to Telegroup's customers in 79 countries.
Customer service offices are equipped with Telegroup customer service and
sales support systems for use in the country or region. Customer service
representatives can access the Company's RepLink order entry system and
Integrated Databases ("IDB"), a customer information database. These systems
facilitate and expedite customer provisioning and changes to customer account
information. In addition, selected customer service offices are connected to
Telegroup's Fairfield, Iowa headquarters by high-speed frame relay data links
which provide real-time access to the Company's central databases.
SERVICES
Telegroup offers a broad array of telecommunications services through the
TIGN and through interconnections with the networks of other carriers. While
the Company offers a broad range of telecommunications services in each of its
markets, the services offered in a particular market vary depending upon
regulatory constraints and local market demands. In order to create a global
brand identity, the Company markets its products primarily under the Telegroup
Spectra or Telegroup Global Access brands in virtually all of its markets. The
Company currently offers the following services:
INTERNATIONAL LONG DISTANCE. The Company provides international voice
services to its customers in over 200 countries. On a market-by-market basis,
access methods required to originate a call vary according to regulatory
requirements and the existing national telecommunications infrastructure. The
Company's call-reorigination services are available in all of its markets,
generally under the brand name Telegroup Global Access CallBack. Telegroup is
actively attracting new customers and completing the migration of existing
customers to its Telegroup Spectra or Telegroup Global Access Direct services,
which are currently available outside of the U.S. and Canada through TIGN
switches located in Germany, Switzerland, Italy, Australia, Japan, Denmark,
Hong Kong, France, the U.K. and the Netherlands. Telegroup Spectra and
Telegroup Global Access Direct provide Telegroup customers call-through
services, which include the provision of long distance service through
conventional international long distance or through a ''transparent'' form of
call-reorigination.
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NATIONAL LONG DISTANCE. The Company currently provides national long
distance service in the United States and Australia, Netherlands and New
Zealand. The Company also expects to provide national long distance service in
the U.K., Denmark, France, Switzerland, Germany and Sweden by the end of 1998.
PREPAID (DEBIT) AND POSTPAID CALLING CARDS. The Company's prepaid
(debit) and postpaid Telegroup Global Access Telecard may be used by customers
for international telephone calls from more than 46 countries to substantially
all other countries in the world. These calling cards also enable the
Company's customers to access Telegroup's enhanced services.
TOLL-FREE SERVICES. The Company currently provides domestic toll-free
services within the United States under its Spectra 800 brand, and toll-free
services for calls to overseas businesses which are originated in the United
States and Canada, under its Telegroup Global Access 800 brand.
ENHANCED SERVICES. Telegroup's enhanced services include fax store and
forward, fax-mail, voice-mail, and conference calling.
WHOLESALE SERVICES. In addition to retail services, the Company
provides international and national call termination services and enhanced
services on a wholesale basis to switch-based telecommunications carriers in
the United States, the Pacific Rim and Europe. Such wholesale arrangements
typically involve the purchase of transmission services on a per-minute basis,
with rates varying according to the destination country and the time of day
the call is placed.
Telegroup constantly evaluates potential new service offerings in order
to increase customer retention and loyalty, and increase usage of the
Company's services. New services the Company expects to introduce in selected
markets in 1998 include:
INTERNET ACCESS SERVICES. The Company intends to offer resold,
switched, and dedicated access to the Internet for use by commercial and
residential customers. These services may be offered on a direct connection to
the Internet or on a resale basis. Once connected to the Internet, customers
will be able to access services provided by others, such as World Wide Web
browsing, electronic mail, news feeds and bulletin boards.
RESOLD LOCAL SWITCHED AND SWITCHLESS SERVICE. The Company intends to
provide local service on a resale basis in the United States, subject to
commercial feasibility and regulatory limitations.
MOBILE RESALE. The Company intends to offer its customers resold mobile
telecommunications services in the United States and other selected markets.
INTEGRATED VOICE-MAIL, E-MAIL AND FAX-MAIL. Integrated services enable
customers to convert e-mail and facsimile data to audio text and to receive
voice-mail messages in writing. The Company intends to offer its customers
integrated voice-mail, e-mail and fax-mail through the TIGN in all countries
where the Company's international telecommunications services are available.
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There can be no assurance that the Company will be able to launch such
services or that, if launched, such services will be successful.
THE INTRODUCTION OF BLENDED SERVICES
As the Company continues the buildout of IRU and IPL trunking facilities
on and the upgrade of the TIGN backbone network, the Company is developing
plans to establish a global ATM-based network. ATM protocol is a
connection-oriented, cell-relay, data transfer standard that could define
future broadbank networks. ATM is a cross between packet switching and
circuit switching technologies. Circuit switching technology is used to
connect end-users as though there were a single wire connected end to end for
the entire duration of a call. Packet switching technology uses computer
protocols to break data into discrete packets. Each packet has an address
attached to it that is used to route the packet through the network. Packets
can take different routes to get to their destinations where they are
reassembled. Packets can be interspersed through each line as a sort of
multiplexing. Delays and missing data packets can severely deteriorate the
voice quality of packet switching. Through the utilization of a global
ATM-based network which is capable of providing blended services on a common
network, the Company believes that it would be able to greatly reduce network
facilities costs, reduce network management costs, and provide a new family of
enhanced services and products. The following are new services and products
which the Company will be able to offer upon implementation of the new
network:
IP VOICE TELEPHONY. The Company will be able to offer new, low-cost
voice products by transmitting digitized and compressed voice as Internet
Protocol (IP) packets over the Company's ATM-based network. ATM will allow
the Company to manage for high quality voice conversation. The new IP voice
services will address the retail market's demand for greater price reductions
and the business market's demand for high quality on-net / off-net voice
delivery with significant price reductions by combining their corporate voice
and data traffic.
FAX OVER DATA NETWORKS. Even with growth in corporate email, faxing is
still growing in importance. More companies will want to migrate fax to data
networks than voice. Telegroup will be able to provide real-time fax,
store-and-forward fax, and broadcast fax using Internet Protocol (IP) over the
Company's ATM-based network.
VIDEO. The Company will be able to offer video conferencing services and
video delivery services for intra-company and inter-company applications.
DATA SERVICES. Corporate data traffic is growing faster than corporate
voice traffic. Over the Company's ATM-based network, Telegroup will be able
to offer managed data network services to support corporate customers' data
needs for vertical applications for industries such as manufacturing, finance,
government, education, and medicine.
14
INTERNET SERVICE PROVIDER. An ATM-based network will allow the Company
to build a faster, more reliable, and more profitable Internet access product
which is scaleable, reliable, and delivers high performance with quality of
service.
ENHANCED SERVICES. By integrating voice and data services over a common
ATM-based network, Telegroup will be able to offer new families of enhanced
premium voice and data services such as video-enhanced messaging services and
data-enhanced voice services.
COMPUTER TELEPHONY INTEGRATION (CTI) PRODUCTS. The Company will be able
to offer a wide variety of newly emerging CTI products for home, small office,
and corporate business applications.
INTEGRATED MANAGED NETWORKS. The corporate trend is towards outsourced,
managed networks capable of supplying general corporate voice and data
services and of supporting specific IP-based vertical market applications. A
major service requirement for international businesses is for carriers to
provide a global solution with local customization. Because of regulatory
differences and country-specific technology differences, such as signaling and
transmission, corporations are looking to their service providers to manage
these differences and make them transparent to the users and applications. The
Company will be able to satisfy these emerging corporate requirements by
offering value-added services such as Internet, Intranets, Extranets, Virtual
Private Networks (VPN), messaging, on-net/off-net faxing, voice-on-net
traffic, multimedia, video conferencing, and managed data network services
supported by Service Level Agreements to companies of all sizes doing
international business.
The implementation of the Company's strategy to develop an ATM-based
network is dependent on, among other things, the ability of the Company to
obtain additional financing. The Company may seek to raise such additional
capital from public or private equity and/or debt sources. There can be no
assurance that the Company will be able to obtain the additional financings or
if obtained, that it will be able to do so on a timely basis or on terms
favorable to the Company.
YEAR 2000 COMPLIANCE
While the Company believes that its software applications are year 2000
compliant, there can be no assurance until the year 2000 occurs that all
systems will then function adequately. All software systems which the Company
purchases are required to be year 2000 compliant. In addition, the Company is
building year 2000 compliancy test suites to test for year 2000 compliancy
end-to-end across all systems. The Company does not believe that either the
risks or the costs incurred to be year 2000 compliant are material. Further,
if the software applications of local exchange carriers, long distance
carriers or others on whose services the Company depends are not year 2000
compliant, the non-compliance of those applications could have a material
adverse effect on the Company's financial condition and results of operations.
15
COMPETITION
The international and national telecommunications industry, estimated to
reach $1 trillion in 1998, is highly competitive. The Company's success
depends upon its ability to compete with a variety of other telecommunications
providers in each of its markets, including the respective ITO in each country
in which the Company operates and global alliances among some of the world's
largest telecommunications carriers. Other potential competitors include cable
television companies, wireless telephone companies, Internet access providers,
electric and other utilities with rights of way, railways, microwave carriers
and large end users which have private networks. The intensity of such
competition has recently increased and the Company believes that such
competition will continue to intensify as the number of new entrants
increases. If the Company's competitors devote significant additional
resources to the provision of international or national long distance
telecommunications services to the Company's target customer base of
high-volume residential consumers and small and medium-sized businesses, such
action could have a material adverse effect on the Company's business,
financial condition and results of operations, and there can be no assurance
that the Company will be able to compete successfully against such new or
existing competitors.
The Company's larger competitors currently include AT&T, MCI, Sprint,
WorldCom, Frontier and LCI in the United States; France Telecom in France; PTT
Telecom B.V. in the Netherlands; Cable & Wireless Communications, BT, AT&T,
WorldCom, Sprint and ACC Corp. in the United Kingdom; Deutsche Telecom in
Germany; Swisscom in Switzerland; Telia AB and Tele-2 in Sweden; HKTI in Hong
Kong, Telstra and Optus in Australia; and KDD, IDC and Japan Telecom in Japan.
The Company competes with numerous other long distance providers, some of
which focus their efforts on the same customers targeted by the Company. In
addition to these competitors, recent and pending deregulation in various
countries may encourage new entrants. For example, as a result of the 1996
Telecommunication Act in the United States, once certain conditions are met,
Regional Bell Operating Companies ("RBOCs") will be allowed to enter the
domestic long distance market in their exchange territories, AT&T, MCI and
other long distance carriers will be allowed to enter the local telephone
services market, and any other entity (including cable television companies
and utilities) will be allowed to enter both the local service and long
distance telecommunications markets. Moreover, while the recently completed
WTO Agreement could create opportunities for the Company to enter new foreign
markets, implementation of the accord by the United States could result in new
competition from ITOs previously limited as to the services they could provide
in the United States and/or the routes on which they could provide services.
Increased competition in the United States as a result of the foregoing, and
other competitive developments, including entry by Internet service providers
into the long-distance market, could have an adverse effect on the Company's
business, financial condition and results of operations. In addition, many
smaller carriers have emerged, most of which specialize in offering
international telephone services utilizing dial up access methods, some of
which have begun to build networks similar to the TIGN.
16
The long distance telecommunications industry is intensely competitive
and is significantly influenced by the pricing and marketing decisions of the
larger industry participants. In the United States, the industry has
relatively limited barriers to entry with numerous entities competing for the
same customers. Customers frequently change long distance providers in
response to the offering of lower rates or promotional incentives by
competitors. Generally, the Company's domestic customers can switch carriers
at any time. The Company believes that competition in all of its markets is
likely to increase and that competition in non-United States markets is likely
to become more similar to competition in the United States market over time as
such non-United States markets continue to experience deregulatory influences.
In each of the countries where the Company markets its services, the Company
competes primarily on the basis of price (particularly with respect to its
sales to other carriers), and also on the basis of customer service and its
ability to provide a variety of telecommunications products and services.
There can be no assurance that the Company will be able to compete
successfully in the future. The Company anticipates that deregulation and
increased competition will result in decreasing customer prices for
telecommunications services. The Company believes that the effects of such
decreases will be at least partially offset by increased telecommunications
usage and decreased costs as the percentage of its traffic transmitted over
the TIGN increases. There can be no assurance that this will be the case. To
the extent this is not the case, there could be an adverse effect on the
Company's margins and financial profits, and the Company's business, financial
condition and results of operations could be materially and adversely
effected.
The telecommunications industry is in a period of rapid technological
evolution, marked by the introduction of new product and service offerings and
increasing satellite transmission capacity for services similar to those
provided by the Company. Such technologies include satellite-based systems,
such as the proposed Iridium and GlobalStar systems, utilization of the
Internet for international voice and data communications and digital wireless
communication systems such as PCS. The Company is unable to predict which of
many possible future product and service offerings will be important to
maintain its competitive position or what expenditures will be required to
develop and provide such products and services.
GOVERNMENT REGULATION
OVERVIEW. The Company's provision of international and national long
distance telecommunications services is heavily regulated. Many of the
countries in which the Company provides, or intends to provide, services
prohibit or limit the services which the Company can provide, or will be able
to provide and the transmission methods by which it can provide such services.
If a violation by the Company of the laws, rules, or regulations governing the
provision of telecommunications services were found by a regulatory authority
to exist, the regulatory authority could impose sanctions and penalties,
including revocation of any authorizations, licenses or permits. Regulatory
restrictions thus could materially limit the optimal and most profitable use
of the TIGN.
17
In addition, the Company provides a substantial portion of its customers
with access to its services through the use of call-reorigination. Revenues
attributable to call-reorigination represented 76.6% of the Company's revenues
in fiscal year 1996 and 65.1% of the Company's revenues for the year ended
December 31, 1997, and in the future are expected to represent a decreasing
portion of the Company's revenues. A substantial number of countries have
prohibited certain forms of call-reorigination as a mechanism to access
telecommunications services. This has caused the Company to cease providing
call-reorigination services to customers in Bermuda, the Bahamas, the
Philippines, and the Cayman Islands, and may require it to do so with respect
to customers in other jurisdictions in the future. As of December 31, 1997,
reports had been filed with the International Telecommunications Union ("ITU")
and/or the FCC claiming that the laws in 79 countries prohibit
call-reorigination. While the Company provides call-reorigination services in
substantially all of these countries, no single country within this group
accounted for more than 2% of the total revenues of the Company for the year
ended December 31, 1997. There can be no assurance that other countries where
the Company derives material revenue will not prohibit call-reorigination in
the future. To the extent that a country with an express prohibition against
the provision of call-reorigination using uncompleted call signaling is unable
to enforce its laws against a provider of such services, it can request that
the FCC enforce such laws in the United States by, for example, requiring a
provider of such services to cease providing call-reorigination services using
uncompleted call signaling to such country or by revoking such provider's FCC
authorizations. As of November 1997, 29 countries have formally notified the
FCC that call-reorigination services violate their laws. The Company provides
call-reorigination in 28 of these countries, which accounted for 7.9% of the
Company's total revenues for the year ended December 31, 1997. Two of the 29
countries have requested assistance from the FCC in enforcing their
prohibition on call-reorigination. Neither of these two countries accounted
for more than 2% of the Company's consolidated revenues for the year ended
December 31, 1997. The FCC has held that it would consider enforcement action
against companies based in the United States engaged in call-reorigination by
means of uncompleted call signaling to customers in countries where this
activity is expressly prohibited. The FCC recently ordered several U.S.
carriers, not including the Company, to cease providing call-reorigination
services using uncompleted call signaling to customers in the Philippines and
allowed the complaining party, the ITO in the Philipines, to seek damages.
Several U.S. carriers have asked the FCC to reconsider its decision. Although
the FCC is currently considering a petition requesting the FCC to stop
enforcing countries laws against call-reorigination, there can be no assurance
that the FCC will not take additional action to limit the provision of
call-reorigination services. Enforcement action by the FCC could include an
order to cease providing call-reorigination services in such country, the
imposition of one or more restrictions on the Company, monetary fines or, in
extreme circumstances, the revocation of the Company's FCC authorization, and
any of such actions could have a material adverse effect on the Company's
business, financial condition and results of operations.
Local laws and regulations differ significantly among the jurisdictions
in which the Company operates, and, within such jurisdictions, the
interpretation and enforcement of such laws and regulations can be
unpredictable. For example, EU member states have inconsistently and, in some
18
instances, unclearly implemented EU directives under which
the Company provides certain voice services in Western Europe. As a result,
some EU member states may limit, constrain or otherwise adversely affect the
Company's ability to provide certain services. There can be no assurance that
certain EU member states will implement, or will implement consistently, the
Full Competition Directive, and either the failure to implement or
inconsistent implementation of such directives could have a material adverse
effect on the Company's business, financial condition and results of
operations.
Additionally, there can be no assurance that future United States or
foreign regulatory, judicial or legislative changes will not have a material
adverse effect on the Company or that regulators or third parties will not
raise material issues with regard to the Company's compliance with applicable
laws or regulations. If the Company is unable to provide the services it is
presently providing or intends to provide or to use its existing or
contemplated transmission methods due to its inability to receive or retain
formal or informal approvals for such services or transmission methods, or for
any other reason related to regulatory compliance or the lack thereof, such
events could have a material adverse effect on the Company's business,
financial condition and results of operations.
The Company has pursued and expects to continue to pursue a strategy of
providing its services to the maximum extent it believes, upon consultation
with counsel, to be permissible under applicable laws and regulations. To the
extent that the interpretation or enforcement of applicable laws and
regulations is uncertain or unclear, the Company's strategy may result in the
Company's (i) providing services or using transmission methods that are found
to violate local laws or regulations or (ii) failing to obtain approvals or
make filings subsequently found to be required under such laws or regulations.
Where the Company is found to be or otherwise discovers that it is in
violation of local laws and regulations and believes that it is subject to
enforcement actions by the FCC or the local authority, it typically seeks to
modify its operations or discontinue operation so as to comply with such laws
and regulations. There can be no assurance, however, that the Company will not
be subject to fines, penalties or other sanctions as a result of violations
regardless of whether such violations are corrected. If the Company's
interpretation of applicable laws and regulations proves incorrect, it could
lose, or be unable to obtain, regulatory approvals necessary to provide
certain of its services or to use certain of its transmission methods. The
Company also could have substantial monetary fines and penalties imposed
against it.
A summary discussion of the regulatory frameworks in certain geographic
regions in which the Company operates or has targeted for penetration is set
forth below. This discussion is intended to provide a general outline of the
more relevant regulations and current regulatory posture of the various
jurisdictions and is not intended as a comprehensive discussion of such
regulations or regulatory posture.
19
UNITED STATES. International Service. The Company's provision of
international service to, from, and through the United States is subject to
regulation by the FCC. Section 214 of the Communications Act of 1934, as
amended (the ''Communications Act'') requires a company to make application
to, and receive authorization from, the FCC to, among other things, resell
telecommunications services of other U.S. carriers with regard to
international calls. In May 1994, the FCC authorized the Company, pursuant to
the Section 214 Switched Voice Authorization, to resell public switched
telecommunications services of other U.S. carriers. The Section 214 Switched
Voice Authorization requires, among other things, that services be provided in
a manner that is consistent with the laws of countries in which the Company
operates. As described above, the Company's aggressive regulatory strategy
could result in the Company's providing services that ultimately may be
considered to be provided in a manner that is inconsistent with local law. If
the FCC finds that the Company has violated the terms of the Section 214
Switched Voice Authorization, it could impose a variety of sanctions on the
Company, including fines, additional conditions on the Section 214 Switched
Voice Authorization, cease and desist or show cause orders, or the revocation
of the Section 214 Switched Voice Authorization, the latter of which is
usually imposed only in extreme circumstances serious violations. Depending
upon the sanction imposed, such sanction could have a material adverse effect
on the Company's business, financial condition and results of operations.
In order to conduct a portion of its business involving the origination
and termination of calls in the United States, the Company uses leased lines.
The Company's Section 214 Private Line Authorization permits the Company to
route switched services over international private lines interconnected to the
PSTNs in the United States and the United Kingdom, Canada, Sweden, The
Netherlands, New Zealand, and Australia (together, "Private Line Countries")
for the purpose of providing switched telecommunications services. However,
the FCC imposes certain restrictions upon the use of the Company's private
lines between the United States and the Private Line Countries. The Company
may route over the private line switched traffic originating in the United
States or in the Private Line Countries and terminating in the United States
or in the Private Line Countries. The Company may also route over the private
line switched traffic originating in the United States or the Private Line
Countries and sent to third countries via the switched services of a carrier
in the United States or the Private Line Countries by taking such switched
services at the carrier's published rates. Similarly, the Company may route
over the private line calls that originate in a third country over an ITO's
tariffed switched services and terminate in the United States or the Private
Line Countries. Recently, the FCC held that carriers will be permitted to
route switched traffic over private lines between the United States and any
country that (i) the FCC determines offers "equivalent resale opportunities"
or (ii) is a member of the WTO and where the local ITO generally charges U.S.
carriers at or below an FCC-determined rate for terminating the U.S. carriers'
traffic. The Company believes that the Company (as well as other private line
resellers) will soon be permitted to route switched traffic over international
private lines initially between the United States and Denmark, Belgium,
Finland, Germany, France, Luxembourg and Norway. Following implementation of
the Full Competition Directive by EU member states, the FCC may authorize the
Company to originate and terminate traffic over its private line between the
United States and other countries. However, there can be no assurance that
20
the FCC will take such action.
