UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
-----------
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Fiscal Year Ended December 31, 2005, or
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.
For the transition period from __________ to _____________
Commission File Number: 000-28063
DELTATHREE, INC.
(Exact name of registrant as specified in charter)
Delaware 13-4006766
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification no.)
75 Broad Street, 31st Floor
New York, New York 10004 10004
(Address of principal executive offices) (Zip code)
Registrant's telephone number, including area code: (212) 500-4850
Securities registered pursuant to Section 12(b) of the Act:
None.
Securities registered pursuant to Section 12(g) of the Act:
Name of Each Exchange on
Title of Each Class Which the Securities are Registered
- ------------------- -----------------------------------
Class A Common Stock, par Nasdaq Capital Market
value $0.001 per share
Indicate by check mark if the registrant is a well-known seasoned issuer,
as defined in Rule 405 of the Securities Act. Yes |_| No |X|
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes |_| No |X|
Indicate by a check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the 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. |_|
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act. (Check one):
Large accelerated filer [_] Accelerated filer [_] Non-accelerated filer [X]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X|
The aggregate market value of the Class A common stock held by
non-affiliates of the Registrant based upon the closing price of the Class A
common stock as reported by The Nasdaq Stock Market on June 30, 2005 was
$51,602,565. Solely for purposes of this calculation, shares beneficially owned
by directors and officers of the Registrant and persons owning 5% or more of the
Registrant's Class A common stock have been excluded, in that such persons may
be deemed to be affiliates of the Registrant. Such exclusion should not be
deemed a determination or admission by the Registrant that such individuals or
entities are, in fact, affiliates of the Registrant.
The number of shares outstanding of the Registrant's capital stock as of
March 24, 2006 is as follows:
Number of Shares Outstanding
Title of Each Class at March 24, 2006
- ------------------- -----------------
Class A Common Stock, $0.001 par value 30,000,982
- --------------------------------------------------------------------------------
Documents incorporated by reference: None
DELTATHREE, INC.
2005 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
Page
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PART I
ITEM 1. Business.................................................................. 1
ITEM 1A. Risk Factors.............................................................. 16
ITEM 1B. Unresolved Staff Comments................................................. 27
ITEM 2. Properties................................................................ 27
ITEM 3. Legal Proceedings......................................................... 27
ITEM 4. Submission of Matters to a Vote of Security Holders....................... 28
PART II
ITEM 5. Market for Registrant's Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity Securities..................................... 29
ITEM 6. Selected Financial Data................................................... 30
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations............................................................. 31
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk................ 39
ITEM 8. Financial Statements and Supplementary Data............................... 39
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure................................................................ 39
ITEM 9A. Controls and Procedures................................................... 39
ITEM 9B. Other Information......................................................... 39
PART III
ITEM 10. Directors and Executive Officers of the Registrant........................ 41
ITEM 11. Executive Compensation.................................................... 44
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters............................................... 52
ITEM 13. Certain Relationships and Related Transactions............................ 53
ITEM 14. Principal Accounting Fees and Service..................................... 53
PART IV
ITEM 15. Exhibits, Financial Statement Schedules................................... 55
Index to Consolidated Financial Statement................................. F-1
PART I
The statements contained in this annual report on Form 10-K, or Annual
Report, that are not descriptions of historical facts may be forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended.
These forward-looking statements are based on current expectations, estimates,
forecasts and projections about us, our future performance, the industries in
which we operate our beliefs and our management's assumptions. In addition,
other written or oral statements that constitute forward-looking statements may
be made by us or on our behalf. Words such as "expects," "anticipates,"
"targets," "goals," "projects," "intends," "plans," "believes," "seeks,"
"estimates," variations of such words and similar expressions are intended to
identify such forward-looking statements. These statements are not guarantees of
future performance and involve certain risks, uncertainties and assumptions that
are difficult to assess. Therefore, actual outcomes and results may differ
materially from what is expressed or forecasted in such forward-looking
statements. Please see the section below entitled "Risk Factors" for detailed
information about the uncertainties and other factors that may cause actual
results to materially differ from the views stated in such forward-looking
statements. All forward-looking statements and risk factors included in this
Annual Report are made as of the date hereof, based on information available to
us as of the date hereof, and we assume no obligation to update any
forward-looking statement or risk factor, whether as a result of new
information, future events, changes in assumptions or otherwise.
Our fiscal year ends on December 31 of each calendar year. Each reference
to a fiscal year in this Annual Report refers to the fiscal year ending December
31of the calendar year indicated. Unless the context requires otherwise,
references to "we," "us," "our," "the Company," and "deltathree" refer to
deltathree, Inc.