The Company also owns capacity in one or more international facilities
(e.g., submarine cables) to provide some services, and may in the future
acquire additional interests in international facilities. The Company has a
Section 214 facilities authorization to provide services over international
facilities between the United States and all countries other than Cuba. The
Company is also required to conduct its facilities-based international
business in compliance with the FCC's International Settlements Policy (the
''ISP''). The ISP establishes the permissible arrangements for U.S. based
facilities-based carriers and their foreign counterparts to settle the cost of
terminating each other's traffic over their respective networks. One of the
Company's arrangements with foreign carriers is subject to the ISP and it is
possible that the FCC could take the view that this arrangement does not
comply with the existing ISP rules. If the FCC, on its own motion or in
response to a challenge filed by a third party, determines that the Company's
foreign carrier arrangements do not comply with FCC rules, among other
measures, it may issue a cease and desist order, impose fines on the Company
or revoke or suspend its FCC authorizations. Such action could have a
material adverse effect on the Company's business, financial condition and
results of operations.
The Company is required to file and has filed with the FCC a tariff
containing the rates, terms and conditions applicable to its international
telecommunications services. The Company is also required to file with the FCC
any agreements with customers containing rates, terms, and conditions for
international telecommunications services, if those rates, terms, or
conditions are different than those contained in the Company's tariff.
Notwithstanding the foregoing requirements, to date, the Company has not filed
with the FCC certain commercially sensitive carrier-to-carrier customer
contracts. If the Company charges rates other than those set forth in, or
otherwise violates, its tariff or a customer agreement filed with the FCC, or
fails to file with the FCC carrier-to-carrier agreements, the FCC or a third
party could bring an action against the Company, which could result in a fine,
a judgment or other penalties against the Company. Such action could have a
material adverse effect on the Company's business, financial condition and
results of operations.
The Company's provision of domestic long distance service in the United
States is subject to regulation by the FCC and relevant state public service
commissions ("PSCs"), which regulate interstate and intrastate rates,
respectively, ownership of transmission facilities, and the terms and
conditions under which the Company's domestic services are provided. In
general, neither the FCC nor the relevant state PSCs exercise direct oversight
over cost justification for the Company's services or the Company's profit
levels, but either or both may do so in the future. The Company, however, is
required by federal and state law and regulations to file tariffs listing the
rates, terms and conditions of services provided. The Company has filed a
domestic long distance tariff with the FCC. Although the FCC has decided to
eliminate the requirement that non-dominant interstate carriers, such as the
Company, maintain FCC tariffs for domestic service, a federal court has stayed
the FCCs's decision pending judicial review of an appeal. Should the appeal
fail and the FCC's order become effective, the Company may benefit from the
21
elimination of FCC tariffs by gaining more flexibility and speed in dealing
with marketplace changes. However, the absence of tariffs will also require
that the Company secure contractual agreements with its customers regarding
many of the terms of its existing tariffs or face possible claims arising
because the rights of the parties are no longer clearly defined. The Company
generally is also required to obtain certification from the relevant state PSC
prior to the initiation of intrastate service and to comply with all
conditions imposed by the PSC. Telegroup has the authorizations required or is
not required to obtain authorization to provide service in 48 states, and has
filed or is in the process of filing required tariffs in each state that
requires such tariffs to be filed. Any failure to maintain proper federal
and state tariffing or certification or to file required reports or otherwise
to comply with FCC or state requirements could have a material adverse effect
on the Company's business, financial condition and results of operations. The
FCC also imposes some requirements for marketing of telephone services and for
obtaining customer authorization for changes in the customer's primary long
distance carrier.
To originate and terminate calls in connection with providing their
services, long distance carriers such as the Company must purchase ''access
services'' from local exchange carriers (''LECs'') or competitive local
exchange carriers (''CLECs''). Access charges represent a significant portion
of the Company's cost of U.S. domestic long distance services and, generally,
such access charges are regulated by the FCC for interstate services and by
PSCs for intrastate services. The FCC has undertaken a comprehensive review of
its regulation of LEC access charges to better account for increasing levels
of local competition. On May 16, 1997, the FCC released an order making
significant changes in the access service rate structure. Some of the changes
may result in increased costs to the Company for the ''transport'' component
of access services, although other revisions of the order likely will reduce
other access costs. Some issues in the FCC proceeding have not yet been
resolved, including a proposal under which LECs would be permitted to allow
volume discounts in the pricing of access charges. While the outcome of these
proceedings is uncertain, if these rate structures are adopted, many long
distance carriers, including the Company, could be placed at a significant
cost disadvantage to larger competitors. In addition, the FCC has taken
actions to implement the 1996 Telecommunications Act that will impose new
regulatory requirements including the requirement that all telecommunications
service providers, including the Company, contribute some portion of their
telecommunications revenues to a "universal service fund" designated to fund
affordable telephone service for consumers in high cost areas, low income
consumers, schools, libraries and rural health care providers. These
contributions became due beginning in 1998 for all providers of interstate
telecommunications service. Such contributions are assessed based on intra-
state, interstate and international end user telecommunications revenues.
Contribution factors vary quarterly and carriers, including the Company, are
billed monthly. Contribution factors for the first quarter are .0319 for the
high cost and low income funds (interstate and international end user tele-
communications revenues) and .0072 for the schools, libraries and rural health
care funds (intrastate, interstate and international end user telecommunications
revenues). Second quarter factors are .0314 and .0076, respectively. In
addition, many state PSCs have instituted proceedings to revise state universal
support mechanisms to make them consistent with the requirements of the 1996
Telecommunications Act. The company may be subject to state universal service
fund contribution requirements, which will vary from state to state, as well
as federal.
In some instances, the Company may be responsible for city sales taxes on
calls made within the jurisdiction of certain U.S. cities. The Company is
implementing software to track and bill for this tax liability. However, the
Company may be subject to sales tax liability for calls transmitted prior to
the implementation of such tax software and not be able to collect
reimbursement for such liability from its customers. While the Company
22
believes that any such liability will not be significant, there can be no
assurance that such tax liability, if any, will not have a material adverse
effect on the Company's business, financial condition or results of
operations.
In November 1996, the FCC adopted rules that would require that
interexchange companies offering toll-free access through payphones (such as
the Company) compensate certain payphone operators for customers' use of the
payphone. After a U.S. federal court reversed the FCC's payphone orders in
part and remanded the case to the FCC for further proceedings, the FCC issued
a further decision requiring that interexchange carriers compensate payphone
owners at a rate of $.284 per call for all calls using their payphones. This
compensation method will be effective from October 7, 1997 through October 7,
1999. After this time period, interexchange carriers will be required to
compensate payphone owners at a market-based rate minus $0.066 per call. A
number of carriers have appealed the Second Report and Order to the U.S. Court
of Appeals for the D.C. Circuit or have sought FCC reconsideration of this
order. Although the Company cannot predict the outcome of the FCC's
proceedings on the Company's business, it is possible that such proceedings
could have a material adverse effect on the Company's business, financial
condition and results of operations.
The FCC and certain state agencies also impose prior approval
requirements on transfers of control, including pro forma transfers of control
and corporate reorganizations, and assignments of regulatory authorizations.
Such requirements may delay, prevent or deter a change in control of the
Company. The FCC also imposes restrictions on certain affiliations with
foreign telecommunications companies.
EUROPE. In Europe, the regulation of the telecommunications industry is
governed at a supra-national level by the EU (consisting of the following
member states: Austria, Belgium, Denmark, Finland, France, Germany, Greece,
Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden and the
United Kingdom), which is responsible for creating pan-European policies and,
through legislation, has developed a regulatory framework to ensure an open,
competitive telecommunications market. The EU was established by the Treaty of
Rome and subsequent conventions and is authorized by such treaties to issue
''directives.'' EU member states are required to implement these directives
through national legislation. If an EU member state fails to adopt such
directives, the European Commission may take action, including referral to the
European Court of Justice, to enforce the directives.
In 1990, the EU issued the Directive on Competition in the Markets for
Telecommunications Services ("Services Directive") requiring each EU member
state to abolish existing monopolies in telecommunications services, with the
exception of Voice Telephony. The intended effect of the Services Directive
was to permit the competitive provision of all services other than Voice
Telephony, including value-added services and voice services to a group of
specified users, such as employees of a company, permitted by applicable
regulations to access a private voice or data network, which access would
23
otherwise be denied to them as individuals ("Closed User Groups" or "CUGs").
However, as a consequence of local implementation of the Services Directive
through the adoption of national legislation, there were differing
interpretations of the definition of prohibited Voice Telephony and permitted
value-added and CUG services. The European Commission generally took a narrow
view of the services classified as Voice Telephony, declaring that voice
services may not be reserved to the ITOs if (i) dedicated customer access is
used to provide the service, (ii) the service confers new value-added benefits
on users (such as alternative billing methods) or (iii) calling is limited by
a service provider to a group having legal, economic or professional ties.
In March 1996, the EU adopted the Full Competition Directive 96/19 (which
together with its subsidiary directives is hereinafter called the "Full
Competition Directive") which required EU member states to allow the creation
of alternative telecommunications infrastructures by July 1, 1996, and which
reaffirmed the obligation of EU member states to abolish the ITOs' monopolies
in Voice Telephony by 1998. The Full Competition Directive encouraged EU
member states to accelerate liberalization of Voice Telephony. Certain EU
countries may delay the abolition of the Voice Telephony monopoly based on
exemptions established in the Full Competition Directive. These countries
include Spain (December 1998), Portugal (January 1, 2001), Ireland (January 1,
2000), Luxembourg (July 1, 1998) and Greece (January 1, 2001).
On January 1, 1998, the Full Competition Directive became effective in
most EU member states, allowing competitive entrants such as the Company to
provide Voice Telephony in those markets. To date, according to the European
Commission's "Third Report on the implementation of the telecommunications
regulatory package," the following countries have granted authorizations to
provide Voice Telephony: the United Kingdom, the Netherlands, France,
Germany, Sweden, Denmark, Norway, Belgium, Austria, and Spain.
Each EU member state in which the Company currently conducts its business
has a different regulatory regime and such differences are expected to
continue. EU law generally prohibits member states from requiring individual
licenses for services other than Voice Telephony. With respect to Voice
Telephony and ownership and operation of infrastructure, EU law allows member
states to impose individual licensing requirements on carriers and the
requirements for the Company to obtain necessary approvals vary considerably
from country to country and are likely to change as competition is permitted
in new service sectors. Except with respect to Voice Telephony and
call-reorigination, the Company believes that, to the extent required, it has
filed or will file applications, received comfort letters or obtained licenses
from the applicable regulatory authorities.
The Company may be incorrect in its assumptions that (i) each EU member
state will abolish, on a timely basis, the respective ITO's monopoly to
provide Voice Telephony within and between member states and other countries,
as required by the Full Competition Directive, (ii) deregulation will continue
to occur and (iii) the Company will be allowed to continue to provide and to
expand its services in the EU member countries. The European Commission has
initiated legal action against Belgium, Denmark, Germany, Greece, Italy,
Luxembourg and Portugal for not implementing the Full Competition Directive
adequately. If the European Commission is not satisfied
24
with the explanation given by these countries for their delay it may take
action that ultimately could result in a decision by the European Court of
Justice concerning whether these countries have violated the Full Competition
Directive. The Company's provision of services in Western Europe may also be
affected if any EU member state imposes greater restrictions on non-EU
international service than on such service within the EU. There can be no
assurance that EU member states will not adopt laws or regulatory requirements
that will adversely affect the Company.
In a number of European countries, the Company has sought to position
itself for the rapidly liberalizing regulatory environment by providing,
first, traditional call reorigination and, later, transparent call
reorigination and other forms of call through, such as enhanced and switched
voice telecommunications services to business users, including CUGs. Although
the Company has provided some or all of these services without a license and
in advance of the January 1, 1998 date for full liberalization of Voice
Telephony in the EU, the Company has not been notified by any regulatory
authority that it is or was operating without a required license, nor does the
Company expect to be so notified. It is possible that the Company could be
fined , or that the Company would not be allowed to provide specific services
in these countries if the Company were found to have been providing Voice
Telephony before January 1, 1998, or after that date without obtaining a
proper license. Such actions could have a material adverse impact on the
Company's business, financial condition and results of operations.
UNITED KINGDOM. The Company owns and operates a switching facility in
London that is connected to the UK international gateway by private line
circuits leased by the Company from third parties. The Company recently
acquired IRU capacity in a digital undersea fiber-optic cable for the
transmission of traffic between its London switching facility and its
international gateway switching center in New York, which allows the Company
to reduce transmission costs associated with leasing international private
leased circuits (''IPLCs'') owned by third parties and to provide additional
capacity between the United States and United Kingdom. In the United Kingdom,
the Company offers direct access and call-reorigination, as well as customized
calling card and prepaid debit calling card services, and provides
international call termination services to other telecommunications carriers
and resellers on a wholesale switched minute basis. The Company's services are
subject to the Telecommunications Act of 1984 (the ''UK Telecommunications
Act''). The Secretary of State for Trade and Industry (the ''TI Secretary'')
is responsible for granting telecommunications licenses and the Director
General of Telecommunications (''DGT'') and his staff, known as the Office of
Telecommunications (''Oftel''), the United Kingdom's telecommunications
regulatory authority, are responsible for enforcing the conditions of such
licenses. The TI Secretary has granted the Company an ISVR license, which
allows the Company to offer certain international and national long distance
services utilizing international private leased circuits. The TI Secretary
also has granted the Company an International Facilities License ("IF
License"), allowing the Company the right to acquire capacity in digital
undersea fiber-optic cables on an Indefeasible Right of Use (''IRU''). The
loss of any of the Company's licenses or the placement of significant
25
restrictions thereon could have a material adverse effect on the Company's
business, financial condition and results of operations.
THE NETHERLANDS. The regulation of telecommunications is currently
controlled by the Onafhankelijke post-en telecommunicatie autoriteit
(''OPTA''), an independent administrative authority. At the end of March 1998,
a draft for a new Telecommunications Act was discussed in the Dutch
Parliament. This new Act will, inter alia, further elaborate the
liberalization of the provision of telecommunications services. It is
unlikely that the new Act will enter into force before mid-1998. Under the
regime of this new Telecommunications Act, the Company and/or Telegroup
Nederland B.V. will have to file a registration before the OPTA. The Company
presently owns and operates a switching facility in Amsterdam, which the
Company connects by leased lines to its international gateway switching center
in New York. The Company presently offers call-through services in The
Netherlands.
GERMANY. The regulation of the telecommunications industry in Germany
is governed by the Telekommunikationsgesetz, the Telecommunications Act of
1996 (''TKG''), which, with respect to most of its provisions, became
effective in August 1996. Under the TKG, a license (''TKG License'') is
generally required by any person that: (i) operates transmission facilities
for the provision of telecommunications services to the public; or (ii) offers
Voice Telephony services to the public through telecommunications networks
operated by such provider. While the TKG represents the final phase of the
reform of the German telecommunications industry, the law protected the
monopoly rights of Deutsche Telekom over the provision of Voice Telephony
until January 1, 1998.
In Germany, the Company is currently providing calling card services as
well as traditional call-reorigination services (through answered or
unanswered call signaling), and is migrating CUGs and other customers to
call-reorigination services provided through Internet/X.25 data link
signaling, to transparent call-reorigination and/or to forms of call-through
other than transparent call-reorigination. The Company is in the process of
applying for a TKG license.
In order to provide the Voice Telephony services to the public that the
Company intends to provide and expand its network switching facilities in
Germany, the Company will be required to obtain a TKG License. There can be
no assurance that the Company will be able to obtain, or, if granted,
thereafter maintain, a TKG License. The failure to obtain, or the loss of, a
TKG License or the placement of significant restrictions thereon could have a
material adverse effect on the Company's business, financial condition and
results of operations. In addition, there can be no assurance that any future
changes in, or additions to, any existing or future German laws, regulations,
government policy, court or administrative rulings regarding
telecommunications will not have a material adverse effect on the Company's
business, financial condition and results of operations.
FRANCE. The Company currently provides call-reorigination services,
including transparent call-reorigination. The Company is permitted to provide
call-reorigination over the ITO's network in France without a license.
26
Although it does not currently provide such services, the Company may lease
circuits and provide switched voice services to CUGs in France without a
license. Until January 1, 1998, the Company was not permitted to provide Voice
Telephony to the public in France.
A new telecommunications law, passed in 1996 by the French legislature to
implement the Full Competition Directive, establishes a licensing regime and
an independent regulator and imposes various interconnection and other
requirements designed to facilitate competition. The Company is in the process
of applying for a license from the Minister of Telecommunications to provide
Voice Telephony services. There can be no assurance, however, that the Company
will be able to obtain necessary licenses, permits, or interconnection
arrangements to fully take advantage of such liberalization. The Company's
inability to take advantage of such liberalization could have a material
adverse impact on the Company's ability to expand its services as planned.
SWITZERLAND. In Switzerland, the Company is currently providing
call-reorigination services as well as forms of call-through other than
call-reorigination. The Company's existing services are subject to the
Federal Law on Telecommunications of April 30, 1997 (''LTC''). Although
Switzerland is not an EU member state, the Swiss government has expressed its
intention to maintain Swiss telecommunications regulations in line with EU
directed liberalization. The new LTC provides therefore a liberalization of
the Swiss telecommunication market compatible with the EU directives. Subject
to Swiss and FCC rules, the Company plans to expand operations in Switzerland
with the installation of additional switching facilities in Zurich and other
metropolitan areas of Switzerland connected via international private leased
circuits (''IPLCs'') to its international gateway switching center to provide
international and national long distance services with switched and dedicated
access. Under the new LTC, the Company is not required to obtain a license
unless it controls the infrastructure over which its services are carried.
Consequently, no license is required for the Company as a mere reseller of
transmission capacity. On the other hand, as a company providing telecom
services in Switzerland, the Company is under the duty to notify the federal
authorities about the telephone services offered in Switzerland.
PACIFIC RIM. Regulation of the Company varies in the Pacific Rim,
depending upon the particular country involved. In Australia and New Zealand,
regulation of the Company's provision of telecommunications services is
relatively permissive, although enrollment (in Australia) or registration (in
New Zealand) with the regulator is required for ISR. The Company's Australian
Subsidiary was enrolled in Australia as a Supplier of Eligible International
Services (and now has the right to provide equivalent services under its
Subsidiary in New Zealand has registered with the Ministry of Commerce as an
International Service Operator under the Telecommunications International
Services Regulations of 1995. Additionally, in Japan, the Company provides
call-reorigination services and is authorized to provide basic switched voice
services to the public using ISR. In Hong Kong, the Company may provide
call-reorigination under its existing license. A range of international
telephone services, including the operation of an international gateway for
all incoming and outgoing international calls, is provided in Hong Kong solely
by HKTI, the ITO, pursuant to an exclusive license which was set to expire on
October 1, 2006. However, the Hong Kong government has agreed to compensate
27
HKTI in exchange for the early termination of HKTI's exclusive license on
January 1, 1999 to operate an international gateway and on January 1, 2000 to
provide international circuits. In all other Pacific Rim countries, the
Company is strictly limited in its provision of public voice and value added
services.
While some countries in the Pacific Rim oppose call-reorigination, the
Company generally has not faced significant regulatory impediments in its high
volume countries. China, Indonesia, and the Philippines have specifically
informed the FCC that call-reorigination using uncompleted call signaling is
illegal in those countries. Australia, New Zealand, Japan and Hong Kong permit
call-reorigination.
AUSTRALIA. In Australia, the provision of the Company's services was
subject to federal regulation pursuant to the Telecommunications Act 1991 of
Australia (the ''1991 Act'') until June 30, 1997, and is now subject to
federal legislation pursuant to the Telecommunications Act 1997 (the ''1997
Act'') and federal regulation of anticompetitive practices pursuant to the
Trade Practices Act 1974. In addition, other federal legislation, various
regulations pursuant to delegated authority and legislation, ministerial
declarations, codes, directions, licenses, statements of Commonwealth
Government policy and court decisions affecting telecommunications carriers
also apply to the Company. There can be no assurance that future declarations,
codes, directions, licenses, regulations, and judicial and legislative changes
will not have a material adverse effect on the Company's business, financial
condition and results of operations.