ITEM 1. BUSINESS
Company Overview
We are a leading provider of integrated Voice over Internet Protocol
(VoIP) telephony services, products, hosted solutions, and infrastructure. We
were founded in 1996 to capitalize on the growth of the Internet as a
communications tool by commercially offering Internet Protocol (IP) telephony
services. IP telephony, or VoIP telephony, is the real time transmission of
voice communications in the form of digitized "packets" of information over the
Internet or a private network, similar to the way in which e-mail and other data
is transmitted. While we began as primarily a low-cost alternative source of
wholesale minutes for carriers around the world, we have evolved into one of the
premier providers of next generation communication services in the world.
Today we support hundreds of thousands of active users around the globe
through our two primary distribution channels: our Service Provider and Reseller
channel and our iConnectHere, or ICH, direct-to-consumer channel. We offer a
broad suite of private label VoIP products and services as well as a back-office
platform for service providers, resellers, and corporate customers. Based on our
customizable VoIP solutions, these customers can offer private label
telecommunications to their own customer bases, under either their own brand
name, a white-label brand, and/or our iConnectHere or deltathree brand name. At
the same time, iConnectHere, our direct-to-consumer offering, provides
award-winning VoIP products directly to consumers and small businesses online
using the same primary platform.
We have built a privately-managed, state-of-the-art global
telecommunications platform using IP technology and offer our customers a unique
suite of IP telephony products, including PC-to-Phone and Broadband Phone
products. We differentiate ourselves from our competitors by providing a robust
set of value-added services that enables us to effectively address the
challenges that have traditionally made the provision of telecommunications
services difficult, and we offer our products and services to a global customer
base in a fashion that meets the disparate needs of this diverse customer set.
These operations management tools include among others: account provisioning;
e-commerce based payment processing systems; billing and account management;
operations management; web development; network management; and customer care.
We are able to provide our services at a cost to users that is generally lower
than that charged by traditional service providers because we minimize our
network costs by using efficient packet-switched technology and we interconnect
to a wide variety of termination options which allow us to benefit from pricing
differences between vendors to the same termination points.
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Prior to 1999, we focused on building a privately-managed, global network
utilizing IP technology, and our business primarily consisted of carrying and
transmitting traffic for communications carriers over our network. Beginning in
1999, we began to diversify our offerings by layering enhanced IP telephony
services over our network. These enhanced services were targeted at consumers
and were primarily accessible through our consumer Web site. During 2000, we
began offering services on a co-branded or private-label basis to service
providers and other businesses to assist them in diversifying their product
offerings to their customer bases. In 2001, we continued to enhance our unique
strengths through our pioneering work with the Session Initiation Protocol, SIP,
an Internet Engineering Task Force standard that has been embraced by industry
leaders such as Microsoft and Cisco. These efforts culminated in the launch of
our state-of-the-art SIP infrastructure, and in doing so we became the first
major VOIP service provider to deploy an end-to-end SIP network and services. In
recent years, we have continued our pioneering efforts in SIP and these efforts
have yielded significant new releases. For example, we released a next
generation SIP-based PC-to-Phone application, certified many new devices which
function as access points to our services, and added new features and new
calling plans to our offerings.
In 2004, we announced our first major service provider contract with
Verizon Communications Inc. In 2005, we remained focused on increasing the
market penetration of our core VoIP solutions and on continuing to diversify and
expand our customer base. As a result, we continued to sell an increasing
diverse set of VoIP products and services to our growing Service Provider and
Reseller base and focused on enhancing our service delivery offering suite by
successfully launching a turnkey VoIP solution for medium size cable and
Internet service providers, adding new features to our VoIP products, launching
new distribution lines for our consumer group, and upgrading our network
capacity.
Going forward, we expect to continue to devote a significant amount of our
resources to develop and expand our Service Provider and Reseller base and we
expect our revenue from this key channel to represent a growing percentage of
our total revenue over the next several years. We are actively marketing our
products and services to a large number of broadband operators, including
telecom, cable companies, Internet service providers, and consumer oriented
retailers around the world. We believe these companies may prefer to buy our
offerings instead of building their own internally developed VoIP service.
Industry Background
VoIP is increasingly becoming a widely used alternative technology that
can replace services provided by a traditional telephone network. VoIP
technology translates voice into data packets, transmits the packets over data
networks such as the Internet or privately managed networks (such as our
network), and reconverts them into voice at the destination. Unlike traditional
telephone networks, VoIP does not use dedicated circuits for each telephone
call; instead, the same VoIP network can be shared by multiple users for voice,
data and video simultaneously. This type of data network is more efficient than
a dedicated circuit network because the data network is not restricted by the
one-call, one-line limitation of a traditional telephone network and, as a
result, greater traffic can be transmitted over this data network. This improved
efficiency creates cost savings that can be passed on to consumers in the form
of lower rates or retained by the VoIP provider. Significant cost savings are
also achieved for international telephone calls carried over data networks
primarily because they bypass the international settlement process, which
represents a significant portion of international long distance tariffs.
Additionally, VoIP allows for features that are not available on traditional
telephony networks - particularly at the consumer level - including voice mail
to email forwarding, find me/follow me, and web-based control of call forwarding
preferences, user account review/revision and a host of other features and
functions.
Forrester Research, a market research firm, estimates that VoIP telephony
services will grow to represent approximately 15% of U.S. households will
convert to VoIP by the end of 2010. Beyond cost savings, we believe that VoIP
telephony technologies will further the potential for the Internet to become the
preferred medium of communications and commerce. As a result, VoIP has
experienced significant growth in recent years due to:
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o improved quality and reliability of VoIP calls due to technological
advances, increased network development and greater bandwidth capacity;
o new product development that allow VoIP providers to offer services not
currently offered by traditional telephone companies;
o greatly improved ease of use, where the end-user essentially perceives no
difference between use of a traditional telephone and a broadband
telephone;
o increasing demand for long distance communication services driven by the
increased mobility of the global workforce; and
o increasing demand for lower cost telephone service around the world.
As a result of these growth trends, various service providers, enterprises
and consumers are continuing to procure offerings from VoIP providers, including
deltathree. Specifically, consumers in emerging markets are increasingly using
VoIP-enabled services, such as Internet Protocol, or IP, telephones, to realize
significant cost savings on long distance and international calls, while in
markets where a significant number of consumers have access to broadband
internet services, these consumers are increasingly looking at VoIP as a viable
and more affordable substitute for their traditional telecommunications
provider.
Accordingly, many of the traditional telecommunications providers are
looking to deploy VoIP as a defensive strategy, while cable companies, ISPs and
other broadband providers are looking at VoIP service offerings as a way to
capture new revenue streams from existing and new customers. These providers
have two primary alternative means to develop and deploy VoIP offerings: they
can build them in-house; or they can partner with a company like deltathree and
outsource all or a portion of the effort. Those seeking to offer VoIP service
offerings by developing an in-house service must learn a vastly different set of
platforms, and integrate several additional components with their existing
systems, which requires the development of significant technical expertise and
the deployment and management of substantial capital expenditures.
Alternatively, a full service VoIP company, like deltathree, can provide these
service providers with the ability to outsource their VoIP services, and thereby
effectively reduce the upfront and ongoing cost of providing the service, and
efficiently reduce the time to market and risks associated with developing and
maintaining an in-house VoIP service.
Our Products and Services
Products.
We have built a privately-managed, global network using IP technology and
offer our customers a broad range and unique suite of IP telephony products. Our
VoIP products include:
PC-to-Phone. Our PC-to-Phone offering enables a user to conveniently and
inexpensively place a call to a standard telephone anywhere in the world
directly from a personal computer while remaining on-line. In order to use this
product, a user need only download our software from our Web site and have
access to the Internet. Once our PC-to-Phone application is downloaded and a
user account is established, the user is able to place a call from the user's
personal computer and, while browsing the Web, speak to a party who uses a
standard telephone.
We are able to provide our PC-to-Phone offering at rates generally lower
than those charged for traditional circuit switched calls. We are able to charge
lower rates because our service utilizes packet-switched technology and because
it routes calls directly from the user's Internet connection onto our
privately-managed IP network and to the called destination, thus avoiding access
and other charges associated with traditional international and domestic long
distance telecommunications services.