The Australian Telecommunications Authority (''AUSTEL''), Australia's
federal telecommunications regulatory authority, had control until June 30,
1997 over a broad range of issues affecting the operation of the Australian
telecommunications industry, including the licensing of carriers, the
promotion of competition, consumer protection and technical matters. Under the
1997 Act, AUSTEL's authority is now divided between the Australian
Communications Authority and the Australian Competition and Consumer
Commission.
The Company owns and operates a switch in Sydney that is connected to the
New York international gateway switch via leased lines. On December 9, 1996,
the Company's Subsidiary, Telegroup Network Services pty Limited, was enrolled
as a Supplier of Eligible International Services (''Class License'') under
Section 226 of the 1991 Act, which allowed the Company to resell national,
local and long distance service, cellular service, and international service,
including to engage an ISR. Under the 1991 Act, the Company's Australian
Subsidiary was required to comply with the conditions of the Class License
until the 1997 Act came into effect on July 1, 1997. Under the 1997 Act, the
Company's Subsidiary is a carriage service provider subject to certain rules,
including an obligation to provide certain operator services, directory
assistance services and itemized billing for customers of the Subsidiary. As a
carriage service provider, the Company's Subsidiary may purchase IRUs for the
Australian portion of the underseas fiber-optic cable between Sydney and New
York, as well as Auckland, New Zealand. If the Company or its affiliate
purchases or constructs a link between places in Australia (e.g., to provide
an extension to its international services), it will be required to apply for
28
a carrier license. It would then be subject to the terms of its own license
and would be subject to greater regulatory controls such as in areas of
regulation of connectivity, provision of access to service providers, land
access and contributions to the net cost of universal service throughout
Australia (to provide telecommunications services at reasonable prices to
remote sections of that country) applicable to licensed facilities-based
carriers.
The FCC has also granted the Company's request for a waiver allowing the
Company to deviate from the existing FCC approved settlement rate and to
contract at $0.05 per minute using leased lines, pursuant to an agreement with
its subsidiary in Australia. The Company has initiated service pursuant to
this agreement.
There can be no assurance that a change in government policy in relation
to telecommunications or competition, or in the enforcement of the 1997 Act,
will not have a material adverse effect on the Company's business, financial
condition and results of operations. For example, there can be no assurance
that the process of deregulation will proceed in accordance with the
government's announced timetable. Any delay in such deregulatory process or in
the granting of licenses to other entities interested in developing their own
transmission facilities in Australia could delay potential price reductions
anticipated in a more competitive marketplace, thereby delaying the Company's
ability to access to potentially less expensive transmission and access
facilities.
HONG KONG. The Company acts as a wholesale carrier in Hong Kong,
utilizing its switch collocated at the business premises of one or more of the
local carriers licensed as Fixed Telecommunications Network Service (''FTNS'')
operators in Hong Kong to provide international services to such FTNS
providers. The Company carries a substantial amount of such FTNS operators'
international traffic on a transparent call-reorigination basis. The Company
operates under a PNETS license granted in 1995 and renewable on an annual
basis. The Company's PNETS license was most recently renewed in March 1997.
The Company's PNETS license will likely be renewed unless there has been a
material breach of one of the license conditions.
The telecommunications market in Hong Kong for the provision of public
telephone services can be categorized into two primary areas: international
long distance services and local telephone services. HKTI currently holds an
exclusive license until September 30, 2006 to provide a variety of
international services including the right to operate an international gateway
for the handling of all outgoing and incoming international calls adn the
right to provide international circuits. However, the Hong Kong government has
agreed to compensate HKTI in exchange for the early termination of HKTI's
exclusive license on January 1, 1999 to operate an international gateway and
on January 1, 2000 to provide international circuits. The Hong Kong government
intends to invite existing FTNS providers to amend their licenses to permit
the provision of international services and facilities, and to establish a new
license for other entities to provide international services.
Prior to June 1995, the Hong Kong Telephone Company Limited was the sole
operator of local fixed network telephone services. Subsequently, the market
29
was liberalized and the Hong Kong government granted licenses to Hutchison,
New World and New T&T Hong Kong Limited to provide fixed local telephone
network services. Each of the four fixed local telephone network operators
each currently hold a FTNS license issued by the Hong Kong government. The
Company plans to apply for a FTNS license if and when the Hong Kong government
decides to grant additional FTNS licenses, which, the Hong Kong government has
indicated, will be no earlier than 1998. Despite the fact that HKTI has the
exclusive right under its license to provide international telephone services,
all three of the other local fixed network operators have in recent years
gained a significant share of the international long distance call market
(approximately 30% to 40% according to the Company's estimates) by utilizing
U.S. and Canada-based call-reorigination services.
On July 1, 1997, China resumed sovereignty over Hong Kong. There can be
no assurance that China will continue the existing licensing regime with
respect to the Hong Kong telecommunications industry. There is also no
assurance that China will continue to implement the existing policies of the
Hong Kong government with respect to promoting the liberalization of Hong Kong
or the telecommunications industry in general, including the policy allowing
call-reorigination, which is currently prohibited in China. For the year ended
December 31, 1997, one wholesale customer in Hong Kong, which may be eligible
to self-provide international services by January 1, 1999 as discussed above,
accounted for approximately 13% of the Company's total revenues. Substantially
all of the services provided by the Company to this customer consist of
call-reorigination services. The initial term of the Company's agreement with
the Hong Kong Customer expires in October 1998, automatically renews for
one-year periods, and may be terminated by the Hong Kong Customer if it
determines in good faith that the services provided pursuant to the agreement
are no longer commercially viable in Hong Kong. There can be no assurance that
regulatory changes affecting the Hong Kong telecommunications market will not
affect the Hong Kong Customer's decision as to the renewal of the agreement.
Moreover, if the Company loses its rights under its PNETS license and/or if it
is unable to provide international telecommunications services in Hong Kong on
a wholesale basis, such action could have a material adverse effect on the
Company's business, financial condition and results of operations. In
addition, a material reduction in the level of services provided by the
Company to the Hong Kong Customer, or a termination of the Company's agreement
with the Hong Kong Customer, could have a material adverse effect on the
Company's business, financial condition and results of operations.
JAPAN. The Company owns and operates a switch in Tokyo. In Japan, the
Company offers traditional call-reorigination services, and anticipates
offering call-through as well as customized calling card and debit calling
card services. The Company's services in Japan are subject to regulation by
the Ministry of Post and Telecommunications (the ''Japanese Ministry'') under
the Telecommunications Business Law (the ''Japanese Law''). The Company has
filed notice with the Japanese Ministry as a General Type II carrier and has
been granted a Special Type II registration, both of which will permit the
Company to provide additional services in Japan. The Special Type II
registration allows the Company to provide international switched voice
30
services to the public using resold leased international lines (e.g., through
ISR), although restrictions in other countries such as the United States
currently limit the Company's ability to use this registration.
INTERNET TELEPHONY. The introduction of Internet telephony is a recent
market development. To the Company's knowledge, there currently are no
domestic and few foreign laws or regulations that prohibit voice
communications over the Internet. The FCC is currently considering whether or
not to impose surcharges or additional regulation upon providers of Internet
telephony. In addition, several efforts have been made to enact U.S. federal
legislation that would either regulate or exempt from regulation services
provided over the Internet. State public utility commissions also may retain
intrastate jurisdiction and could initiate proceedings to regulate the
intrastate aspects of Internet telephony. A number of countries that
currently prohibit competition to the ITO in the provision of voice telephony
also have prohibited Internet telephony. Other countries permit but regulate
Internet telephony. If foreign governments, Congress, the FCC, or state
utility commissions prohibit or regulate Internet telephony, there can be no
assurances that any such regulation will not materially affect the Company's
business, financial condition or results of operation.
EMPLOYEES
As of December 31, 1997, the Company had 588 full-time and 79 part-time
employees. None of the Company's employees are covered by a collective
bargaining agreement. Management believes that the Company's relationship with
its employees is satisfactory.
AGREEMENTS WITH INDEPENDENT AGENTS
INDEPENDENT AGENTS. The Company's agreements with its independent
agents (other than Country Coordinators) typically provide for a two-year term
and require the agents to offer the Company's services at rates prescribed by
the Company and to abide by the Company's marketing and sales policies and
rules. Independent agent compensation is paid directly by the Company and is
based exclusively upon payment for the Company's services by customers
obtained for Telegroup by the independent agents. The commission paid to
independent agents ranges between five to twelve percent of revenues received
by the Company and varies depending on individual contracts, the exclusivity
of the agent and the type of service sold. Commissions are paid each month
based on payments received during the prior month from customers obtained by
independent agents. Independent agents are held accountable for customer
collections and are responsible for up to 40% of bad debt attributable to
customers they enroll. The Company may change commissions on any of its
services with 30 days written notice to the independent agent.
As of December 31, 1997, approximately one-third of the Company's retail
revenues was derived from customers enrolled by agents who are contractually
prohibited from offering competitive telecommunications services to their
customers during the term of their contract and typically for a period of two
years thereafter. Contracts with independent agents entered into by the
31
Company after July 1996 typically provide for such exclusivity. As earlier
agreements expire, the Company has generally required its independent agents
to enter into such new agreements. In the past, certain independent agents
have elected to terminate their relationships with the Company in lieu of
entering into new independent agent agreements. In the event that independent
agents transfer a significant number of customers to other service providers
or that a significant number of agents decline to renew their contracts under
the new terms and move their customers to another carrier, either of such
events may have a material adverse effect on the Company's business, financial
condition and results of operations. The Company's agreements with its
independent agents typically provide that the agents have no authority to bind
Telegroup or to enter into any contract on the Company's behalf.
COUNTRY COORDINATORS. In significant international markets, Telegroup
appoints Country Coordinators. Country Coordinators are typically
self-financed, independent agents, with contracts that bind them exclusively
to Telegroup. Country Coordinators also have additional duties beyond
marketing Telegroup services, including the responsibility in a country or
region to coordinate the activities of Telegroup independent agents including
training and recruitment, customer service and collections. As of December 31,
1997, Telegroup had 28 Country Coordinators who were responsible for sales,
marketing, customer service and collections in 79 countries. Telegroup has
begun to vertically integrate its operations by opening offices in Germany and
the U.K. which provide Country Coordinator services and acquired the business
operations of its Country Coordinators in France, Japan, and Australia/New
Zealand.
Country Coordinators offer the Company's services at rates prescribed by
the Company, and enforce standards for all advertising, promotional, and
customer training materials relating to Telegroup's services that are used or
distributed in the applicable country or region. Country Coordinators review
all proposed marketing or advertising material submitted to them by the
independent agents operating in their country or region and ensure such
agents' compliance with the Company's standards and policies. The Company's
agreements with its independent Country Coordinators typically have a two-year
term and include an exclusivity provision restricting the County Coordinator's
ability to offer competing telecommunication services. Such agreements
typically entitle the Country Coordinator to an override based on a percentage
of revenues collected by Telegroup from customers within the Country
Coordinator's country or region, as well as a commission similar to the
commission paid to independent agents with respect to customers obtained
directly by the Country Coordinator. The Company's agreements with its Country
Coordinators typically provide that the agents have no right to enter into any
contract on Telegroup's behalf or to bind Telegroup in any manner not
expressly authorized in writing.
ITEM 2. PROPERTIES
The Company leases certain office space under operating leases and
subleases that expire at various dates through October 31, 2001, including the
32
Company's principal headquarters in Fairfield, Iowa. The principal offices
currently leased or subleased by the Company are as follows:
Location Square Footage Lease Expiration
-------- -------------- ----------------
Fairfield, Iowa (Corporate Headquarters) 31,632 January 2001
Fairfield, Iowa (Various Offices) 35,000 Various
Coralville, Iowa (Network Operations Center) 7,200 October 2001
San Francisco, California 850 January 31, 1998
Dusseldorf, Germany (Sales and
Customer Service Office) 2,100 April 1999
London, England (Sales and Customer
Service Office) 1,200 April 2001
Paris, France (Sales and Customer
Service Office) 1,600 September 1999
The Company's switches in New York City, Australia, France, Japan, Hong
Kong, the Netherlands, Denmark, Switzerland, Frankfurt, Milan and the U.K. are
located in various facilities pursuant to separate colocation agreements. The
Company's aggregate rent expense for its domestic and international
operations, excluding costs relating to colocation agreements, was $1,423,104
in 1997.
ITEM 3. LEGAL PROCEEDINGS
The Company makes routine filings and is a party to customary regulatory
proceedings with the FCC relating to its operations. The Company is not a
party to any lawsuit or proceeding which, in the opinion of management, is
likely to have a material adverse effect on the Company's business, financial
condition and results of operations.
33
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information regarding the
Company's directors, executive officers and certain other officers as of March
15, 1998.
Name Age Position
------ ---- ---------
Fred Gratzon 52 Chairman of the Board and Director
Clifford Rees 46 Chief Executive Officer and Director
Steven J. Baumgartner 46 President, Chief Operating Officer
and Director
John P. Lass 47 Senior Vice President--Strategy and
Business Development
Ronald B. Stakland 44 Senior Vice President--International
Marketing and Operations and Director
Douglas A. Neish 42 Vice President--Finance, Chief Financial
Officer, and Director
Stanley Crowe 52 Vice President--North America
Michael Lackman 46 Vice President--Intelligent Networks
Eric E. Stakland 45 Vice President--Global Carrier Services
Ronald L. Jackenthal 33 Vice President--North American Carrier
Sales
Robert E. Steinberg 43 Vice President and General Counsel
Ellen Akst Jones 47 Vice President--Administration
Andrew Munro 37 Vice President--Revenue Systems
Steven W. Hathaway 49 Vice President--Enhanced Services
Sudhir Chadalavada 39 Vice President--Marketing
Thomas Brand 59 Vice President--Chief Technology Officer
Stan Bierbrier 45 Treasurer
J. Sherman Henderson III 54 Director
Rashi Glazer 49 Director
FRED GRATZON, a co-founder of the Company, has served as Chairman of the
Company's Board of Directors and a Director since its formation in 1989. Mr.
Gratzon founded The Great Midwestern Ice Cream Company in Fairfield, Iowa, in
1979 and served as its Chairman from 1979 to 1988. Mr. Gratzon received a BA
in fine arts from Rutgers University in 1968.
34
CLIFFORD REES, a co-founder of the Company, has served as Chief Executive
Officer and a Director of the Company since its formation in 1989. Prior to
co-founding Telegroup, Mr. Rees was a co-founder of Amerex Petroleum
Corporation, a multinational oil brokerage company. Mr. Rees has been a member
of the Board of Directors of the Telecommunications Resellers Association
(''TRA'') since its inception, and was the founding chairman of the TRA's
International Resale Council, which advises the TRA Board of Directors on
issues concerning the expansion of telecommunications resale throughout the
world. Mr. Rees received a BA, summa cum laude, in biochemistry from Michigan
State University in 1974.
STEVEN J. BAUMGARTNER, President and Chief Operating Officer from
February 1998, has served as a director of the Company since October 1997. Mr.
Baumgartner served as Executive Vice President and Sector President Global
Commercial Print for R.R. Donnelley & Sons Company (''R.R. Donnelley'') from
1995 to 1998. At R.R. Donnelley Mr. Baumgartner was responsible for all
printing business outside the United States and is a member of R.R.
Donnelley's five-person executive committee. Prior to that time, Mr.
Baumgartner served as Executive Vice President of R.R. Donnelley responsible
for strategy, communication, technology and human resources from 1993 to 1995.
Prior to working at R.R. Donnelley, Mr. Baumgartner was co-founder and chief
executive officer of FRC Management, Inc., a retirement concepts corporation,
from 1991 to 1993.
JOHN P. LASS served as Senior Vice President and Chief Operating Officer
of the Company from January 1997 until January 1998 and is currently serving
as Senior Vice President of Strategy and Business Development. Prior to
joining the Company, from November 1987 through December 1996, Mr. Lass served
as Director and President of Capital Management Partners, Inc., an
NASD-registered broker-dealer firm. During the same period, Mr. Lass was also
Director and President of Everest Asset Management, Inc., an investment
management firm. From 1983 to 1987, Mr. Lass served as Investment Manager for
the Zimmerman Capital Group and from 1982 to 1983, Mr. Lass was a consultant
with the Boston Consulting Group. Mr. Lass received an MBA from Harvard
Business School in 1982, where he graduated as a Baker Scholar. Mr. Lass
received a BA from the University of Washington in 1972.
RONALD B. STAKLAND has served as Senior Vice President of International
Marketing and Operations of the Company since 1992 and as a Director since
April 1997. Prior to joining the Company, Mr. Stakland was a broker for Prime
Energy, Inc., an oil brokerage company from January 1988 to August 1992. Mr.
Stakland received a BFA from the University of Minnesota in 1975.
DOUGLAS A. NEISH has served as Vice President of Finance of the Company
since November 1995, Treasurer from October 1996 to February 1998, and Chief
Financial Officer and a Director since April 1997. From 1990 to 1995, Mr.
Neish served as Deputy Treasurer for Canada Mortgage and Housing Corporation
and from 1988 to 1990 as Vice President of Canada Development Investment
Corporation (''CDIC''). Prior to his position with CDIC, from 1979 to 1988,
Mr. Neish was employed by Export Development Corporation where he served in a
number of positions including Senior Treasury Officer and Manager of
Marketing. Mr. Neish received a BA from Acadia University, Nova Scotia, Canada
in 1976 and an MBA from Dalhousie University, Nova Scotia, Canada in 1979.
35
STANLEY CROWE has served as Vice President of North America of the
Company since 1993. Prior to joining the Company, Mr. Crowe was a manager for
Mall Network Services, a telecommunications consulting and management firm
from 1990 to 1993. Prior to his position with Mall Network Services, Mr. Crowe
served as Vice President of Marketing of Guild Investment Management, a
national investment management firm, from 1988 to 1990 and President of
Stanley Crowe & Associates (predecessor to Oakwood Corp.), a real estate
development and brokerage firm, from 1979 to 1986. Mr. Crowe received a BA
from the University of California in 1968.
Michael Lackman has served as Vice President of Intelligent Networks of
the Company since 1994. Mr. Lackman served as Senior Manager at MCI from 1991
to 1994, where he was responsible for managing global development projects for
MCI and its alliance partners. From 1988 to 1991, Mr. Lackman was development
manager for Computer Associates, Inc. From 1980 to 1988, Mr. Lackman was a
consultant with the Resource Consulting Group. From 1978 to 1980, he served as
a system administrator with the California Institute of Technology. He
received his BS in Computer Science from the University of Oregon in 1975.
ERIC E. STAKLAND has served as Vice President of Global Carrier Services
since 1995. Prior to joining the Company, Mr. Stakland was Chief Executive
Officer of Impact Solutions, Inc. (also known as Fiberflex, Inc.), a golf club
manufacturing and marketing company based in Fairfield, Iowa, from July 1993
to October 1994. Prior to May 1993, Mr. Stakland was Chief Operating Officer
of USA Global Link, a telecommunications company. Mr. Stakland received a BSCI
from Maharishi European Research University in 1983 and an MBA from Maharishi
University of Management in 1985.
RONALD L. JACKENTHAL has served as Vice President of North American
Carrier Sales since May 1997. Prior to joining the Company, Mr. Jackenthal
served as National Director, Carrier Sales for Cable & Wireless, Inc., the
U.S. subsidiary of Cable & Wireless, PLC. Beginning in 1987, Mr. Jackenthal
held various positions at Cable & Wireless, including Manager Carrier Sales
from 1993 to 1995 and National Manager, Major Accounts, from 1990 to 1993. Mr.
Jackenthal received a B.A. from the University of Florida in 1987.
ROBERT E. STEINBERG has served as Vice President and General Counsel of
the Company since June 9, 1997. Prior to joining the Company, Mr. Steinberg
served from 1988 to May 1997 as Managing Partner of the Washington, D.C.
office of Porter, Wright, Morris & Arthur (a 250 attorney law firm based in
Ohio). Mr. Steinberg served from 1983 to 1986 as Special Assistant to U.S.
Attorney General William French Smith and as Special Litigation Counsel at the
U.S. Department of Justice. Mr. Steinberg is the author of five books and
thirty articles on regulatory and litigation topics, including in law journals
at Yale and Columbia law schools. Mr. Steinberg received a B.A. in 1976 and
J.D. in 1979 from Washington University.