3
Broadband Phone. In early 2001, we successfully deployed one of the
world's first commercially available Broadband Phone offering. Our Broadband
Phone product is a complete phone replacement solution available to business and
consumer customers over the "last mile" through broadband connections via cable
modem, DSL or fixed wireless. Broadband Phone challenges the traditional public
switched telephone network (PSTN) and circuit switched networks with a full VoIP
solution. With our high call quality, "always on" reliability and increased
functionality provided by the high bandwidth access line, we are able to offer
potential partners and their customers some of the most sophisticated VoIP
solutions available in the market through a highly scalable, low-cost and easily
implemented product. In addition to offering capabilities similar to those
offered by traditional telephony providers and allowing users to use their
existing phone, Broadband Phone enables a user to conveniently operate features
and retrieve voice mail through email, web or a phone interface. For our
potential partners, the turnkey solution is delivered with our full back-end
infrastructure, including customer service for end users, customer service for
service providers, pricing information, fulfillment, billing and provisioning
and fraud services. Additionally, Broadband Phone is easily integrated (a
variety of devices are available to plug directly into a PC or IP network) so as
to allow broadband providers to begin delivering our voice solution rapidly.
Services.
We differentiate ourselves from our competitors by providing a robust set
of value-added services that enables us to effectively address the challenges
that have traditionally made the provision of telecommunications services
difficult. These operations management tools include the following:
o account provisioning: we provide our service provider and reseller
customers with a dedicated Web page through which they can order
additional services or accounts, generate and activate PINs and
perform other customary implementation functions;
o payment processing systems: we provide our customers with a fraud
detection and prevention system to permit secure credit card
transactions over the Web;
o billing and account management: we provide our customers with
real-time, Web-based access to billing records to check billing and
usage information or to increase prepaid accounts; and
o customer care: we have moved and consolidated traditional first tier
customer care functions onto the Web for ease and flexibility and
support this with second tier customer care via toll-free access.
The provision of VoIP telephony products and services through our service
provider and reseller sales efforts (including sales of our Outsourced Platform
Solution) accounted for 77.5% and 61.2% of our total revenues in 2005, while the
provision of VoIP telephony (primarily PC-to-Phone) through iConnectHere
accounted for 22.36% of our total revenues in 2005.
Our Distribution Channels
Service Provider and Reseller Channel
We have developed and will continue to develop high-value, globally
relevant solutions for the large number of service providers and resellers that
are focused on providing their customers with VoIP telephony products and
services. Our service provider and reseller offerings include:
Our Outsourced Platform Solution. Our "Outsourced Platform Solution"
leverages our VoIP expertise and delivers to our resellers, corporate customers
and service providers a highly customizable, private-label suite of VoIP
products and services. Using our infrastructure, we enable these enterprises to
offer their customers any combination of our basic products and services,
accessible through a single account. We believe that our Outsourced Platform
Solution brings our customers the value-added services they need to leverage
their strong customer bases and generate new revenues. Our largest service
provider customers demand a completely customized offering, and we have built
our platforms in a manner that efficiently and effectively allows us to deploy a
fully customized VoIP offering in a very short amount of time, and at
significantly reduced cost when compared to the development of a in-house
solution.
4
In 2005 we introduced our "Launch Ready" Outsourced Platform Solution, a
turnkey VoIP solution specifically designed to provide our medium sized cable
and Internet service provider customers with the ability to rapidly and
efficiently deploy advanced VoIP services to their end customers. The "Launch
Ready" solution enables us to deploy a full VoIP solution in a very compressed
period of time while still allowing for the offering of a broad suite of
services, features, and support services. We have used this solution as the
basis for several of our recently announced trials and transactions, and
anticipate that it will be the preferred platform for our smaller service
provider customers.
As we add new offerings to our suite of VoIP products and services,
customers can realize new revenue streams from their existing customer base and
make their own offering even more powerful and attractive. The products and
services delivered under our Outsourced Platform Solution are supported at all
times by our Network Operations Center ("NOC") and our customer care center.
Convergence of the Outsourced Platform Solution and the Reseller Program.
For several years we have offered businesses the opportunity to become resellers
of our services through our global reseller program. In the early years, these
resellers met their customers' needs by purchasing account numbers in bulk at
reseller specific rates, and they in turn resold these accounts to private
individuals under the deltathree brand, their own brand, or as "white-label"
product (i.e., no brand name is indicated). As our resellers became more
sophisticated, we introduced new features and functions that allowed them to
develop their own unique price plans and service bundles to more closely align
their offerings with their own customers' unique needs. In addition, we
developed increasingly sophisticated online toolsets that allowed our resellers
to better manage their internal processes and enabled them to utilize our
web-based customer care tools to provide customer service to their end-users
through their own customer service team. In doing so, we have increasingly set
ourselves apart from our competitors by moving from an undifferentiated source
of "telecom minutes" to a highly differentiated partner by providing them with a
full suite of tools to manage and grow their business.
In doing so, the lines of differentiation between service providers and
resellers continue to narrow as they grow increasingly similar. Both service
providers and resellers are looking to leverage their own brands, are
increasingly looking to sell sophisticated products and services to their own
customers under their own brand, with their own look and feel. As such, our
reseller customers are looking for advanced VoIP feature sets and applications
to support their ability to deliver unique calling plans and bundled services to
their end customers. Our customers desire for, and our ability to deliver, these
increasingly sophisticated offerings is proving to be a critical competitive
advantage in terms of growing sales with existing customers, securing new
customers, and converting customers from other vendor platforms. In order to
continue to provide our reseller customers the best features and services
available, we are constantly assessing our customer needs and deploying new
enhanced services for the VoIP reseller market.
iConnectHere
We have positioned iConnectHere as a powerful showcase and test facility
for our current and future products and services, and as a leverage point for
service provider and reseller sales. iConnectHere demonstrates our products,
services and hosting capabilities to our reseller customers and service
providers. Through iConnectHere, an account holder can access all of our product
offerings, including PC-to-Phone and Broadband Phone. Our customer care and
support teams utilize the full range of our back-end infrastructure and support
in servicing iConnectHere customers. Additionally, iConnectHere permits us to
collect usage information on our products and services and enables us to provide
our service provider and reseller customers with key information and
recommendations regarding implementation of our products and services.
Through iConnectHere, consumer users can:
o sign up for any of our services, including PC-to-Phone, and
Broadband Phone;
o download our software and/or order IP-based Broadband Phone devices;
o recharge their accounts, either by entering their credit card
information or authorizing automatic recharging;
o send a PC-to-Phone call;
5
o check real-time billing and usage information;
o communicate by e-mail with a customer service representative, and;
o view answers to frequently-asked questions.
Our Competitive Advantages
We believe we have several core competitive advantages that will allow us
to maintain and expand our position as a leading provider of VoIP services.
Experience and Expertise in VoIP. We pioneered the development and
deployment of commercially viable VoIP products and standards, and in doing so,
we have become one of the most recognized providers of VoIP around the world. We
have a proven track record of rapidly deploying robust, modular VoIP offerings
to the most demanding large service providers, while successfully managing our
VoIP services around the world and across a variety of networks and
technologies. Over our ten-year history, our engineering teams have consistently
demonstrated their ability to develop and deploy innovative platforms, including
what has become the dominant VoIP technology standard, SIP, while our research
and development team has created inventive new products, feature enhancements
and applications to improve the performance and quality of our services. Our
service provider and reseller solutions leverage the leading edge platform we
developed for our own direct-to-consumer VoIP business, and the lessons learned
from first-hand experience in developing and deploying VoIP services around the
world for almost a decade.
Financial Strength. We have a strong balance sheet, with $15.7 million in
cash, restricted cash, and short-term and long-term investments and no debt as
of December 31, 2005. We have demonstrated our ability to simultaneously grow
revenues and improve the bottom-line. Our financial strength allows us to pursue
new sales opportunities, such as the service provider and reseller markets,
while at the same time growing our existing core business lines in targeted
areas. In addition, our financial strength allows us to offer our customers
flexible strategic, operational and economic alternatives for deploying VoIP
solutions to their customers.
Scale. We deliver VoIP telephone services to hundreds of thousands of
active, paying consumer and business users in over 150 countries through our
direct-to-consumer channel, our service provider customers and our global
distribution network of over 400 resellers. As end-users around the world
continue to look for alternative and improved telecommunications services, we
can employ our products and services to a growing distribution network and
capitalize on our existing relationships to partner with incumbent
telecommunications providers, cable companies, and ISPs. In addition, as our
customer base continues to grow, we expect to benefit from the scale and quality
of that combined market power and expect to be well positioned to effectively
and quickly deliver new products and services to large numbers of consumers
through large and small service providers, resellers and our direct-to-consumer
channel, iConnectHere.
Strategic Relationships. We have established and expect to expand our
strategic relationships with large and mid-sized incumbent telecommunications
providers, cable operators, and ISPs. Through our relationships with companies
such as Level 3 Communications and XO Communications, we are able to obtain
access to high quality telecommunications services and networks at competitive
prices, and also obtain access to such companies' existing and potential
partners. We believe our VoIP telephony platform, combined with our strategic
relationships with a variety of leading providers around the world will enable
us to continue to differentiate ourselves from other VoIP providers.
Our Strategy
Our strategy is to become the leading provider of VoIP telephony products
and services, worldwide. The following are key elements of our strategy:
Capitalize on the Growth of the VoIP Marketplace. We believe we are well
positioned to take advantage of the expected growth of the VoIP services and
cable telephony markets. The Yankee Group, a leading technology research firm,
predicts that almost 20 million consumers will switch to VoIP telephony by 2008
in the United States alone.