ELLEN AKST JONES has served as the Company's Vice President of
Administration and Director of Human Resources since August 1997. Prior to
joining the Company, Ms. Jones ran a private law practice in Fairfield, Iowa
from 1992 to 1997. Prior to that time, Ms. Jones served as an Associate
Professor of Law and Government and Dean of Maharishi International University
36
College of Natural Law in Washington, DC, an Associate Counsel to the United
States Senate for the Senate Committee on Human Resources and an Assistant
General Counsel for the United States Conference of Mayors and Assistant
Attorney General of Texas. Ms. Jones received a B.A. and a J.D. from the
University of Pennsylvania in 1970 and 1974, respectively. Ms. Jones is
admitted to practice in Iowa and before the United States Supreme Court.
ANDREW MUNRO has served as the Company's Vice President of Revenue
Systems since September 1997. Prior to joining the Company, Mr. Munro held
positions with MCI in its Engineering and Information Technologies divisions,
where he was responsible for architectural definitions, design, and
implementation of multiple custom billing applications. Mr. Munro received a
B.S. in Political Science from Charter Oak College in 1988.
STEVEN W. HATHAWAY has served as the Company's Vice President of Enhanced
Services since August 1997 and, previously, as the Company's Director of
Enhanced Services from September 1994 to July 1997. Prior to joining the
Company, Mr. Hathaway co-founded and served as Vice President of Marketing for
Keyboard Advancements. Prior to that time, Mr. Hathaway served as Vice
President of Sales and Marketing for Laser's Edge and as a Product and
Marketing Manager for Computer Associates. Mr. Hathaway received a BA from
Rutgers University in 1971.
SUDHIR CHADALAVADA has served as the Company's Vice President of
Marketing since February 1998. He first joined the Company in October 1997 as
marketing consultant for international marketing and new business development.
Previously, he served as Senior Manager of the micro computer and logic
division of Toshiba, America, Inc., with profit and loss responsibility for
$60 million in annual revenues. Prior to that, he co-founded and served as
Chief Operating Officer of Stellar Solutions, Inc., where he established and
implemented successful marketing and sales strategy in emerging multimedia and
Internet markets.
THOMAS BRAND joined the Company as Vice President and Chief Technology
Officer in March, 1998, after 27 years of diversified engineering and
telecommunications experience in managing the design, development, production
and implementation of telecommunications systems and networks. Prior to
joining the Company, Mr. Brand was Executive Director of Strategic Accounts
Engineering at MCI since 1986. Prior to that time, he was a Director of
Service Engineering and Network Engineering for Satellite Business Systems.
He retired from the United States Air Force in 1980 after holding positions of
Director of Joint Tactical Communications Programs and Director of AF
Satellite Communications Program.
STAN BIERBRIER has served as Treasurer since February 1998, and
previously was Director of Treasury for the Company from 1997 to 1998. Prior
to joining the Company, Mr. Bierbrier served from 1993 to 1996 as Senior
Business Analyst at AIT where he was responsible for all financial aspects of
a large-scale business process re-engineering and systems automation project
for a Government agency. Mr. Bierbrier held various positions at Telesat from
1987 to 1993, including Venture Development Manager and Director of MediaSat
Services.
37
J. SHERMAN HENDERSON III has served as a director of the Company since
October 1997 and has served as President and CEO of UniDial Communications
from 1993 to the present. Prior to that, Mr. Henderson was employed by US
Network where he served as a regional telecommunications distributor for
American Centrex beginning in 1989. Mr. Henderson currently serves as Chairman
of the Telecommunications Resellers Association's Board of Directors. Mr.
Henderson has over 35 years of business experience in sales, marketing,
management and company ownership.
RASHI GLAZER has served as a director of the Company since October 1997
and has served on the faculty of the Walter A. Haas School of Business,
University of California, Berkeley and Co-Director of the Berkeley Center for
Marketing and Technology from 1992 to the present. Prior to that time, Mr.
Glazer served on the faculty of the Columbia University Graduate School of
Business.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER
MATTERS
The Common Stock was initially offered to the public on July 9, 1997 at a
price of $10.00 per share and commenced trading on the Nasdaq National Market
on that date under the symbol ''TGRP.'' The following table sets forth, for
the calendar period indicated, the high and low sale prices per share for the
Common Stock, as reported on the Nasdaq National Market. These prices do not
include retail markups, markdowns or commissions.
Calendar Year 1997 High Low
- ------------------ ------- ------
Third Quarter, July 9-September 30, 1997 $13 3/4 $8 7/8
Fourth Quarter, October 1-December 31, 1997 $15 1/4 $9 3/4
On March 25, 1998 the last sale price of the Common Stock as reported by
Nasdaq National Market was $19.875 per share. As of March 25, 1998, there were
approximately 76 shareholders of record.
The Company has paid no cash dividends since 1996. The Company currently
intends to retain all future earnings for use in the operation of its
business and, therefore, does not anticipate paying any cash dividends in
the foreseeable future. The declaration and payment in the future of any
cash dividends will be at the discretion of the Company's Board of
Directors and will depend upon, among other things, the earnings, capital
requirements and financial position of the Company, existing and/or future
loan covenants and general economic conditions.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth certain consolidated financial information
for the Company for the years ended December 31, 1995, 1996 and 1997, which
have been derived from the Company's audited consolidated financial statements
38
and notes thereto included elsewhere in this Form 10-K, and for the years
ended December 31, 1993 and 1994, which have been derived from audited
consolidated financial statements of the Company which are not included
herein. The following financial information should be read in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results
of Operations" and the Company's consolidated financial statements and notes
thereto appearing elsewhere herein.
Year Ended December 31,
1993 1994 1995 1996
1997
----- ---- ---- ----
----
(in thousands, except per share and other
operating data)
Statement of Operations Data:
Revenues:
Retail $ 29,790 $ 68,714 $ 128,139 $ 179,147
$ 225,023
Wholesale - - 98 34,061
112,409
---------- --------- --------
- ---------- --------
Total revenues 29,790 68,714 129,119 213,208
337,432
Cost of revenues 22,727 49,513 83,101 150,537
255,741
---------- --------- --------
- ---------- ---------
Gross profit 7,063 19,201 46,018 62,671
81,691
Operating expenses:
Selling, general and
administrative 7,341 19,914 39,222 59,652
88,177
Depreciation and amortization 172 301 655 1,882
4,995
Stock option based compensation - - - 1,032
342
------- ------ ------ --------
-------
Total operating expenses 7,513 20,215 39,877 62,566
93,514
Operating income (loss) (450) (1,014) 6,141 105
(11,823)
Extraordinary item, loss on
extinguishment of debt, net
of income taxes - - - -
9,971
Net earnings (loss) (707) (538) 3,821
(118) (23,725)
-------- -------- ------
- --------- --------
-------- -------- ------
- --------- --------
Basic and diluted earnings (loss)
per share (1) (.03) (.02) .16
(.00) (.84)
Weighted-average number of
common shares (in thousands)-
basic and diluted 24,652 24,652 24,652 25,091
28,324
OTHER FINANCIAL DATA:
EBITDA(2) $ (278) $ (577) $ 6,994 $ 2,990
$ (6,799)
Net cash provided by (used in)
operating activities 924 1,364 5,561 4,904
(12,826)
Net cash (used in) investing
activities (765) (700) (2,818)
(11,262) (42,486)
Net cash (used in) provided by
financing activities (10) 957 (115) 15,924
115,630
Ratio of earnings to fixed charges(5) .84
-
Capital expenditures 449 1,056 2,652 9,068
20,768
Dividends declared per common share - - .02 .02
-
OTHER OPERATING DATA:
Retail customers(3):
Domestic (US) 7,021 16,733 17,464 34,294
54,266
International 5,301 28,325 56,156 109,922
156,520
Wholesale customers(4) 0 0 4 18
28
Number of employees 97 217 296 444
667
Number of switches 1 2 3 7
21
BALANCE SHEET DATA:
Cash and cash equivalents $ 342 $ 1,963 $ 4,591 $ 14,155
$ 95,317
Current working capital (629) (2,171) (478) 9,659
91,953
Property & equipment, net 948 2,165 3,979 11,256
27,913
---------- --------- --------- ---------
--------
Total assets 7,677 17,537 33,576 65,956
193,758
Long term debt, less
current portion - - - 11,217
101,451
Total shareholders' equity 389 (149) 3,147 13,363
30,263
(1) Net earnings (loss) per common share for the years ended December 31,
1993, 1994, 1995, 1996, and 1997 is based on the weighted average number
of common shares outstanding pursuant to the requirements of Statement
of Financial Accounting Standard No. 128, EARNINGS PER SHARE. As a
result of the Company's recent initial public offering, Securities and
Exchange Commission Staff Accounting Bulletin No. 98, EARNINGS PER SHARE
(SAB No. 98), was considered in the calculation of earnings per share
("EPS"). Pursuant to SAB No. 98, issuances of common stock, options,
warrants and other potentially diluted securities for nominal
consideration (Nominal Issuances) are included in the calculation of
EPS, as if they were outstanding for all of the pre-initial public
offering periods in the manner of a stock split for which retroactive
restatement is required. The Company believes that there were no
Nominal Issuances during the periods presented in the accompanying
financial statements.
(2) EBITDA represents net earnings (loss) plus net interest expense
(income), income taxes, depreciation and amortization, non-cash stock
option based compensation and the extraordinary loss on the
extinguishment of debt. While EBITDA is not a measurement of
financial performance under generally accepted accounting principles and
should not be construed as a substitute for net earnings (loss) as a
measure of performance, or cash flow as a measure of liquidity, it is
included herein because it is a measure commonly used in the
telecommunications industry.
(3) Consists of retail customers who received invoices for the last month of
the period indicated. Does not include active international customers
who incurred charges in such month but who had outstanding balances as
of the last day of such month in an amount at which the Company does not
render invoices in such instances.
(4) Consists of wholesale customers who received invoices for the last month
of the applicable period indicated.
(5) The ratio of earnings to fixed charges was computed by dividing earnings
by fixed charges. For this purpose, earnings consists of income from
continuing operations, before income taxes and fixed charges of the
Company. Fixed charges consist of the Company's interest expense and
the portion of rent expense representative of an interest factor. For
the years ended December 31, 1996 and 1997, earnings were inadequate to
cover fixed charges. The dollar amount of the coverage deficiency was
$125,770 and $14,330,321, respectively.
39
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS OVERVIEW
Telegroup is a rapidly growing global telecommunications company
providing high quality, competitively priced, international and domestic long
distance telecommunications services. The Company established an early
presence in key European, Asia-Pacific and Latin American markets in order to
capitalize on the market opportunity presented by full deregulation and the
telecommunications industry. The Company offers a broad range of
international, national, value-added wholesale and enhanced telecommunications
services to approximately 220,000 small and medium-sized business,
residential and wholesale customers (those that incurred charges in February
1998 and were invoiced) providing service to over 200 countries. Telegroup has
achieved its significant international market penetration by developing what
it believes to be one of the most comprehensive sales, marketing and customer
service organizations in the global telecommunications industry. The Company
operates a reliable, flexible, cost-effective, digital, facilities-based
network (the ''Telegroup Intelligent Global Network(R)'' or ''TIGN''). The
TIGN is one of the largest alternative global telecommunications networks and
consists of 21 Nortel DMS and Excel LNX switches, five enhanced services
platforms, 19,000 miles of owned and leased capacity on nine digital
fiber-optic cable links, leased parallel data capacity and the Company's
Network Operations Centers in Iowa City, Iowa. Telegroup's revenues have
increased from $29.8 million in 1993 to $337.4 million in 1997. In 1993, the
Company had an operating loss of $0.5 million and a net loss of $0.7 million,
compared to an operating loss of $11.8 million and a net loss of $23.7 million
in 1997.
Incorporated in 1989, Telegroup was one of the first resellers of AT&T's
Software Defined Network and Distributed Network Service long distance
services. The Company derived its initial growth by aggregating long distance
services to individuals and small businesses in the U.S. in order to fulfill
large volume commitments to AT&T. In early 1993, Telegroup initiated call
reorigination service in certain countries in Western Europe and the Pacific
Rim. By 1994, more than one half of Telegroup's retail customers were located
outside the United States. At December 31, 1997, the Company had
approximately 54,000 active retail customers within the United States and
approximately 157,000 active retail customers outside the United States. The
Company's network currently includes switches located in Australia, Denmark,
France, Germany, Hong Kong, Italy, Japan, the Netherlands, Switzerland the
U.K. and the U.S., and leased and owned transmission facilities, enabling the
Company to offer a variety of enhanced telecommunications services.
The Company has attained positive EBITDA (as defined in ''Selected
Financial Data'') and net earnings in only one of the last five years--1995.
The Company expects to incur lower gross margins, negative EBITDA and
significant operating losses and net losses for the near term as it incurs
additional costs associated with the development and expansion of the TIGN,
the expansion of its marketing and sales organization, and the introduction of
new telecommunications services. As the development and expansion of the TIGN
continues and the Company attracts customers to its new Telegroup Spectra and
Telegroup Global Access Direct services, the Company expects that its gross
40
margins, EBITDA, and operating and net income will improve. However there can
be no assurance that this will be the case.
Telegroup's revenues are derived from the sale of telecommunications
services to retail customers, typically residential users and small to
medium-sized businesses worldwide and to wholesale customers, typically other
U.S. and non-U.S. telecommunications carriers. The Company's revenues from
retail and wholesale customers represented 67% and 33%, respectively, of the
Company's total revenues for the year ended December 31, 1997. The Company's
retail customer base is diversified both geographically and by customer type.
No single retail customer accounted for more than 1% of the Company's total
revenues for the years ended December 31, 1996 and 1997. Revenues from the
Company's wholesale customers have grown from $1.0 million in 1995, the first
year in which the Company derived revenues from wholesale customers, to $112.4
million for the year ended December 31, 1997. For the year ended December 31,
1997, one wholesale customer in Hong Kong accounted for approximately 13% of
the Company's total revenues. See ''Business--Customers.''
The FCC has adopted certain measures to implement the 1996
Telecommunications Act that will impose new regulatory requirements, including
the requirement that the Company contribute some portion of its
telecommunications revenues to a ''universal service fund'' designated to fund
affordable telephone service for consumers, schools, libraries and rural
healthcare providers. These contributions will become payable beginning in
1998 for all interexchange carriers. Although the FCC has not determined the
precise amount of the contribution, the Company estimates at this time that it
will constitute approximately 4% of its gross revenues from domestic end-user
customers. It is currently anticipated that the Company will add a separate
line item to its invoices to charge customers for this contribution.
The following chart sets forth the Company's combined retail and
wholesale revenues for the year ended December 31, 1997 for each of the
Company's ten largest markets, determined by customers' billing addresses:
Year Ended
December 31, 1997 Percentage of
Country Revenues Total Revenues
------- ------------------ ---------------
(Millions)
United States $124.2 36.8%
Hong Kong 54.6 16.2
Netherlands 21.5 6.4
Australia 15.3 4.5
France 13.9 4.1
Switzerland 12.7 3.8
Germany 11.4 3.4
Sweden 8.7 2.6
Japan 7.0 2.1
Denmark 5.9 1.7
41
During calendar year 1997, the geographic origin of the Company's revenues
was as follows: United States-36.8%; Europe-28.6%; Pacific Rim-25.4%;
Other-9.2%. The Company has developed its wholesale carrier business, which
accounted for 33% of revenues for the year ended December 31, 1997 compared to
16% for the year ended December 31, 1996, primarily by serving wholesale
customers in the U.S. and the Pacific Rim. In addition, the Company has
expanded its Country Coordinator offices and retail marketing activities
primarily in its core markets, six of which are located in Western Europe, and
three in the Pacific Rim. The Company believes that, because its core markets
comprised approximately 64% of the total global long distance
telecommunications market in 1996, according to TeleGeography, the U.S.,
Europe, and Pacific Rim regions will continue to comprise the bulk of the
Company's revenues.
The Company believes its retail services are typically competitively
priced below those of the ITO in each country in which the Company offers its
services. Prices for telecommunications services in many of the Company's core
markets have declined in recent years as a result of deregulation and
increased competition. The Company believes that worldwide deregulation and
increased competition are likely to continue to reduce the Company's retail
revenues per billable minute. The Company believes, however, that any decrease
in retail revenues per minute will be at least partially offset by an increase
in billable minutes by the Company's customers, and by a decreased cost per
billable minute as a result of the expansion of the TIGN and the Company's
ability to use least cost routing in additional markets.
Factors that may affect the Company's revenue growth include competitive
responses from ITOs and alternative service providers in the international
markets in which the Company operates, legal and regulatory changes, and the
availability of interconnection and transmission capacity. While deregulation
may enable the Company to own and operate network facilities in a country, the
Company may experience reduced revenue growth during the initial stages of
deregulation. One example is the European Economic Community market where
traditional call reorigination, which was once competitive, became less
competitive as deregulation was implemented and prices were adjusted by the
ITOs. The ability of the Company to install facilities and network in core
European markets enabled the provision of a superior call-through service to
replace or supplement traditional call reorigination, but during the
transition in services, growth in the revenues of many of the core markets
often remained flat or declined for a period before resuming growth. For 1998,
the Company expects significant change in the operating and regulatory
conditions of its core markets internationally for its retail and wholesale
services, and therefore expected revenue growth could be affected by sudden or
unanticipated consequences of competitive responses and regulatory change.
For example, the Company has significant wholesale business in the Hong Kong
market, where an unanticipated acceleration in deregulation was announced by
the Hong Kong government. The Hong Kong government agreed to compensate HKTI
for the early termination of HKTI's exclusive license on January 1, 1999 to
operate an international gateway and on January 1, 2000 to provide
international circuits. The change in regulations will create a transition
which may have a material adverse effect on the carrier-level
call-reorigination service provided by the Company in that market, which
42
constitutes a significant proportion of the Company's revenue base. However,
as a result of such deregulation, the Company will be able to provide a wide
range of international wholesale, retail and value-added telecommunications
services to new and existing customers in Hong Kong that were previously
prohibited. The current atmosphere of uncertainty, changes in customer
relationships, and the ability to remain price competitive may have a material
adverse effect on the Company's revenues.
For the years ended December 31, 1996 and 1997, 83.8% and 74.4%,
respectively, of the Company's retail revenues were derived from Telegroup
Global Access CallBack services. As the Company's Telegroup Global Access
Direct and Telegroup Spectra service is provided to customers currently using
traditional call-reorigination services, the Company anticipates that revenue
derived from Telegroup Global Access Direct and Telegroup Spectra will
increase as a percentage of retail revenues. However, the Company expects to
continue to market its Telegroup Global Access CallBack service in markets not
served by the TIGN and to use transparent call-reorigination as an alternative
routing methodology for its Telegroup Global Access Direct and Telegroup
Spectra customers where appropriate.
Historically, the Company has not been required to collect VAT (typically
15% to 25% of the sales price) on call-reorigination services provided to
customers in the EU because prior laws deemed such services to be provided
from the U.S. However, Germany and France have adopted rules whereby, as of
January 1, 1997, telecommunications services provided by non-EU based firms
are deemed to be provided where the customer is located. Since April 1, 1997,
Austria, Belgium, Denmark, Finland, Greece, Ireland, Italy, Luxembourg, Spain,
the Netherlands, Portugal, Sweden and the United Kingdom have imposed VAT on
telecommunications services provided by non-EU based companies.
Cost of retail and wholesale revenues is comprised of (i) variable costs
associated with the origination, transmission and termination of voice and
data telecommunications services by other carriers, and (ii) costs associated
with owning or leasing and maintaining switching facilities and circuits. The
Company also includes as a cost of revenues payments resulting from traffic
imbalances under its operating agreement with AT&T Canada. Currently, a
significant portion of the Company's cost of revenues is variable, based on
the number of minutes of use transmitted and terminated over other carriers'
facilities. The Company's gross profitability is driven mainly by the
difference between revenues and the cost of transmission and termination
capacity.
The Company seeks to lower the variable portion of its cost of services
by originating, transporting and terminating a higher portion of its traffic
over the TIGN. However, in the near term, the Company expects that its cost of
revenues as a percentage of revenues will increase as the Company continues
the development and expansion of the TIGN and introduces new
telecommunications services. Subsequently, as the Company increases the volume
and percentage of traffic transmitted over the TIGN, cost of revenues will
increasingly consist of fixed costs associated with leased and owned lines and
the ownership and maintenance of the TIGN, and the Company expects that the
cost of revenues as a percentage of revenues will decline. The Company seeks
43
to lower its cost of revenues by: (i) expanding and upgrading the TIGN by
acquiring owned and leased facilities and increasing volume on these
facilities, thereby replacing a variable cost with a fixed cost and spreading
fixed costs over a larger number of minutes; (ii) negotiating lower cost of
transmission over the facilities owned by other national and international
carriers; and (iii) expanding the Company's least cost routing choices and
capabilities.