6
Target large to Mid-sized Telecom Providers. Our service provider and
reseller channel will leverage several large wins and specifically target large
to mid-sized incumbent telecom providers in the U.S. and worlwide, with similar
offerings, as we believe these companies may be more likely to buy our services
than to build their own VoIP service as a viable defensive strategy. We believe
our service and our expertise in VoIP reduce these providers' costs, time to
market and risks associated with developing and maintaining an in-house VoIP
service.
Target Small to Mid-sized Cable Providers. Our service provider and
reseller channel will leverage our demonstrated success in the deployment of
sophisticated VoIP solutions, and target small to mid-sized cable operators in
the U.S. and worldwide, whom we believe may be more likely to buy our services
than the larger companies in the cable space. We believe that they will seek out
the same incremental revenue opportunities as their larger peers, but may not
have the significant technical and financial resources required to develop an
internal cable telephony solution, such as the personnel to support network
operations, engineering, support and project management, and may therefore
instead embrace outsourcing as an effective manner to enter the marketplace. We
believe our service and our expertise in VoIP reduces their costs, time to
market and risks associated with developing and maintaining an in-house VoIP
service.
Offer Flexible and Modular Deployment Alternatives. We offer our service
providers and resellers a choice of deployment alternatives ranging from full
outsourcing to partial outsourcing through our modular offering suite. Depending
on the particular needs of each of our customers, we design our offering to fit
within their business objectives, available resources and desire level of
participation. We can develop and integrate specific features and functions into
our package, such as various network elements, access components, fulfillment,
and the specific feature/functions the provider can offer to its end-users. For
resource and capital constrained providers, we offer alternatives that require a
lower amount of human resources, development time and financial investment by
the customer.
Sales and Marketing
Service Provider and Reseller Channel
Service Provider Sales. We have developed and deployed a focused sales
team that specifically targets large and medium incumbent telecom providers,
mid-sized to smaller cable companies, ISPs and other broadband service providers
and virtual network operators. This highly talented team will market to these
customer targets around the world, focusing on developed and developing markets
in the US, Europe, Latin America and Asia. Our well-known success in deploying
sophisticated solutions to the most demanding large telecom providers, provides
us with significant leverage as we introduce these services to other service
providers. Recent examples of success in this market include our agreement with
Verizon Communications and our current large market trials with several
mid-sized and large service providers.
Reseller Program. Our Reseller sales force contracts with smaller service
providers and resellers around the world, who in turn sell our products and
services, under their own brand, a white-label brand and/or our deltathree brand
to retailers, businesses, Internet cafes and others in their local markets. Our
experience in provided differentiated VoIP solutions in the emerging
international telecommunications environment enables us to effectively enter new
markets as they open to competition. This group will continue to market to these
resellers around the world, focusing on emerging markets in the Middle East,
Asia and Central and South America.
Using our platform, and solutions, resellers can quickly and easily sell
our products to their own customers in their own specific markets.
iConnectHere
We have developed and will continue to develop low-cost, diversified
marketing, advertising and promotional programs to stimulate demand for our
iConnectHere services. Our marketing, advertising and promotional programs
include:
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o On-line "affiliate" agent commission program. We have developed a
Web-based agent program that allows for rapid agent enrollment and
agent account maintenance. Agents may devise their own marketing
programs, including Web-links, direct mail campaigns or co-branding
of our services in select markets. Agents receive as commissions a
percentage of revenue generated from end users who sign up for our
services through the agent's Web site.
o Off-line "affiliate" agent commission program. Our off-line agent
commission program allows non-Web agents to design their own
marketing programs to solicit sales of our services. Off-line agents
market and advertise through traditional channels such as newspaper
and magazine advertisements, direct mail campaigns and telemarketing
campaigns. Off-line agents receive a percentage of revenue generated
from users who sign up for our services through the agent's
programs.
Our Infrastructure
Network
In order to deliver leading VoIP products and services, we operate a
privately-managed IP telephony network. By managing our network, we have the
ability to regulate traffic volumes and to directly control the quality of
service from each originating point of presence, or POP, to the termination
point via a variety of termination options. Our ability to interconnect to a
wide variety of termination options increases the diversity and robustness of
our network, minimizes and eliminates single points of failure, and
simultaneously allows us to benefit from pricing differences between vendors to
the same termination points. In addition, our network allows us to avoid the
significant transmission delays associated with the Internet, which may impede
delivery of high quality, reliable services to our users.
In 2001, we rolled out our state of the art SIP infrastructure. The SIP
protocol is one of the most advanced VoIP protocols and unlike its predecessors,
which were modeled after traditional telephony protocols, SIP has the ability to
scale with a distributed architecture and at a lower cost. SIP's superior
attributes also include faster and more cost effective development and lower
hardware requirements, which allows us to incur lower capital expenditure costs.
Our SIP network currently powers the majority of our offerings, and during 2006,
we intend to continue to expand our offerings on this network.
Our network is built around a redundant, high availability backbone that
connects New York, London, Los Angeles, Atlanta, Chicago, London, Amsterdam,
Hong Kong and Jerusalem. In each of, and between, these locations we maintain
multiple interconnections or peering arrangements with Internet backbone and
voice providers. These points are strategically located to allow access from our
network to and from the Internet with the best performance. While operating as a
private extension of the Internet, our backbone has a high level of security
designed to isolate it from security threats found on the public Internet.
Access to our network is possible through several products and services. A
call can originate from the PC-to-Phone product using our downloadable software
application "soft-phones," a Web browser, or Broadband Phone devices. These
calls enter our network from the Internet through our interconnection points. We
carefully manage each originating point and use innovative capacity planning
tools and techniques to provide the best and most cost effective service to
customers.
Our network can terminate calls through any of our POPs and termination
providers' POPs. Termination decisions are based on a sophisticated Least Cost
Routing system which applies routing rules based on origination point, time of
day, termination cost and other factors. These rules are constantly updated to
ensure maximum economic and quality efficiency. Each termination port is
carefully managed with innovative capacity planning tools and techniques to
provide the best and most cost effective service to customers, along with
multiple termination options to ensure the highest possible levels of
redundancy.
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We are party to service agreements with several telecommunications
providers, including competitive local exchange carriers, foreign post,
telephone and telegraph companies, Internet backbone providers and others.
Pursuant to these agreements, we can transport VoIP packets to our hubs and
terminate calls throughout the world in a cost effective and efficient manner.
Support
Our NOC monitors and manages our network from a central location, seven
days a week, 24 hours a day. The NOC monitors all aspects of our network,
including the routers, databases, switches, leased lines, Internet connections,
gatekeepers and gateways, to ensure that they are functioning at optimal levels.
In the event of a failure of any of these network components, NOC personnel are
provided with a real time, systems generated notification via an instant
messaging system consisting of pagers, cellular phones, screen pop-ups and
e-mail, which identifies the malfunction so that proper measures can be taken to
restore service in a timely fashion. Our NOC utilizes a combination of
proprietary and leading industry technologies, including Hewlett-Packard Open
View software and Ericsson IPT management console, as well as unique
applications developed by us. The NOC serves all of the different parts of our
operations environment, including network nodes, Web servers and specific
applications.
We provide customer support on various levels to different customers. With
respect to our service provider and reseller customers, we provide customer care
and technical support directly to these customers, and they in turn provide
their own support directly to the end user. Customers of iConnectHere receive
technical support and customer care through our web-based customer service site,
e-mail support and telephone support.
Our services are supported by our on-line interactive customer service and
billing center, which enables an end user to set up an account, receive an
account number and a PIN, pay by credit card for services, find answers to
frequently asked questions and contact customer service representatives. Once a
user has established an account, the user can prepay for additional usage by
credit card as well as access real-time detailed information such as call logs
and transaction records. Through the on-line billing system, a user can
personalize the billing information to select the data most relevant to them.
This on-line interactive customer service and billing center is supported by a
human customer care contact center that provides voice and e-mail support to the
customers.
Suppliers
We outsource from third-party vendors the provisioning of certain of our
local telecommunications services, including local phone numbers, access to the
PSTN, operator assistance, directory listings and assistance, E911 emergency
services and local number portability. We also outsource the provisioning of our
consumer premises equipment, such as our analog telephone adapters, IP Phones
and gateways. We do not rely on any one specific vendor for providing these
services, except for E911 emergency services. While we believe our relations
with our suppliers are good, we believe that we could replace our suppliers if
necessary, and believe that our ability to provide services to our customers may
be impacted but do not expect that this would have a significantly adverse
affect on our business, financial condition and results of operation.
Proprietary Rights
We rely and expect to be able to rely on trademark and trade secret laws,
confidentiality agreements and other contractual arrangements with our
employees, strategic partners and others to protect our proprietary rights.