The Company generally realizes higher gross margins from its retail
services than from its wholesale services. Wholesale services, however,
provide a source of additional revenue and add significant minutes originating
and terminating on the TIGN, thus enhancing the Company's purchasing power for
leased lines and switched minutes and enabling it to take advantage of volume
discounts. The Company also generally realizes higher gross margins from
direct access services than from call-reorigination. The Company expects its
gross margins to continue to decline in the near term as a result of increased
wholesale revenues as a percentage of total revenues. In addition, the Company
intends to reduce prices in advance of corresponding reductions in
transmission costs in order to maintain market share while attracting new
customers and completing the migration of customers from traditional
call-reorigination to Telegroup Spectra and Telegroup Global Access Direct.
The Company then expects gross margins to improve as the volume and percentage
of traffic originated, transmitted and terminated on the TIGN increases and
cost of revenues is reduced. The Company's overall gross margins may fluctuate
in the future based on its mix of wholesale and retail long distance services
and the percentage of calls using direct access as compared to
call-reorigination, any significant long distance rate reductions imposed by
ITOs to counter external competition, and any risks associated with the
Company agreeing to minimum volume contracts and not achieving the volume
necessary to meet the commitments.
Operating expenses include: (i) selling, general and administrative
expenses; (ii) depreciation and amortization; and (iii) stock option based
compensation.
Selling, general and administrative expenses include: (i) selling
expenses; (ii) general and administrative expenses; and (iii) bad debt
expense. Selling expenses are primarily sales commissions paid to internal
salespersons and independent agents, the primary cost associated with the
acquisition of customers by the Company. The Company's decision to use
independent agents to date has been primarily driven by the low initial fixed
costs associated with this distribution channel, and the agents' familiarity
with local business and marketing practices. The Company strives to reduce its
customer acquisition costs where possible by acquiring successful independent
agents and by developing its internal sales and customer service operations in
countries where there is sufficient market penetration. Sales commissions have
increased over the past three years as the Company's business has expanded.
The Company anticipates that, as revenues from the Telegroup Global Access
Direct, Telegroup Spectra, and wholesale carrier services increase relative to
its existing services, selling expense will decline as a percentage of
revenue, because of the generally lower commission structure associated with
these services.
44
The general and administrative expense component includes salaries and
benefits, other corporate overhead costs and costs associated with the
operation and maintenance of the TIGN. These costs have increased due to the
development and expansion of the TIGN and corporate infrastructure. The
Company expects that general and administrative expenses may increase as a
percentage of revenues in the near term as the Company incurs additional costs
associated with the development and expansion of the TIGN, the expansion of
its marketing and sales organization, and the introduction of new
telecommunications services.
The Company spends considerable resources to collect receivables from
customers who fail to make payment in a timely manner. While the Company
continually seeks to minimize bad debt, the Company's experience indicates
that a certain portion of past due receivables will never be collected, and
that such bad debt is a necessary cost of conducting business in the
telecommunications industry. Expenses attributable to the write-off of bad
debt represented approximately 3.1%, 2.4% and 2.5% of revenues for the years
ended December 31, 1995, 1996 and 1997, respectively. In addition to
uncollectible receivables, the telecommunications industry has historically
been exposed to a variety of forms of customer fraud. The TIGN and the
Company's billing systems are designed to detect and minimize fraud, where
practicable, and the Company continuously seeks to enhance and upgrade its
systems in an effort to minimize losses as it expands into new markets.
As the Company begins to integrate its distribution network in selected
strategic locations by acquiring Country Coordinators and independent agents
or by establishing internal sales organizations, it may incur added selling,
general and administrative expenses associated with the transition which may
result, initially, in an increase in selling, general and administrative
expenses as a percentage of revenues. The Company anticipates, however, that
as sales networks become fully integrated, new service offerings are
implemented, and economies of scale are realized, selling, general and
administrative expenses will decline as a percentage of revenue.
Depreciation and amortization expense primarily consists of expenses
associated with the depreciation of assets, amortization of goodwill derived
from business combinations and the amortization of debt issuance costs
associated with the private placement of the Company's Senior Subordinated
Notes in November 1996.
Stock option based compensation expense results from the granting of
certain non-qualified and performance based options to employees at exercise
prices below that of fair market value at the date of grant or when specified
performance criteria have been met. As a result of certain non-qualified stock
option grants during 1996, the Company incurred stock option based
compensation expense of $342,000 in 1997 and expects to incur stock option
based compensation expense of $342,000 and $283,000 in 1998 and 1999,
respectively.
RESULTS OF OPERATIONS
The following table sets forth for the periods indicated certain
financial data as a percentage of revenues.
45
PERCENTAGE OF REVENUES
Year Ended December 31,
1995 1996 1997
---- ---- ----
Revenues................................. 100.0% 100.0% 100.0%
Cost of revenues......................... 64.4 70.6 75.8
Gross profit............................. 35.6 29.4 24.2
Operating expenses:
Selling, general and administrative... 30.4 28.0 26.1
Depreciation and amortization......... 0.5 0.8 1.5
Stock option based compensation - 0.5 0.1
Total operating expenses................. 30.9 29.3 27.7
Operating income (loss).................. 4.7 0.1 (3.5)
Income tax benefit (expense)............. (2.0) 0.0 0.2
Extraordinary item, loss on
extinguishment of debt, net of
income taxes.......................... - - (3.0)
Net earnings (loss)...................... 3.0 (0.1) (7.0)
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
REVENUES. Revenues increased 58.3%, or $124.2 million, from $213.2
million in the year ended December 31, 1996, to $337.4 in the year ended
December 31, 1997. This increase was primarily due to growth in international
and domestic retail sales and international and domestic wholesale revenues.
Wholesale revenues increased from $34.1 million, or 16.0% of total revenues in
the year ended December 31, 1996, to $112.4 million or 33.3% of revenues for
the year ended December 31, 1997.
COST OF REVENUES. Cost of revenues increased 69.9%, or $105.2 million,
from $150.5 million in the year ended December 31, 1996 to $255.7 million in
the year ended December 31, 1997. As a percentage of revenues, cost of
revenues increased from 70.6% to 75.8%, primarily as a result of a larger
percentage of lower margin wholesale revenues, the competitive price effects
of deregulation in certain of the Company's core markets, such as France and
the Netherlands, in advance of corresponding carrier cost declines, and the
further addition of fixed recurring costs associated with the expansion of the
network
OPERATING EXPENSES. Operating expenses increased 49.4%, or $30.9
million, from $62.6 million in the year ended December 31, 1996, to $93.5
million in the year ended December 31, 1997, primarily as a result of an
increase in the number of employees necessary to provide network and systems
development and support, customer service, billing, collection and accounting
support, as well as increased sales commissions related to revenue growth.
Other contributing factors were bad debt, depreciation and amortization, as
discussed below. As a percentage of revenues, operating expenses decreased
1.6% from 29.3% in the year ended December 31, 1996, to 27.7% in the year
ended December 31, 1997.
BAD DEBT. Bad debt expense increased from $5.1 million, or 2.4% of
revenues in the year ended December 31, 1996, to $8.5 million, or 2.5% of
46
revenues, in the year ended December 31, 1997. The increase in bad debt
expense as a percentage of revenues in the year ended December 31, 1997, was
due primarily to the write-off of accounts receivable for services rendered to
a single domestic customer during the first quarter of 1997. Services to this
customer were discontinued.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased
from $1.9 million in the year ended December 31, 1996, to $5.0 million in the
year ended December 31, 1997, primarily due to increased capital expenditures
incurred in connection with the development and expansion of the TIGN during
the year ended December 31, 1997, as well as amortization expenses associated
with intangible assets.
OPERATING INCOME. Operating income decreased by $11.9 million, from
$0.1 million in the year ended December 31, 1996, to $(11.8) million in the
year ended December 31, 1997, primarily as a result of the foregoing factors.
EXTRAORDINARY ITEM. The Company recorded an extraordinary item, loss on
extinguishment of debt, of approximately $10.0 million, net of tax, in the
third quarter of 1997 resulting from the prepayment of the Senior Subordinated
Notes.
NET LOSS. Net loss increased approximately $23.6 million, from $0.1
million in the year ended December 31, 1996, to $23.7 million in the year
ended December 31, 1997. The increase was attributable to lower operating
income, a $2.0 million increase in net interest expense, a $0.5 million
increase in foreign currency transaction losses and an extraordinary charge of
$10.0 million for loss on early extinguishment of debt. The foreign currency
transaction losses resulted primarily from a strengthening of the US Dollar in
such period versus foreign currencies in which the Company had unhedged
positions.
EBITDA. EBITDA decreased from $3.0 million in the year ended December
31, 1996, to $(6.8) million in the year ended December 31, 1997.
YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995
REVENUES. Revenues increased 65.1%, or $84.1 million, from $129.1
million in 1995 to $213.2 million in 1996. The increase in revenues was due
primarily to an increase in billed customer minutes from the domestic and
international call-reorigination distribution channels and the first full year
of wholesale carrier operations. Revenues from international and domestic
retail call service usage increased by 39.8%, or $51.0 million, from $128.1
million in 1995 to $179.1 million in 1996. Revenues from wholesale carrier
service usage increased by $33.1 million, from $1.0 million in 1995 to $34.1
million in 1996. The wholesale revenue growth is largely the result of a
significant increase in traffic utilization from one international carrier,
using carrier level, value-added call-reorigination to service its market more
competitively.
COST OF REVENUES. Cost of revenues increased 81.1%, or $67.4 million,
from $83.1 million in 1995, to $150.5 million in 1996. The increase in cost of
revenues was attributable primarily to increased traffic being handled by the
47
Company and increased costs associated with the expansion of the TIGN. The
increase in cost of revenues as a percent of revenues was attributable
primarily to the greater increase in the wholesale business as a percentage of
revenues. Other factors contributing to the increase in cost of revenues as a
percent of revenues included volume discounts to one large wholesale customer
in the fourth quarter of 1996, traffic rerouting penalties associated with
certain wholesale carrier traffic that exceeded the capacity of the Company's
network in the first two months of the fourth quarter; certain rate reductions
to customers in the U.S., Japan and France ahead of corresponding carrier cost
declines and the addition of fixed access costs associated with the expansion
of the TIGN.
The cost of revenues as a percentage of total revenues increased from
64.4% in 1995 to 70.6% in 1996. Of the contributing factors identified above,
increases in wholesale business accounted for 3.0%, volume discounts being
offered accounted for 1.0% and rate reductions to customers in advance of
corresponding rate decreases from carriers and other factors accounted for the
additional 2.2% of the difference.
GROSS PROFIT. Gross profit increased 36.3%, or $16.7 million, from
$46.0 million in 1995 to $62.7 million in 1996. As a percentage of revenues,
gross profit decreased from 35.6% in 1995 to 29.4% in 1996.
OPERATING EXPENSES. Operating expenses increased 56.9%, or $22.7
million, from $39.9 million in 1995 to $62.6 million in 1996. This increase
was primarily due to greater employee and contract employee costs,
professional fees for network and operating systems developers and legal,
financial and accounting costs associated with the development of the TIGN and
the supporting information and financial systems. From 1995 to 1996, the
Company's staff levels grew from 296 full and part time positions to 444 full
and part time positions, representing a 50.0% increase in the number of
employees. Growth was mainly in the professional category, with the hiring of
additional telecommunications technicians and programmers, and finance and
accounting professionals.
Bad debt expense increased $1.1 million, from $4.0 million in 1995, to
$5.1 million in 1996. As a percentage of revenues, bad debt expense decreased
from 3.1% in 1995 to 2.4% in 1996, primarily as a result of improvements in
the Company's collections systems and procedures.
Depreciation and amortization increased $1.2 million, from $0.7 million
in 1995, to $1.9 million in 1996. The increase in depreciation and
amortization is primarily attributable to increased capital expenditures
incurred in connection with the development and expansion of the TIGN and
amortization of goodwill associated with: (i) the acquisition of the
operations of the Company's Country Coordinator in France in August 1996; and
(ii) expenses incurred by the Company in connection with the private placement
of its Senior Subordinated Notes in November 1996.
The Company also incurred a non-cash stock option based compensation
expense of $1.0 million in the fourth quarter of 1996, resulting from the
grant of non-qualified and performance base stock options to certain
employees.
48
As a percentage of revenues, operating expenses decreased from 30.9% in
1995 to 29.3% in 1996, as the additional costs and expenses were more than
offset by increased revenues during the period.
OPERATING INCOME. Operating income decreased by $6.0 million, from $6.1
million in 1995 to $0.1 million in 1996. As a percentage of revenues,
operating income decreased from 4.7% in 1995 to 0.1% in 1996, for the reasons
discussed above.
INTEREST EXPENSE. Interest expense increased from $0.1 million for 1995
to $0.6 million for 1996, an increase of $0.5 million. The increase is
directly attributable to the increase in long-term indebtedness during 1996.
NET EARNINGS (LOSS). Net earnings decreased $3.9 million from $3.8
million in 1995 to $(0.1) million in 1996.
EBITDA. EBITDA decreased from $7.0 million in 1995, to $3.0 million
in 1996.
49
SELECTED QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
First Second Third Fourth
1996 Quarter Quarter Quarter Quarter
---- -------- ------- ------- --------
Revenues $43,350,540 47,276,416 57.151,685 65,428,868
Cost of Revenues 27,741,329 32,199,361 40,853,396 49,742,773
---------- ---------- ---------- ----------
Gross Profit 15,609,211 15,077,055 16,298,289 15,686.095
---------- ---------- ---------- ----------
Net earnings (loss) 1,387,527 358,651 303,374 (2,167,874)
---------- ---------- ---------- -----------
---------- ---------- ---------- -----------
Basic and diluted net
earnings (loss) 0.06 0.01 0.01 (0.08)
---------- ---------- ---------- -----------
---------- ---------- ---------- -----------
First Second Third Fourth
1997 Quarter Quarter Quarter Quarter
---- -------- ------- ------- --------
Revenues $74,095,777 80,061,005 84,321,304 98,954,326
Cost of Revenues 53,282,940 59,113,863 61,876,405 81,467,470
----------- ---------- ---------- ----------
Gross Profit 20,812,837 20,947,142 22,444,899 17,486,856
Earnings (loss) before
extraordinary item (277,012) (1,010,686) (1,561,160)(10,904,937)
----------- ---------- ---------- ----------
Net earnings (loss) (277,012) (1,010,686) (1,561,160)(10,904,937)
Basic and diluted earnings
(loss) per common share
before extraordinary item (0.01) (0.04) (0.05) (0.35)
------------ ---------- ---------- ----------
Extraordinary item - - (0.33) -
Basic and diluted net
earnings (loss) (0.01) (0.04) (0.38) (0.35)
---------- ---------- ---------- -----------
---------- ---------- ---------- -----------
In the fourth quarter of 1997, the Company increased its valuation allowance
to equal the net deferred tax assets at December 31, 1997, including an
allowance for the net deferred tax assets of $908,219 at September 30, 1997.
The effect of this adjustment in the fourth quarter was an increase in the net
loss by $0.03 per common share.
50
LIQUIDITY AND CAPITAL RESOURCES
Historically, the Company's capital requirements have consisted of
capital expenditures in connection with the acquisition and maintenance of
switching capacity and funding of accounts receivable and other working
capital requirements. The Company's capital requirements have been funded
primarily by funds provided by operations, term loans and revolving credit
facilities from commercial banks, and by capital leases. The Company may
require additional capital to develop and expand the TIGN, open new offices,
introduce new telecommunications services, upgrade and/or replace its
management information systems, fund its acquisition plans, and fund its
anticipated operating losses and net cash outflows in the near term. In
addition, the implementation of the Company's strategy to develop an ATM-based
network is dependent on, among other things, the ability of the Company to
obtain additional financing. The Company may seek to raise such additional
capital from public or private equity and/or debt sources. There can be no
assurance that the Company will be able to obtain the additional financings or
if obtained, that it will be able to do so on a timely basis or on terms
favorable to the Company.
The Company currently anticipates entering into a new credit facility for
available borrowings in an amount not expected to exceed $20 million with a
bank or other financial institution.
In July, the Company completed an IPO, issuing 4 million shares at a
price to the public of $10 per share, yielding $40 million of gross proceeds.
In August, an additional 450,000 shares were issued pursuant to the exercise
of the underwriters' over-allotment option, yielding an additional $4.5
million of gross proceeds. The net proceeds to the Company from the IPO
(including the over-allotment issue), after fees and other expenses, were
approximately $39.8 million. Approximately $8.6 million has been used as of
December 31, 1997 to expand the TIGN, including the purchase of 60% of the
stock of PCS Telecom, Inc.; approximately $12.9 million was used for
prepayment of the outstanding $20 million in Senior Subordinated Notes. The
Company expects that an additional $17.2 million will be used to further
expand the TIGN and the balance, $1.1 million, will be used for working
capital.
On September 5, 1997, the Company prepaid in full all of its outstanding
Senior Subordinated Notes. The Company paid $21,400,000, which included
$20,000,000 in principal and $1,400,000 for a prepayment penalty. In
addition, the Company recognized a loss of $8,741,419 and $1,298,882 for the
write-off of the unamortized original issue discount and debt issuance costs,
respectively. The early extinguishment of the Senior Subordinated Notes is
reflected on the statement of operations as an extraordinary item, net of
income taxes. The Company financed the prepayment of the Senior Subordinated
Notes with $12.9 million of the net proceeds from the IPO and $8.5 million of
borrowings under the Revolving Credit Facility.
51
On September 30, 1997, the Company consummated a private placement of
$25 million aggregate principal amount of Convertible Notes. The Convertible
Notes are eligible for resale under Rule 144A of the Securities Act. The net
proceeds to the Company from the issuance of the Convertible Notes were
approximately $24.1 million and approximately $15.0 million of such net
proceeds were used to repay all amounts outstanding under the Revolving Credit
Facility. Unless redeemed by the Company previously, the Convertible Notes
are convertible into Common Stock of the Company at the conversion price of
$12 per share.
On October 23, 1997, the Company consummated a private placement of $97
million aggregate principal amount at maturity of its Senior Discount Notes,
receiving gross proceeds of approximately $72.1 million. The Senior Discount
Notes will accrete in value from the date of issuance to May 1, 2000, at a
rate of 10 1/2% per annum, compounded semi-annually. Cash interest on the
Senior Discount Notes will neither accrue nor be payable prior to May 1, 2000.
Commencing May 1, 2000, interest will be payable in cash on the Senior
Discount Notes semi-annually in arrears on each May 1, and November 1, at a
rate of 10 1/2% per annum. The Senior Discount Notes will mature on November
1, 2004. On March 4, 1998, all of the privately placed Senior Discount Notes
were exchanged for Senior Discount Notes that are registered under the
Securities Act.
Net cash provided by (used in) operating activities was $4.9 million in
the year ended December 31, 1996 and $(12.8) million in the year ended
December 31, 1997. The net cash provided by operating activities in the year
ended December 31, 1996 was primarily due to an increase in the provision for
credit losses on accounts receivable and an increase in accounts payable,
commissions payable and accrued expenses partly offset by an increase in
accounts receivable. The net cash used in operating activities in the year
ended December 31, 1997 was primarily due to the net loss and an increase in
accounts receivable, partly offset by an increase in depreciation and
amortization expense, the loss on early extinguishment of debt, the increase
in the provision for credit losses on accounts receivable, and an increase in
accounts payable, commissions payable and accrued expenses. The $4.5 million
increase in deposits and other assets in the year ended December 31, 1997, was
due primarily to deposits on major accounting and billing software systems not
yet in service at year end.
Net cash used in investing activities was $(11.3) million in the year
ended December 31, 1996, and $(42.5) million in the year ended December 31,
1997. The net cash used in the year ended December 31, 1996 was primarily due
to increases in equipment purchases. The net cash used in the year ended
December 31, 1997 was primarily due to increases in equipment purchases and
purchases of securities available-for-sale.
Net cash provided by financing activities was $15.9 million in the year
ended December 31, 1996, and $115.6 million in the year ended December 31,
1997. The net cash provided in the year ended December 31, 1996, was
primarily due to proceeds from long-term borrowings. The net cash provided in
the year ended December 31, 1997, was primarily due to proceeds from the IPO
and long-term borrowings.
52
The development and expansion of the TIGN, the upgrade and/or replacement
of the Company's management information systems, the opening of new offices,
the introduction of new telecommunications services, funding future
acquisitions, as well as the funding of anticipated losses and net cash
outflows, may require additional capital. The Company has identified a total
of $79 million of capital expenditures, including acquisitions, which the
Company intends to undertake in 1998.
The Company expects that the net proceeds from the IPO, the Convertible
Notes and the Senior Discount Notes will provide the Company with sufficient
capital to fund planned capital expenditures and anticipated operating losses
through December 1998. The net proceeds from the IPO, the Convertible Notes
and the Senior Discount Notes are expected to provide sufficient funds for the
Company to expand its business as planned and to fund anticipated operating
losses and net cash outflows through December, 1998. The amount of the
Company's actual future capital requirements will depend upon many factors,
including the performance of the Company's business, the rate and manner in
which it expands the TIGN, increases staffing levels and customer growth,
upgrades or replacements to management information systems and opening of new
offices, acquisitions, as well as other factors that are not within the
Company's control, including competitive conditions, general economic
conditions, and regulatory or other government actions. In the event that the
Company's plans or assumptions change or prove to be inaccurate or internally
generated funds and funds from other financings, if obtained, prove to be
insufficient to fund the Company's growth and operations, then some or all of
the Company's development and expansion plans could be delayed or abandoned.
FOREIGN CURRENCY
Although the Company's functional currency is the U.S. Dollar, the
Company derives a substantial percentage of its telecommunications revenues
from international sales. In countries where the local currency is freely
exchangeable and the Company is able to hedge its exposure, the Company bills
for its services in the local currency. In cases where the Company bills in a
local currency, the Company is exposed to the risk that the local currency
will depreciate between the date of billing and the date payment is received.
In certain countries in Europe, the Company purchases foreign exchange
contracts through its fiscal agent to hedge against this foreign exchange
risk. For the year ended December 31, 1997, approximately $74.3 million (U.S.
Dollar equivalent) or 22.0% of the Company's billings for telecommunications
services were billed in currencies other than the US dollar with a significant
percentage of these billings covered by foreign forward exchange contracts.
The Company's financial position and results of operations for the year
ended December 31, 1997 were not significantly affected by foreign currency
exchange rate fluctuation. As the Company continues to expand the TIGN and
increase its customer base in its targeted markets, an increasing proportion
of costs associated with operating and maintaining the TIGN, as well as local
selling expenses, will be billed in foreign currencies. Although the Company
attempts to match costs and revenues and borrowings and repayments in terms of
local currencies, there will be many instances in which costs and revenues and
53
borrowings and repayments will not be matched with respect to currency
denominations. The Company may choose to limit any additional exposure to
foreign exchange rate fluctuations by the purchase of foreign forward exchange
contracts. There can be no assurance that any currency hedging strategy would
be successful in avoiding exchange-related losses.
COMMITMENTS WITH TELECOMMUNICATIONS COMPANIES
The Company has an agreement with Sprint Communications Company L.P.
(Sprint) to use Sprint's fiber-optic network in its delivery of
telecommunication services. This agreement requires net quarterly usage
commitments of $6,000,000. In the event such quarterly commitments are not
met, the Company is required to remit to Sprint 25% of the difference between
the $6,000,000 quarterly commitment and actual usage. This agreement extends
through December 1998. When total usage exceeds $24,000,000 during 1998, the
Company has no further commitment.
The Company has a one year $3,000,000 usage commitment with MFS/WorldCom
in Frankfurt, Germany, to use MFS/WorldCom's fiber-optic network in its
delivery of telecommunication services. This agreement began on September 5,
1997.
The Company has an agreement with Meyer Group Limited (Meyer) with a
usage commitment to terminate $3,000,000 in Hong Kong call traffic on Meyer's
network by December 31, 1998. The Company's commitment on this agreement is
contingent upon the Company's network remaining operational in the Hong Kong
market.
Shortfalls in usage commitments, if any, are recorded as cost of revenues
in the period identified.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
SFAS 130, ''Reporting Comprehensive Income,'' was issued in June 1997 and
is effective in the first quarter of 1998. It establishes standards for
reporting and display of comprehensive income and its components in a full set
of general-purpose financial statements.
SFAS 131, ''Disclosures about Segments of an Enterprise and Related
Information,'' was issued in June 1997 and is effective for periods beginning
after December 15, 1997. It establishes standards for the way that public
business enterprises report information about operating segments in annual
financial statements and requires that those enterprises report selected
information about operating segments in interim financial reports issued to
shareholders. It also establishes standards for related disclosures about
products and services, geographic areas, and major customers. The Company
believes that adoption of this standard in 1998 will not have a significant
effect on its segment reporting in the consolidated financial statements.
EFFECTS OF INFLATION
Inflation is not a material factor affecting the Company's business and
54
has not had a significant effect on the Company's operations to date.
SEASONAL FLUCTUATIONS
The Company has historically experienced, and expects to continue to
experience, reduced growth rates in revenues in the months of August and
December due to extended vacation time typically taken by Americans and
Europeans during these months.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
Not applicable.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements of the Company together with the
reports thereon of KPMG Peat Marwick LLP (dated March 6, 1998), set forth on
pages F-1 through F-23 herein are incorporated by reference in this Item 8
(see Item 14 of this Form 10-K for the Index).
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 appears in and is incorporated by
reference herein from the Company's Proxy Statement for its 1998 Annual
Meeting of Shareholders (the "Proxy Statement").
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 appears in and is incorporated by
reference herein from the Proxy Statement, except for the sections entitled
"Compensation Committee Report on Executive Compensation" and "Performance
Graph" which shall not be deemed to be incorporated herein.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 12 appears in and is incorporated by
reference herein from the Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 appears in and is incorporated by
reference herein from the Proxy Statement.
55
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as a part of this Annual Report on
Form 10-K:
1. Financial Statements
Independent Auditors' Report
Consolidated Balance Sheets
- December 31, 1996
- December 31, 1997
Consolidated Statement of Operations
- Year ended December 31, 1995
- Year ended December 31, 1996
- Year ended December 31, 1997
Consolidated Statements of Shareholders' Equity
Consolidated Statements of Cash Flows
- Year ended December 31,1995
- Year ended December 31, 1996
- Year ended December 31, 1997
Notes to Consolidated Financial Statements
2. All Financial Statement Schedules other than those listed
below have been omitted because they are not required under the instructions
to the applicable accounting regulations of the Securities and Exchange
Commission or the information to be set forth therein is included in the
financial statements or in the notes thereto. The following additional
financial data included on pages F-23 and F-24 should be read in conjunction
with the financial statements set forth on pages F-1 through F-22 of this
Annual Report on Form 10-K:
Independent Auditors' Report
Schedule II--Valuation and Qualifying Accounts
3. Exhibits
The exhibits filed or incorporated by reference as part of
this report are set forth in the Index of Exhibits on page 82 of this Annual
Report on Form 10-K.
56
(b) Reports on Form 8-K.
Date of Report Date of Filing Description
-------------- -------------- -----------
October 9, 1997 October 10, 1997 Company in negotiations
to acquire all of the
outstanding capital
stock of World Tele-
communications
Corporation Limited
October 9, 1997 October 10, 1997 Commencement of a
private offering of debt
securities to certain
qualified investors
yielding up to $75
million gross proceeds
to the Company.
August 14, 1997 October 28, 1997 Unaudited pro forma
financial statements of
Telegroup and its
subsidiaries and PCS
Telecom, Inc. giving
effect to the IPO and
the Company's
acquisition of PCS
Telecom's common stock
accounted for as a
purchase in accordance
with generally accepted
accounting principles.
August 14, 1997 October 29, 1997 Amending the Form 8-K
filed on October 28,
1997
October 31, 1997 November 4, 1997 Terminating negotiations
to acquire all of the
outstanding capital
stock of World
Telecommunications
Corporation Limited
November 25, 1997 December 9, 1997 Acquisition of certain
property and equipment
from Fastnet UK Limited
for $239,920.85.
November 25, 1997 January 13, 1998 Amending the Form 8-K
filed on December 9,
1997 regarding Fastnet
UK Limited
(c) Exhibits.
Refer to Item 14(a)(3) above, for Exhibits required by Item
601 of Regulation S-K.
57
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.
TELEGROUP, INC.
Date: March 30, 1998 By: *
---------------------------
Clifford Rees
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities on March 30, 1998.
*
- ----------------------- Chairman of the Board and Director
Fred Gratzon
*
- ------------------------ Chief Executive Officer and
Clifford Rees Director (Principal Executive
Officer)
*
- --------------------------- President, Chief Operating Officer
Steven J. Baumgartner and Director
*
- --------------------------- Vice President-Finance, Chief
Douglas A. Neish Financial Officer, and Director
(Principal Financial Officer)
*
- --------------------------- Director of Finance and Controller
Gary Korf (Principal Accounting Officer)
*
- --------------------------- Senior Vice President-International
Ronald B. Stakland Marketing and Operations
*
- ----------------------------- Director
J. Sherman Henderson III
*
- ----------------------------- Director
Rashi Glazer
/s/ Charles Johanson Attorney-in-Fact
- -----------------------------
Charles Johanson
*Charles Johanson, by signing his name hereto, signs this document on behalf
of each of the persons so indicated above pursuant to powers of attorney duly
executed by such persons and filed with the Securities and Exchange
Commission.
58
TABLE OF CONTENTS
TELEGROUP, INC. AND SUBSIDIARIES
- ----------------------------------------------------------------------------
Page
----
Independent Auditors' Report F-2
Consolidated Balance Sheets as of December 31, 1996 and 1997 F-3
Consolidated Statements of Operations for the years ended
December 31, 1995, 1996 and 1997 F-5
Consolidated Statements of Shareholders' Equity for the years
ended December 31, 1995, 1996 and 1997 F-6
Consolidated Statements of Cash Flows for the years ended
December 31, 1995, 1996 and 1997 F-7
Notes to Consolidated Financial Statements F-9
Independent Auditors' Report on Financial Statement Schedules F-23
Schedule II - Valuation and Qualifying Accounts F-24
F-1
59
INDEPENDENT AUDITORS' REPORT
The Board of Directors
Telegroup, Inc.:
We have audited the accompanying consolidated balance sheets of Telegroup,
Inc. and subsidiaries as of December 31, 1996 and 1997, and the related
consolidated statements of operations, shareholders' equity, and cash flows
for each of the years in the three-year period ended December 31, 1997. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Telegroup,
Inc. and subsidiaries as of December 31, 1996 and 1997, and the results of its
operations and its cash flows for each of the years in the three-year period
ended December 31, 1997, in conformity with generally accepted accounting
principles.
Lincoln, Nebraska
March 6, 1998
F-2
60
TELEGROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 1996 and 1997
- ----------------------------------------------------------------------------
December 31,
------------
1996 1997
---- ----
Assets
Current assets:
Cash and cash equivalents..................... $14,155,013 $ 74,213,856
Securities available-for-sale - 21,103,030
Accounts receivable and unbilled services,
less allowance for credit losses of
$3,321,119 in 1996, and $6,173,846 in 1997.. 32,288,507 54,188,757
Income tax recoverable........................ 1,796,792 2,693,679
Deferred income taxes (note 8)............... 1,392,058 -
Prepaid expenses and other assets............. 245,271 1,384,886
Receivables from shareholders................. 14,974 39,376
Receivables from employees.................... 85,539 152,259
---------- -----------
Total current assets........................ 49,978,154 153,775,843
---------- -----------
Net property and equipment (note 5)............. 11,256,139 27,912,978
---------- -----------
Other assets:
Deposits and other assets................... 376,614 3,594,101
Goodwill, net of amortization of $22,768 in
1996 and $142,203 in 1997 (note 3)......... 1,001,841 3,102,707
Capitalized software, net of amortization
(note 1)................................... 1,906,655 1,724,758
Debt issuance costs, net of amortization
(note 2)................................... 1,437,004 3,648,026
---------- ----------
$ 4,722,114 $ 12,069,592
---------- -----------
Total assets................................ $65,956,407 $193,758,413
---------- -----------
---------- -----------
(Continued)
F-3
61
TELEGROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (Continued)
December 31, 1996 and 1997
- -----------------------------------------------------------------------------
December 31,
------------
1996 1997
---- ----
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable.............................. 30,719,562 48,434,985
Commissions payable........................... 5,857,342 7,691,401
Accrued expenses.............................. 2,703,699 4,479,515
Customer deposits............................. 602,940 778,024
Unearned revenue.............................. 64,276 186,779
Current portion of capital lease obligations
(note 6).................................... 138,309 158,706
Current portion of long-term debt (note 2).... 232,596 93,788
---------- ----------
Total current liabilities................... 40,318,724 61,823,198
---------- ----------
Deferred income taxes (note 8).................. 756,891 -
Capital lease obligations, excluding current
portion (note 6).............................. 301,393 221,179
Long-term debt excluding current portion
(note 2)....................................... 11,216,896 101,450,951
Minority interest (note 3)...................... - -
Shareholders' equity (note 7):
Common stock, no par or stated value;
150,000,000 shares authorized, 26,211,578
and 30,889,945 issued and outstanding in
1996 and 1997, respectively.................. - -
Additional paid-in capital.................... 10,765,176 51,649,660
Retained earnings (deficit)................... 2,599,530
(21,125,080)
Foreign currency translation adjustment....... (2,203)
(261,495)
----------- ----------
Total shareholders' equity.................. 13,362,503 30,263,085
Commitments and contingencies (note 9)
----------- -----------
Total liabilities and shareholders' equity.. $ 65,956,407 $193,758,413
----------- -----------
----------- -----------
See accompanying notes to consolidated financial statements.
F-4
62
TELEGROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
- ------------------------------------------------------------------------------
December 31,
------------
1995 1996 1997
---- ---- ----
Revenues:
Retail............................. $128,138,947 179,146,795 225,023,507
Wholesale.......................... 980,443 34,060,714 112,408,905
----------- ----------- -----------
Total revenues................... 129,119,390 213,207,509 337,432,412
Cost of revenues..................... 83,100,708 150,536,859 255,740,678
----------- ----------- -----------
Gross profit....................... 46,018,682 62,670,650 81,691,734
----------- ----------- -----------
Operating expenses:
Selling, general and administrative
expenses.......................... 39,221,849 59,651,857 88,176,934
Depreciation and amortization...... 654,966 1,881,619 4,995,146
Stock option-based compensation.... - 1,032,646 342,380
----------- ----------- -----------
Total operating expenses......... 39,876,815 62,566,122 93,514,460
----------- ----------- -----------
Operating income (loss).......... 6,141,867 104,528 (11,822,726)
----------- ----------- -----------
Other income (expense):
Interest expense................... (120,604) (578,500) (4,208,385)
Interest income.................... 193,061 377,450 2,014,604
Foreign currency transaction (loss) (101,792) (147,752) (604,436)
Other.............................. 298,627 118,504 290,622
----------- ----------- -----------
Earnings (loss) before income taxes
and extraordinary item.............. 6,411,159 (125,770) (14,330,321)
Income tax benefit (expense) (note 8). (2,589,700) 7,448 576,526
Minority interest in shares of (loss). - - -
----------- ----------- -----------
Earnings (loss) before extraordinary
item................................. 3,821,459 (118,322) (13,753,795)
Extraordinary item, loss on
extinguishment of debt, net of
income tax benefit of $1,469,486
(note 2)............................. - - (9,970,815)
----------- ----------- -----------
Net earnings (loss)............... $3,821,459 (118,322) (23,724,610)
----------- ----------- -----------
----------- ----------- -----------
Basic and diluted earnings (loss)
per common share:
Earnings (loss) before
extraordinary item................ 0.16 (0.00) (.049)
----------- ----------- -----------
----------- ----------- -----------
Extraordinary item................. - - (0.35)
----------- ----------- -----------
Net earnings (loss)................ $ 0.16 (0.00) (0.84)
----------- ----------- -----------
----------- ----------- -----------
Weighted-average common shares
outstanding - basic and undiluted..... 24,651,989 25,091,482 28,324,123
----------- ----------- -----------
----------- ----------- -----------
See accompanying notes to consolidated financial statements.
F-5
63
TELEGROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT)
YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
- -----------------------------------------------------------------------------
Foreign Total
Additional Retained currency shareholders'
Common Stock paid-in earnings translation equity
Shares Amount capital (deficit) adjustment (deficit)
------ ------ ---------- --------- ---------- ----------
Balances at
January 1, 1995 24,651,989 $ - 4,595 (153,607) - (149,012)
Dividends....... - - - (525,000) - (525,000)
Net earnings.... - - - 3,821,459 - 3,821,459
---------- ----- ------ --------- --------- ------------
Balances at
December 31,
1995........... 24,651,989 - 4,595 3,142,852 - 3,147,447
Dividends....... - - - (425,000) - (425,000)
Net loss........ - - - (118,322) - (118,322)
Issuance of
common stock... 1,297,473 - 52,366 - - 52,366
Notes receivable
from shareholders
for common stock. - - (52,366) - - (52,366)
Shares issued in
connection with
business
combinations
(note 3)......... 262,116 - 573,984 - - 573,984
Compensation
expense in
connection with
stock option plan
(note 7)......... - - 1,032,646 - - 1,032,646
Warrants issued in
connection with the
Private Offering
(note 7).......... - - 9,153,951 - - 9,153,951
Change in foreign
currency
translation....... - - - - (2,203) (2,203)
-------- ---- --------- -------- -------- ---------
Balances at
December 31,
1996.............26,211,578 - 10,765,176 2,599,530 (2,203) 13,362,503
Net loss......... - - - (23,724,610) - (23,724,610)
Issuance of
shares, net of
offering
expenses........ 4,450,000 - 39,825,343 - - 39,825,343
Shares issued in
connection with
business
combination
(note 3)......... 40,000 - 470,000 - - 470,000
Compensation
expense in
connection with
stock option plan
(note 7)......... - - 342,380 - - 342,380
Issuance of shares
for options
exercised (note 7) 188,367 - 246,761 - - 246,761
Change in foreign
currency trans-
lation........... - - - - (259,292) (259,292)
-------- ---- ------- ------- --------- ---------
Balances at
December 31,
1997............ 30,889,945 $ - 51,649,660 (21,125,080) (261,495) 30,263,085
---------- ----- ----------- ------------ --------- ----------
---------- ----- ----------- ------------ --------- ----------
See accompanying notes to consolidated financial statements.
F-6
64
TELEGROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
- -----------------------------------------------------------------------------
December 31,
------------
1995 1996 1997
---- ---- -----
Cash flows from operating activities:
Net earnings (loss)..................... $ 3,821,459 (118,322) (23,724,610)
Adjustments to reconcile net earnings
(loss) to net cash provided by
operating activities:
Depreciation and amortization........... 654,966 1,881,619 4,995,146
Deferred income taxes................... (937,200) 229,933 635,167
Loss on sale of equipment............... 261,241 - 227,672
Loss on extinguishment of debt.......... - - 10,040,301
Provision for credit losses on
accounts receivable.................... 3,981,525 5,124,008 8,503,414
Accretion of debt discounts............. - 48,077 1,874,090
Stock option-based compensation expense. - 1,032,646 342,380
Changes in operating assets and
liabilities, excluding the effects
of business combinations:
Accounts receivable and unbilled
services............................... (14,571,500) (14,199,095) (30,092,707)
Prepaid expenses and other assets....... 145,656 (134,946) (1,089,645)
Deposits and other assets............... 157,762 (80,001) (4,555,632)
Accounts payable, commissions
payable, and accrued expenses.......... 8,375,566 16,292,448 20,785,102
Income taxes............................ 3,526,900 (5,323,692) (1,064,375)
Unearned revenue........................ - 64,276 122,503
Customer deposits....................... 144,961 87,506 175,084
----------- ---------- ----------
Net cash provided by (used in) operating
activities............................... 5,561,336 4,904,457 (12,826,110)
----------- ---------- ----------
Cash flows from investing activities:
Purchases of equipment.................. (2,651,823) (9,067,923) (20,768,447)
Purchases of securities
available-for-sale..................... - - (21,103,030)
Proceeds from sale of equipment......... 9,543 - 450,000
Capitalization of software.............. (117,051) (1,789,604) (316,785)
Business combinations, net of
cash acquired.......................... - (468,187) (656,334)
Net change in receivables from
shareholders and employees............. (58,464) 63,334 (91,122)
---------- ---------- ----------
Net cash used in investing activities..... (2,817,795) (11,262,380) (42,485,718)
---------- ---------- ----------
Cash flows from financing activities:
Net payments on notes payable........... - (2,000,000) -
Proceeds from issuance of senior
subordinated notes..................... - 20,000,000 -
Proceeds from issuance of convertible
subordinated notes..................... - - 25,000,000
Proceeds from issuance of senior
discount notes......................... - - 74,932,500
(Continued)
F-7
65
TELEGROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
- -----------------------------------------------------------------------------
December 31,
------------
1995 1996 1997
---- ---- -----
Prepayment of senior subordinated
notes.................................. - - (20,000,000)
Debt issuance costs..................... - (1,450,281) (3,753,558)
Net proceeds from issuance of stock..... - - 39,825,343
Net proceeds from options exercised..... - - 246,761
Dividends paid.......................... - (950,000) -
Net proceeds (principal payments)
from other long-term borrowings........ - 530,803 (452,762)
Principal payments under capital
lease obligations...................... (112,863) (180,901) (168,321)
Net change in due to shareholders....... (2,119) (25,881) -
------------ --------- -----------
Net cash (used in) provided by
financing activities................... (114,982) 15,923,740 115,629,963
------------ ---------- -----------
Effect of exchange rate changes on cash... - (2,203) (259,292)
------------ ---------- -----------
Net increase in cash and cash
equivalents............................. 2,628,559 9,563,614 60,058,843
Cash and cash equivalents at beginning
of year.................................. 1,962,840 4,591,399 14,155,013
------------ ---------- -----------
Cash and cash equivalents at end of year.. $ 4,591,399 14,155,013 74,213,856
------------ ---------- -----------
------------ ---------- -----------
Supplemental disclosures of cash
flow information:
Interest Paid........................... $ 120,604 356,270 3,930,615
------------ ---------- -----------
------------ ---------- -----------
Income taxes paid............. ......... - 5,164,634 795
------------ ---------- -----------
------------ ---------- -----------
Supplemental disclosures of noncash
investing and activities:
Dividends declared.................... $ 525,000 425,000 -
------------ ---------- -----------
------------ ---------- -----------
Common stock issued in connection with
business combinations.................. $ - 573,984 470,000
------------ ---------- -----------
------------ ---------- -----------
Common stock issued in consideration
for notes receivable................... $ - 52,366 -
------------ ---------- -----------
------------ ---------- -----------
Equipment acquired under capital lease.. $ 87,553 $ - $ 108,504
------------ ---------- -----------
------------ ---------- -----------
See accompanying notes to consolidated financial statements.
F-8
66
TELEGROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
- ------------------------------------------------------------------------------
(1) NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES
NATURE OF BUSINESS
Telegroup, Inc. and subsidiaries (the Company) is an alternative provider
of domestic and international telecommunications services. Telegroup's
revenues are derived from the sale of telecommunications to retail
customers, typically residential users and small- to medium-sized business and
wholesale customers, typically telecommunications carriers. The Company's
customers are principally located in the United States, Europe and the Pacific
Rim, which consists of Asia, Australia and New Zealand. In both the retail
and wholesale aspects of its business, the Company extends credit to customers
on an unsecured basis with the risk of loss limited to outstanding amounts.
The Company markets its services through a worldwide network of independent
agents and supervisory "country coordinators". The Company extends credit to
its sales representatives and country coordinators on an unsecured basis with
the risk of loss limited to outstanding amounts, less commissions payable to
the representatives and coordinators.
A summary of the Company's significant accounting policies follows:
BASIS OF PRESENTATION
The accompanying consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States,
and include the accounts of the Company and its wholly-owned subsidiaries.
All significant intercompany accounts and transactions have been eliminated in
consolidation.
CASH EQUIVALENTS AND SECURITIES AVAILABLE-FOR-SALE
The Company considers all highly liquid investments with original maturities
of three months or less to be cash equivalents. At December 31, 1996, cash
equivalents consisted of a certificate of deposit of $60,000. At December 31,
1997, cash equivalents consisted of money market instruments, United States
Government securities, and commercial paper totaling $70,133,492. Securities
available-for-sale represent United States Government securities with
maturities greater than three months. Securities available-for-sale are
recorded at the lower of amortized cost or market value. At December 31,
1997, amortized cost approximates market value.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Equipment held under capital
leases are stated at the lower of the fair value of the asset or the net
present value of the minimum lease payments at the inception of the lease.
Depreciation on property and equipment is provided using the straight-line
method over the estimated useful lives of the assets. Equipment held under
capital leases and leasehold improvements are amortized straight line over the
shorter of the lease term or estimated useful life of the asset.
F-9
67
TELEGROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
- ------------------------------------------------------------------------------
CAPITALIZED SOFTWARE DEVELOPMENT COSTS
The Company capitalizes software costs incurred in the development of its
telecommunications switching software, billing systems and other support
platforms. The Company capitalizes only direct labor costs incurred in the
development of internal use software. Capitalization begins at achievement of
technological feasibility and ends when the software is placed in service.
Amortization of capitalized software is provided using the straight-line
method over the software's estimated useful life, which ranges from one to
five years. For the year ended
December 31, 1997, amortization of software development costs totaled
$498,682. There was no amortization during 1996 as the software had not yet
been placed in service.
STOCK OPTION PLAN
The Company accounts for its stock option plan using the intrinsic value based
method prescribed by Accounting Principles Board Opinion No. 25, Accounting
for Stock Issued to Employees (APB No. 25), and related interpretations. As
such, compensation expense is recorded on the date of grant only if the
current market price of the underlying stock exceeds the exercise price. On
January 1, 1996, the Company adopted Statement of Financial Accounting
Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, which
permits entities to recognize as expense over the vesting period the fair
value of all stock-based awards on the date of grant. Alternatively, SFAS No.
123 also allows entities to continue to apply the provisions of APB No. 25 and
provide pro forma net income and pro forma earnings per share disclosures as
if the fair-value method defined in SFAS No. 123 had been applied. The
Company has elected to continue to apply the provisions of APB No. 25 and
provide the pro forma disclosure provisions of SFAS No. 123.
IMPAIRMENT OF LONG-LIVED ASSETS
Effective January 1, 1996, the Company adopted SFAS No. 121, Accounting for
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of
(SFAS No. 121), which requires that the long-lived assets and certain
identifiable intangibles, held and used by an entity be reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying value of an asset may not be recoverable. An impairment loss is
recognized when estimated undiscounted future cash flows expected to be
generated by the asset is less than its carrying value. If such assets are
considered to be impaired, the measurement of the impairment loss is based on
the fair value of the asset, which is generally determined using valuation
techniques such as the discounted present value of expected future cash flows.
Adoption of SFAS No. 121 had no effect on the consolidated financial
statements of the Company.
GOODWILL
Goodwill results from the application of the purchase method of accounting for
business combinations and represents the excess of purchase price over fair
value of net assets acquired. Amortization is provided using the
straight-line method over a maximum of fifteen years. Impairment is
determined pursuant to the methodology used for other long-lived assets.
F-10
68
TELEGROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
- ------------------------------------------------------------------------------
INCOME TAXES
The Company accounts for income taxes under the provisions of SFAS No. 109,
Accounting for Income Taxes (SFAS No. 109). Under the asset and liability
method of SFAS No. 109, deferred tax assets and liabilities are recognized for
the future tax consequences attributable to differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. Under
SFAS No. 109, the effect on deferred tax assets and liabilities of a change in
tax rates is recognized in income in the period that includes the enactment
date.
ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities at the date of the
financial statements and the reported amounts of revenue and expenses during
the reporting period. Actual amounts could differ from those estimates.
BUSINESS AND CREDIT CONCENTRATION
Financial instruments which potentially expose the Company to a concentration
of credit risk, as defined by SFAS No. 105, Disclosure of Information about
Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments
with Concentrations of Credit Risk (SFAS No. 105), consist primarily of
accounts receivable. At December 31, 1997, the Company's accounts receivable
balance from customers in countries outside of the United States was
approximately $32,700,000 with an associated reserve for credit losses of
approximately $2,600,000. At December 31, 1997, approximately 2.1% of the
international accounts receivable balance is collateralized by deposits paid
by a portion of its international customers upon the initiation of service.
The Company estimates an allowance for doubtful accounts based on the credit
worthiness of its customers as well as general economic conditions.
Consequently, an adverse change in those factors could effect the Company's
estimate of its bad debts.
FOREIGN CURRENCY CONTRACTS
The Company uses foreign currency contracts to hedge foreign currency risk
associated with its international accounts receivable balances. Gains or
losses pursuant to these foreign currency contracts are reflected as an
adjustment of the carrying value of the hedged accounts receivable. At
December 31, 1996 and 1997, the Company had no material deferred hedging gains
or losses.
EARNINGS (LOSS) PER SHARE
The Company has adopted SFAS No. 128, Earnings Per Share (SFAS No. 128), which
has changed the method for calculating earnings per share (EPS). Prior period
EPS data has been restated in accordance with SFAS No. 128. SFAS No. 128
requires the presentation of "basic" and "diluted" EPS on the face of the
statement of operations. Basic EPS is computed by dividing the net earnings
available to common shareholders by the weighted-average common shares
outstanding during the period. The difference in shares utilized in
calculating basic and diluted EPS represents the effects of the convertible
securities and the number of shares issued under the Company's stock option
plan and outstanding warrants less shares assumed to be purchased with
proceeds from the exercise of the stock options and warrants. In addition, in
computing the dilutive effect of convertible securities, the numerator is
adjusted to add back the after-tax amount of interest recognized in the period
associated with any convertible debt. The numerator also is adjusted for any
other changes in earnings or loss that would result from the assumed
conversion of those potential common shares.
F-11
69
TELEGROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
- ------------------------------------------------------------------------------
As a result of the Company's recent initial public offering (note 7),
Securities and Exchange Commission Staff Accounting Bulletin No. 98, Earnings
Per Share (SAB No. 98), was considered in the calculation of EPS. Pursuant to
SAB No. 98, issuances of common stock, options, warrants and other potentially
diluted securities for nominal consideration (Nominal Issuances) are included
in the calculation of EPS, as if they were outstanding for all of the
pre-initial public offering periods in the manner of a stock split for which
retroactive restatement is required. There were no Nominal Issuances during
the periods presented in the accompanying financial statements.
Due to the net loss in 1996 and 1997, the anti-dilutive effect of the
Company's convertible securities, stock options, and outstanding warrants are
not included in the calculation of diluted EPS. In addition, there were no
dilutive potential common shares outstanding during 1995. As a result, the
basic and diluted earnings (loss) per share are identical in 1995, 1996 and
1997.
REVENUES, COST OF REVENUES AND COMMISSIONS EXPENSE
Revenues from retail telecommunications services are recognized when customer
calls are completed. Revenues from wholesale telecommunications services are
recognized when the wholesale carrier's customers' calls are completed. Cost
of retail and wholesale revenues are based primarily on the direct costs
associated with owned and leased transmission capacity and the cost of
transmitting and terminating traffic on other carriers' facilities. The
Company does not differentiate between the cost of providing transmission
services on a retail or wholesale basis. Commissions paid to acquire customer
call traffic are expensed in the period when associated call revenues are
recognized.
PREPAID PHONE CARDS
Substantially all the prepaid phone cards sold by the Company have an
expiration date of 24 months after issuance or six months after last use. The
Company records the net sales price as deferred revenue when cards are sold
and recognizes revenue as the ultimate consumer utilizes calling time.
Deferred revenue relating to unused calling time remaining at each card's
expiration is recognized as revenue upon the expiration of such card.
FOREIGN CURRENCY TRANSLATION
The functional currency of the Company is the United States (U.S.) dollar.
The functional currency of the Company's foreign operations generally is the
applicable local currency for each wholly-owned foreign subsidiary. Assets
and liabilities of its foreign subsidiaries are translated at the spot rate in
effect at the applicable reporting date, and the combined statements of
operations and the Company's share of the results of operations of its foreign
subsidiaries are translated at the average exchange rates in effect during the
applicable period. The resulting unrealized cumulative translation adjustment
is recorded as a separate component of equity.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair values of cash and cash equivalents, receivables, accounts payable
and lease obligations are estimated to approximate carrying value due to the
short-term maturities of these financial instruments. The carrying value of
the long-term debt approximates fair value as the debt was secured primarily
during September and October of 1997 at rates consistent with those in effect
at December 31, 1997.
F-12
70
TELEGROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
- ------------------------------------------------------------------------------
NEW ACCOUNTING PRONOUNCEMENTS
SFAS No. 130, Reporting Comprehensive Income, was issued in June 1997 and is
effective in the first quarter of 1998. It establishes standards for
reporting and display of comprehensive income and its components in a full set
of general-purpose financial statements.
SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information, was issued in June 1997 and is effective for periods beginning
after December 15, 1997. It establishes standards for the way that public
business enterprises report information about operating segments in annual
financial statements and requires that those enterprises report selected
information about operating segments in interim financial reports issued to
shareholders. It also establishes standards for related disclosures about
products and services, geographic areas and major customers. The Company does
not believe that adoption of either of these standards will have a significant
effect on its financial statements. The Company believes that adoption of
this standard in 1998 will not have a significant effect on its segment
reporting in the consolidated financial statements.
RECLASSIFICATIONS
Certain amounts have been reclassified for comparability with the 1997
presentation.
(2) Debt
Long-term debt at December 31, 1996 and 1997 is shown below:
- ------------------------------------------------------------------------------
1996 1997
12.00% senior subordinated notes,
net of discount, paid in September 1997 $ 10,894,126 -
8.00% convertible subordinated notes,
due April 15, 2005, unsecured - 25,000,000
10.50% senior discount notes, net of discount,
due November 1, 2004, unsecured - 76,442,135
8.50% note payable, due monthly through fiscal 2000,
secured by vehicle 19,003 11,082
10.80% note payable, due monthly through fiscal 1998,
secured by equipment financed 160,628 80,955
12.00% note payable, paid in February 1997 74,319 -
12.00% note payable, paid in February 1997 276,853 -
6.85% note payable, due monthly through fiscal 1999,
unsecured 14,138 8,204
8.00% note payable, due monthly through fiscal 1998,
unsecured 10,425 2,363
- ------------------------------------------------------------------------------
11,449,492 101,544,739
Less current portion (232,596) (93,788)
- ------------------------------------------------------------------------------
$11,216,896 101,450,951
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
SENIOR SUBORDINATED NOTES
On November 27, 1996, the Company completed a private placement (Private
Offering) of 12% senior subordinated notes (the Subordinated Notes) for gross
proceeds of $20,000,000 which was due and payable on November 27, 2003. Net
proceeds from the Private Offering, after issuance costs of $1,450,281, were
$18,549,719. In connection with the Private Offering, the Company issued
20,000 warrants to purchase 1,160,107 shares of the Company's common stock
(see note 7).
F-13
71
TELEGROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
- ------------------------------------------------------------------------------
The Subordinated Notes were originally recorded at $10,846,049 (a yield of
26.8%), which represents the $20,000,000 in proceeds less the $9,153,951 value
assigned to the detachable warrants, which is included in additional paid-in
capital. The value assigned to the warrants was being accreted to the debt
using the interest method over 7 years. The accretion of the value assigned
to the warrants is included in interest expense in the accompanying
consolidated financial statements.
On September 5, 1997, the Company prepaid in full all of the outstanding
Subordinated Notes. The Company paid $21,400,000, which included $20,000,000
in principal and $1,400,000 for a prepayment penalty. In addition, the
Company recognized a loss of $8,741,419 and $1,298,882 for the write-off of
the unamortized original issue discount and debt issuance costs, respectively.
The early extinguishment of the Subordinated Notes is reflected on the
statement of operations as an extraordinary item, net of income taxes.
CONVERTIBLE SUBORDINATED NOTES
On September 30, 1997, the Company issued $25,000,000 in aggregate principal
amount of convertible subordinated notes due April 15, 2005. Net proceeds
from the convertible notes, after issuance costs of $890,475, were
$24,109,525.
The convertible notes bear interest at 8% per annum, payable on each April 15
and October 15, commencing April 15, 1998. The convertible notes are
convertible into shares of common stock of the Company at any time before
April 15, 2005, at a conversion price of $12.00 per share, subject to
adjustment upon the occurrence of certain events.
The convertible notes are redeemable, in whole or in part, at the option of
the Company, at any time on or after October 15, 2000 at redemption prices
(expressed as a percentage of the principal amount) declining annually from
104% beginning October 15, 2000 to 100% beginning October 15, 2003 and
thereafter, together with accrued interest to the redemption date and subject
to certain conditions.
The convertible notes are unsecured obligations of the Company and are
subordinated to all existing and future senior indebtedness of the Company.
SENIOR DISCOUNT NOTES
On October 23, 1997, the Company issued $97,000,000 in aggregate principal
amount of 10.5% senior discount notes due November 1, 2004. Net proceeds from
the senior discount notes, after issuance costs of $2,863,083, were
$72,069,417. The discount of $22,067,500 recorded on the senior discount
notes is being accreted to the debt through May 1, 2000 using the interest
method, resulting in an effective interest rate of 10.5%. The accreted value
of the notes will equal the following on their semi-annual accrual dates.
Semi-annual date Accreted value
- -------------------------------------------------------------------------
May 1, 1998 $ 79,068,099
November 1, 1998 83,213,561
May 1, 1999 87,576,365
November 1, 1999 92,167,906
May 1, 2000 97,000,000
- --------------------------------------------------------------------------
Interest on the senior discount notes will neither accrue nor be payable prior
to May 1, 2000 and are payable on each May 1 and November 1 thereafter. The
notes are redeemable, in whole or in part, at the option of the Company, at
any time on or after November 1, 2001 at redemption prices (expressed as a
percentage of the principal amount) declining annually from 105.25% beginning
F-14
72
TELEGROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
- ------------------------------------------------------------------------------
November 1, 2001 to 100% beginning November 1, 2004 and thereafter, together
with accrued interest to the redemption date and subject to certain
conditions.
The notes are unsecured obligations of the Company and are subordinated to all
existing and future indebtedness of the Company, with the exception of the
convertible subordinated notes.
The convertible subordinated note and senior discount note indentures place
certain restrictions on the ability of the Company and its subsidiaries to (i)
incur additional indebtedness, (ii) make restricted payments (dividends,
redemptions and certain other payments), (iii) incur liens, (iv) enter into
mergers, consolidations or acquisitions, (v) sell or otherwise dispose of
property, business or assets, (vi) issue and sell preferred stock of a
subsidiary, and (vii) engage in transactions with affiliates. At December 31,
1997, the Company was in compliance with these restrictions.
The following is a schedule by years of future minimum debt service
requirements as of December 31, 1997:
- --------------------------------------------------------------------------
Year ending December 31:
1998 $ 93,788
1999 7,783
2000 1,033
2001 -
2002 -
Later years 122,000,000
- ----------------------------------------------------------------------------
122,102,604
Less discount on the
senior discount notes (20,557,865)
- ----------------------------------------------------------------------------
$101,544,739
- ----------------------------------------------------------------------------
- ----------------------------------------------------------------------------
(3) BUSINESS COMBINATIONS
On August 21, 1996, the Company purchased TeleContinent, S.A. for $200,000.
Also on August 21, 1996, the Company purchased Telegroup South Europe, Inc.
Consideration for the purchase was $1,031,547 and 262,116 shares of common
stock of the Company valued at $573,984, for total consideration of
$1,605,531. The value of the common stock was determined by management based
on information obtained from the Company's independent financial advisors.
The acquisitions have been accounted for using the purchase method of
accounting and, accordingly, the net assets and results of operations are
included in the consolidated financial statements from the date of
acquisition. The aggregate purchase price of the acquisitions was allocated
based on fair values as follows:
- ------------------------------------------------------------------------------
Current assets $ 794,452
Property and equipment 54,571
Goodwill 1,024,609
Current liabilities (68,101)
- ------------------------------------------------------------------------------
Total $ 1,805,531
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
Pro forma operating results of the Company, assuming these acquisitions were
consummated on January 1, 1996, do not significantly differ from reported
amounts.
F-15
73
TELEGROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
- ------------------------------------------------------------------------------
On August 14, 1997, the Company acquired 60% of the common stock of, and
controlling interest in, PCS Telecom, Inc. (PCS). Consideration for the
purchase was $1,340,000 and 40,000 shares of unregistered common stock of the
Company valued at $470,000, for total consideration of $1,810,000. PCS is a
developer and manufacturer of calling card platforms used by the Company and
other companies.
This acquisition has been accounted for using the purchase method of
accounting and, accordingly, the net assets and results of operations are
included in the consolidated financial statements from the date of
acquisition. The aggregate purchase price of the acquisition was allocated
based on the fair values as follows:
- ----------------------------------------------------------------------------
Current assets $ 1,279,971
Property and equipment 534,600
Other assets 1,855
Goodwill 2,041,258
Current liabilities (2,047,684)
- ----------------------------------------------------------------------------
Total $ 1,810,000
- ----------------------------------------------------------------------------
- ----------------------------------------------------------------------------
The minority interest deficit of 40% was included in the calculation of the
Company's goodwill due to the Company recognizing 100% of PCS's net earnings
and losses until the historical stockholders' equity of PCS becomes positive.
Until PCS's net asset deficit becomes positive, no minority interest is
reflected in the accompanying financial statements.
Pro forma operating results of the Company, assuming this acquisition was
consummated on January 1, 1996, do not significantly differ from reported
amounts.
In January 1998, the Company purchased the telephony portion of the operations
of its country coordinator in Japan. Consideration for the purchase was
$472,500. Also in January 1998, the Company acquired the operations of its
Australian and New Zealand country coordinators. Consideration for the
Australian country coordinator was $60,000 and 118,446 shares of common stock
of the Company valued at $1,612,075, for total consideration of $1,740,112.
Consideration for the New Zealand country coordinator was $90,000 and 178,554
shares of Common Stock of the Company valued at $2,522,075, for total
consideration of $2,612,075. Additional consideration is due by the Company
if certain performance measures are met by the Australian and New Zealand
country coordinators.
Pro forma operating results of the Company, assuming this acquisition was
consummated on January 1, 1996, do not significantly differ from reported
amounts.
(4) RELATED PARTIES
During 1995, and a portion of 1996, the Company had a management agreement
with an affiliate owned by certain shareholders of the Company whereby it paid
a management fee, determined annually, plus an incentive fee based upon
performance. Amounts paid under this agreement totaled $1,334,000 and
$415,000 during 1995 and 1996, respectively. The management agreement was
terminated on May 15, 1996.
(5) PROPERTY AND EQUIPMENT
Property and equipment, including network equipment owned under capital leases
of $612,278 and $720,782 in 1996 and 1997, respectively, is comprised of the
following:
- -----------------------------------------------------------------------------
December 31 Useful
1996 1997 lives
Land $ 88,857 155,707 -
Building and leasehold improvements 298,483 900,660 2-20
Furniture, fixtures and office equipment 327,368 818,368 5-7
Computer equipment 5,021,884 10,698,744 5
Network equipment 8,344,824 21,561,172 5
Automobiles 104,260 193,426 5
- ------------------------------------------------------------------------------
14,185,676 34,328,077
Less accumulated depreciation,
including amounts applicable to
assets acquired under capital
leases of $269,098 in 1996 and
$315,805 in 1997 2,929,537 6,415,099
- ------------------------------------------------------------------------------
Net property and equipment $11,256,139 27,912,978
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
F-16
74
(6) LEASES
The Company leases certain network equipment under capital leases and certain
network equipment and office space under operating leases. Future minimum
lease payments under these lease agreements for each of the next five years
are summarized as follows:
Capital Operating
leases leases
- -----------------------------------------------------------------------------
Year ending December 31:
1998 $202,589 $1,747,797
1999 188,780 714,660
2000 54,227 616,282
2001 - 208,860
Thereafter - -
- ----------------------------------------------------------------------------
Total minimum lease payments $445,596 $3,287,599
Less amount representing interest (65,711)
- ------------------------------------------------------------------------------
$379,885
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
As operating leases expire, it is expected that they will be replaced with
similar leases. Rent expense under operating leases totaled $306,933,
$682,630 and $1,423,104 for the years ended December 31, 1995, 1996 and 1997,
respectively.
(7) SHAREHOLDERS' EQUITY
INITIAL PUBLIC OFFERING (IPO)
On July 14, 1997, the Company consummated an IPO. The Company sold 4,000,000
shares of common stock at a price to the public of $10 per share for net
proceeds of $35,640,343. On August 12, 1997, the underwriters exercised their
over-allotment option and purchased an additional 450,000 shares at $10 per
share which yielded net proceeds to the Company of $4,185,000.
STOCK OPTION PLAN
The Company has a stock option plan (the Plan) pursuant to which the Company's
Board of Directors may grant nonqualified and performance-based options to
employees. The Plan authorizes grants of option to purchase up to 4,000,000
shares of authorized but unissued common stock. All options subsequent to
September 30, 1996 have been granted at not less than 100% of the fair market
value of the stock on the date of grant. All stock options have a three or
ten-year term and become fully exercisable on the date of grant or in
increments over a three-year vesting period.
F-17
75
TELEGROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
- ------------------------------------------------------------------------------
Stock option activity during the periods indicated is summarized below:
- ------------------------------------------------------------------------------
Weighted
Shares Average
Reserved Options Exercise
for Options Outstanding Price
- ----------------------------------------------------------------------------
Outstanding at January 1, 1996 4,000,000 - $ -
Granted 2,368,969 1,631,031 1.31
Exercised - - -
Canceled 2,373,079 (4,110) 1.31
- ------------------------------------------------------------------------------
Outstanding at December 31, 1996 2,373,079 1,626,921 1.31
Granted 1,889,640 483,439 10.06
Exercised - (188,367) 1.31
Canceled 1,915,055 (25,415) 1.39
- ------------------------------------------------------------------------------
Outstanding at December 31, 1997 1,915,055 1,896,578 $ 3.54
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
Options Outstanding Options Exercisable
------------------------------------- ------------------------------
Weighted
Number Average Weighted Number Weighted
Range of Outstanding at Remaining Average Exercisable at Average
Exercise December 31, Contractual Exercise December 31, Exercise
Prices 1997 Life (years) Price 1997 Price
- ------------------------------------------------------------------------------
$ 1.31 1,413,389 8.27 $ 1.31 929,926 $ 1.31
10.00 432,914 9.41 10.00 104,118 10.00
10.18 275 9.58 10.18 - -
10.22 30,000 2.75 10.22 - -
11.13 20,000 9.84 11.13 2,500 11.13
- ------------------------------------------------------------------------------
$1.31-11.13 1,896,578 8.46 $ 3.54 1,036,544 $ 2.21
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
The Company applies the intrinsic value method prescribed by APB No. 25 in
accounting for the Plan and, accordingly, compensation costs of $1,032,646 and
$342,380 have been recognized for its stock options for the year ended
December 31, 1996 and 1997, respectively. Had the Company determined
compensation cost based on the fair value at the grant date for its stock
options under SFAS No. 123, the Company's net loss and basic and diluted net
loss per common share would have been:
- ------------------------------------------------------------------------------
December 31, 1996 December 31, 1997
As reported Pro forma As reported Pro forma
- ------------------------------------------------------------------------------
Loss before extraordinary item $ 118,322 79,767 13,753,795 14,526,416
- ------------------------------------------------------------------------------
Net loss $ 118,322 79,767 23,724,610 24,497,231
- ------------------------------------------------------------------------------
Basic and diluted loss
per common share:
Loss before extraordinary item $ 0.00 0.00 0.49 0.51
- ------------------------------------------------------------------------------
Net loss $ 0.00 0.00 0.84 0.86
- ------------------------------------------------------------------------------
F-18
76
TELEGROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
- ------------------------------------------------------------------------------
The pro forma impact on income assumes no options will be forfeited. The pro
forma effects are not representative of the effects on reported net income for
future years, as most of the Company's employee stock option grants vest in
increments over a period of three years.
Under SFAS No. 123, the per-share minimum value of stock options granted in
1996 was $0.61. For the year ended December 31, 1996, the minimum value,
estimated as of the grant date, does not take into account the expected
volatility of the underlying stock as prescribed by SFAS No. 123 for privately
held companies. The input variables used to calculate the per-share minimum
value included a weighted-average risk-free interest rate of 6.43%, no
expected dividend yields, and an estimated option life of 3 years.
The per-share weighted-average fair value of stock options granted in 1997 was
$4.79. For the year ended December 31, 1997, the fair value was estimated as
of the grant data using the Black-Scholes option pricing model. Input
variables used in the model included a weighted-average risk-free interest
rate of 5.33%, no expected dividend yields, an expected volatility factor of
65% and an estimated option life of 3.05 years.
Options granted during 1996 included performance based options. The
compensation expense recorded for these performance based options under APB
No. 25 was greater than the expense recorded if the Company had determined
compensation cost under SFAS No. 123.
WARRANTS
In connection with the Private Offering, the Company issued warrants to
purchase 1,160,107 shares of the Company's common stock which, at the time of
closing of the Private Offering, represented 4% of the Company's fully diluted
common stock. On July 2, 1997, in accordance with the provisions of the
Private Offering Agreement, the warrants increased in value by 153,644 shares
to represent 4.5% of the Company's fully diluted common stock. The warrants
are currently exercisable, carry an exercise price of $.002 per share, and
expire November 27, 2003. As of December 31, 1997, all warrants remain
outstanding.
(8) INCOME TAX MATTERS
Income tax expense (benefit) for the years ended December 31 is comprised of
the following:
- ----------------------------------------------------------------------------
1995 1996 1997
- -----------------------------------------------------------------------------
Current:
Federal $ 2,733,080 (172,478) (1,309,398)
State 793,820 (64,903) (42,202)
Foreign - - 139,907
- ------------------------------------------------------------------------------
3,526,900 (237,381) (1,211,693)
- ------------------------------------------------------------------------------
Deferred:
Federal (726,259) 167,066 552,571
State (210,941) 62,867 82,596
Foreign - - -
- ------------------------------------------------------------------------------
(937,200) 229,933 635,167
- ------------------------------------------------------------------------------
$ 2,589,700 (7,448) (576,526)
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
F-19
77
TELEGROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
- ------------------------------------------------------------------------------
Income tax expense (benefit) differs from the amount computed by applying the
federal income tax rate of 34% to earnings (loss) before taxes, as follows:
- -----------------------------------------------------------------------------
1995 1996 1997
- -----------------------------------------------------------------------------
Expected federal income tax (benefit) $2,180,000 (42,762) (4,872,309)
State income tax (benefit), net of
federal effect 384,700 (1,344) 26,660
Environmental tax 10,200 - -
Increase of valuation allowance,
net of amount allocated to
extraordinary item - - 3,695,829
Foreign and unconsolidated subsidiary,
net operating losses - - 931,415
Other nondeductible expenses, net 14,800 36,658 (358,121)
- ------------------------------------------------------------------------------
$2,589,700 (7,448) (576,526)
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
The tax effect of significant temporary differences giving rise to deferred
income tax assets and liabilities as of December 31 are shown below:
- ------------------------------------------------------------------------------
1996 1997
- ------------------------------------------------------------------------------
Deferred income tax liabilities:
Property and equipment, principally
depreciation adjustments 502,711 1,404,074
Capitalized software 669,160 605,321
Basis in subsidiaries 32,898 -
Unearned foreign exchange difference - 323
- -----------------------------------------------------------------------------
Total gross deferred tax liabilities 1,204,769 2,009,718
- -----------------------------------------------------------------------------
- -----------------------------------------------------------------------------
Deferred income tax assets:
Allowance for credit losses 1,151,172 2,115,503
Accrued compensation 447,878 603,001
Net operating loss carryforward - 4,986,678
Charitable contribution carryforward 107,729 -
Unearned revenue 22,558 65,552
Unearned foreign exchange difference 4,543 -
Tax credit carryforward - 248,985
Other 106,056 106,044
- ------------------------------------------------------------------------------
Total gross deferred tax assets 1,839,936 8,125,763
Less valuation allowance - (6,116,045)
- ------------------------------------------------------------------------------
Net deferred tax assets 1,839,936 2,009,718
- ------------------------------------------------------------------------------
Net deferred tax asset (liability) 635,167 -
- ------------------------------------------------------------------------------
- ------------------------------------------------------------------------------
During 1997 the Company provided for a valuation allowance for derred tax
assets of $6,116,045. In assessing the realizability of deferred tax assets,
management considers whether it is more likely than not that some portion or
all of the deferred tax assets will not be realized. The ultimate realization
of
F-20
78
TELEGROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
- ------------------------------------------------------------------------------
deferred tax assets is dependent upon the generation of future taxable income
during the periods in which those temporary differences become deductible.
Management considers the scheduled reversal of deferred tax liabilities,
projected future taxable income, and tax planning strategies in making this
assessment. Taxable loss for the years ended December 31, 1997 and 1996 was
approximately $22,000,000 and $600,000, respectively. Based upon the level of
historical taxable income and projections for future taxable income over the
periods which the deferred tax assets are deductible, a valuation allowance
has been established for the Company's net deferred tax assets as of December
31, 1997.
At December 31, 1997, the Company has net operating loss carryforwards for
federal income tax purposes of approximately $14,200,000, which are available
to offset future federal taxable income, if any, through 2012.
(9) COMMITMENTS AND CONTINGENCIES
COMMITMENTS WITH TELECOMMUNICATIONS COMPANIES
The Company has an agreement with Sprint Communications Company L.P. (Sprint)
to use Sprint's fiber-optic network in its delivery of telecommunication
services. This agreement requires net quarterly usage commitments of
$6,000,000. In the event such quarterly commitments are not met, the Company
is required to remit to Sprint 25% of the difference between the $6,000,000
quarterly commitment and actual usage. This agreement extends through
December 1998. When total usage exceeds $24,000,000 during 1998, the Company
has no further commitment.
The Company has a one year $3,000,000 usage commitment with MFS/WorldCom in
Frankfurt, Germany, to use MFS/WorldCom's fiber-optic network in its delivery
of telecommunication services. This agreement began on September 5, 1997.
The Company has an agreement with Meyer Group Limited (Meyer) with a usage
commitment to terminate $3,000,000 in Hong Kong call traffic on Meyer's
network by December 31, 1998. The Company's commitment on this agreement is
contingent upon the Company's network remaining operational in the Hong Kong
market.
Shortfalls in usage commitments, if any, are recorded as cost of revenues in
the period identified.
LETTERS OF CREDIT
The Company has outstanding irrevocable letters of credit in the amount of
$923,053 as of December 31, 1997 with certain carriers. These letters of
credit, which have expiration dates from March 1998 to August 1998,
collateralize the Company's obligations for network usage on the carriers'
networks. The fair value of these letters of credit is estimated to be the
same as the contract values based on the nature of the arrangement with
issuing banks.
RETIREMENT PLAN
Effective January 1, 1996, the Company adopted the Telegroup, Inc. 401(k)
Retirement Savings Plan (the Plan). The Plan is a defined contribution plan
covering all employees of the Company who have one year of service and have
attained the age of 21. Participants may contribute up to 15% of their base
pay in pretax dollars. The Company will match employee contributions on a
discretionary basis. Vesting in Company contributions is 100% after 5 years
in the Plan. The Company made no contributions to the Plan in 1996 and 1997.
F-21
79
TELEGROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
- ------------------------------------------------------------------------------
LITIGATION
The Company is a party to certain litigation which has arisen in the ordinary
course of business. In the opinion of management, the ultimate resolution of
these matters will not have a significant effect on the financial statements
of the Company.
(10) BUSINESS SEGMENT AND SIGNIFICANT CUSTOMER
The Company operates in a single industry segment. The geographic origin of
revenue is as follows:
- ------------------------------------------------------------------------------
Year ended December 31,
----------------------------------
1995 1996 1997
- ---------------------------------------------------------------------------
United States $ 35,154,246 60,360,882 124,195,135
Europe 41,173,425 81,137,404 96,725,712
Pacific Rim 22,613,550 42,185,403 85,579,916
Other 30,178,169 29,523,820 30,931,649
- -----------------------------------------------------------------------------
$129,119,390 213,207,509 337,432,412
- -----------------------------------------------------------------------------
- -----------------------------------------------------------------------------
All revenue was derived from unaffiliated customers. For the years ended
December 31, 1996 and 1997, approximately 12% and 13% , respectively, of the
Company's total revenues were derived from a single customer. There were no
customers representing over 10% of the Company's total revenues during 1995.
F-22
80
INDEPENDENT AUDITORS' REPORT
The Board of Directors
Telegroup, Inc.:
Under the date of March 6, 1998, we reported on the consolidated balance
sheets of Telegroup, Inc. and subsidiaries as of December 31, 1996 and 1997
and the related consolidated statements of operations, shareholders' equity
and cash flows for each of the years in the three-year period ended December
31, 1997. In connection with our audits of the aforementioned consolidated
financial statements, we also audited the related consolidated financial
statement Schedule II. This consolidated financial statement schedule is the
responsibility of the Company's management. Our responsibility is to express
an opinion on this consolidated financial statement schedule based on our
audits.
In our opinion, such consolidated financial statement schedule, when
considered in relation to the basic consolidated financial statements taken as
a whole, presents fairly, in all material respects, the information set forth
therein.
March 6, 1998
Lincoln, Nebraska
F-23
81
TELEGROUP, INC. AND SUBSIDIARIES
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)
Balance At Charged to Balance At
Beginning Costs and End of
of Period Expenses Deduction Period
- ----------------------------------------------------------------------------
Year ended December
31, 1995:
Allowance for
doubtful accounts $ 325 $ 3,982 $ 2,207 $ 2,100
- ----------------------------------------------------------------------------
Year ended December
31, 1996:
Allowance for
doubtful accounts 2,100 5,124 3,903 3,321
- ------------------------------------------------------------------------------
Year ended December
31, 1997:
Allowance for
doubtful accounts 3,321 8,503 5,650 6,174
- ------------------------------------------------------------------------------
F-24
82
INDEX TO EXHIBITS
(ITEM 14(A))
Exhibit
Number Description
- ------- -------------
*2.1 Plan and Agreement of Reorganization Between the Company, George
Apple and Telegroup South Europe, Inc. Dated September 6, 1996
*2.2 Plan and Agreement of acquisition between the Company, Telecontinent,
S.A. and Georges Apple dated September 6, 1996
2.3 Agreement Between Fastnet UK Limited, Telegroup UK Limited, Giles
Redpath and Telegroup, Inc. (Incorporated by reference to Exhibit 10
to the Company's Form 8-K filed on December 9, 1997, SEC File No.
0-29284)
*3.1 Restated Articles of Incorporation of Telegroup, Inc.
*3.2 Form of Second Restated Articles of Incorporation of Telegroup, Inc.
*3.3 Bylaws of Telegroup, Inc.
*3.4 Form of Amended and Restated Bylaws of Telegroup, Inc.
*4.1 Form of Common Stock Certificate of Telegroup, Inc.
*4.2 Reference is made to Exhibits 3.1, 3.2, 3.3 and 3.4
*4.3 Note and Warrant Purchase Agreement dated as of November 27, 1996
*4.4 Form of Warrant to Purchase Class A Common Stock of Telegroup, Inc.
*4.5 Indenture dated as of November 27, 1996 between Telegroup, Inc. and
The Chase Manhattan Bank
4.6 Indenture for 8.0% Convertible Notes dated September 30, 1997
(Incorporated by reference to Exhibit 4.1 to the Company's Form 10-Q
for the quarter-ended September 30, 1997, SEC File No. 0-29284)
4.7 Indenture for 10.5% Senior Discount Notes dated October 23, 1997
(Incorporated by reference to Exhibit 4.2 to the Company's Form 10-Q
for the quarter-ended September 30, 1997, SEC File No. 0-29284)
E-1
83
Exhibit
Number Description
- ------- ------------
*10.1 Loan Agreement Dated as of March 28, 1997 by and between the
Company and American National Bank and Trust Company of Chicago
*10.1.1 First Amendment to Loan Agreement between the Company and American
National Bank and Trust Company of Chicago dated as of June 6,
1997.
*10.2 Amended and Restated 1996 Telegroup, Inc. Stock Option Plan
*10.3 Form of Employment Agreement between the Company and Fred Gratzon
*10.4 Form of Employment Agreement between the Company and Clifford Rees
*10.5 Form of Indemnification Agreement
*10.6 Registration Rights Agreement among Telegroup, Inc., Greenwich
Street Capital Partners, L.P., Greenwich Street Capital Offshore
Fund, Ltd., TRV Employees Fund, L.P., The Travelers Insurance
Company and The Travelers Life and Annuity Company Dated as of
November 27, 1996
*10.7 Form of Registration Rights Agreement between the Company and
certain Shareholders of the Company
*^10.8 Agreement between Telegroup, Inc. and New T & T Hong Kong Limited
*^10.9 Resale Solutions Switched Services Agreement between Sprint
Communications Company L.P. and Telegroup, Inc.
*10.10 Form of Employment Agreement between the Company and John P. Lass
*10.11 Form of Employment Agreement between the Company and Ron
Jackenthal
*10.12 Form of Employment Agreement between the Company and Certain
Executive Officers
***10.13 Notes Registration Rights Agreement between the Company and Smith
Barney Inc., and Alex Brown Incorporated Dated as of October 23,
1997
**10.14 Registration Rights Agreement between the Company and Smith Barney
Inc. Dated as of September 30, 1997
E-2
84
Exhibit
Number Description
- ------- -------------
12.1 Statement re Computation of Ratio of Earnings to Fixed Charges
*21.1 Subsidiaries of Telegroup, Inc.
23.1 Consent of KPMG
24.1 Power of Attorney
27.1 Financial Data Schedule
* Incorporated by reference to the Company's Registration Statement on
Form S-1, SEC File No. 333-25065.
** Incorporated by reference to the Company's Registration Statement on
Form S-1, SEC File No. 333-42965.
*** Incorporated by reference to the Company's Registration Statement on
Form S-4, SEC File No. 333-42979
^ Confidential Treatment has been granted for portions of this document.
The redacted material has been filed separately with the Commission.
E-3