We have registered trademarks for "deltathree(TM)" and
"iConnectHere.com(TM)" in the United States and internationally. However, these
trademarks may not provide adequate protection against competitive technology
and may not be held valid and enforceable if challenged. We do not own any
registered copyrights.
To further safeguard our intellectual property, we have a policy that
requires our employees to execute confidentiality and technology ownership
agreements when they begin their relationships with us.
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Regulation
Regulatory Environment Overview
The use of the Internet and private IP networks to provide voice service
is a relatively recent market development. Although the provision of such
services is currently generally not as regulated as traditional telephony
services within the United States, the Federal Communications Commission, or
FCC, is reviewing whether to apply additional regulations to VoIP services. The
United States Congress is also considering whether to impose new and additional
regulations on providers of VoIP services, including us. In addition, several
foreign governments have adopted or proposed regulations that could be
interpreted to restrict or prohibit the provision of VoIP services. Other
countries, however, have begun to open their markets to competition from new
Internet-based voice services. Regulation of Internet telephony providers and
services may materially and adversely affect our business, financial condition,
operating results and future prospects, particularly if increased numbers of
governments impose regulations restricting the use and sale of IP telephony
services.
Federal Regulation
Regulatory Classification of VoIP Services
To date, the FCC has not imposed broad-based regulatory charges or
traditional common carrier regulation upon providers of Internet communications
services, but it has begun regulating this area on a limited basis as outlined
in this section. On February 12, 2004, the FCC initiated a rulemaking proceeding
concerning the provision of voice and other services using IP technology,
including assessing whether VoIP services should be classified as information
services or telecommunications services. We believe that the VoIP services that
we provide constitute information services. This proceeding, however, could
result in the FCC determining, for instance, that certain types of Internet
telephony should be regulated like basic telecommunications services. Thus,
Internet telephony could no longer be exempt from access charges, which
reimburse local carriers for use of their local telephone network and other
telecommunications related fees and regulatory obligations. The FCC could also
conclude that Internet telephony providers should contribute to the Universal
Service Fund, which provides support to ensure universal access to telephone
service.
The imposition of access charges, regulatory fees, or universal service
contributions could substantially increase our costs of serving our customers in
the U.S. We may have to increase our prices to cover these costs, which could
have a negative impact on our ability to compete with other telephony providers.
The imposition of regulation and contribution requirements might also negatively
affect the incentives for companies to continue to develop IP technologies to
offer VoIP services because companies may need to divert resources from research
and development to comply with regulatory and contribution requirements. It is
also possible that the FCC might adopt a regulatory framework that is unique to
IP telephony providers or one where IP telephony providers are subject to
reduced regulatory requirements, which we believe would be good for us. We
cannot predict what regulations, or the extent of regulation, if any, the FCC
may impose. We cannot predict when the FCC will issue a final decision, the
outcome of the decision, or the result of any subsequent proceedings or actions
that may arise out of the FCC's decision. As a result, we cannot assure you that
some or all of our products and services will not be regulated in the future.
VoIP E911 Matters
On June 3, 2005, the FCC released an order and notice of proposed
rulemaking concerning VoIP emergency 911 services. The order set forth two
primary requirements for providers of "interconnected VoIP services", meaning
VoIP services that can be used to send or receive calls to or from users on the
public switched telephone network. The order applies to our iConnectHere
customers. We do not believe that we are responsible for compliance with this
order in connection with the services sold to our customers who purchase our
services for the provision of services directly to end users. Clarification of
this issue has been raised by similar providers with the FCC, however, the FCC
has not addressed it to date and we cannot predict how the FCC would rule on
this issue. Furthermore, depending on the FCC's ruling on this issue, we cannot
predict whether we would be subject to any third-party litigation in connection
with such customers who resell our services.
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First, the order required us to notify our iConnectHere customers of the
differences between the emergency services available through us and those
available through traditional telephony providers. We also had to receive
affirmative acknowledgment from all of our iConnectHere customers that they
understand the nature of the emergency services available through our service.
On September 27, 2005, the FCC's Enforcement Bureau released an order stating
that the Enforcement Bureau will not pursue enforcement actions against VoIP
providers, like us, that have received affirmative acknowledgement from at least
90% of their subscribers. We are required to file a report with the FCC when we
receive affirmative acknowledgments from 100% of our customer base. We have
received affirmative acknowledgment from more than 94% of our iConnectHere
customers that they understand the nature of the emergency services available
through our service, and thus we are substantially in compliance with the first
aspect of the FCC's June 3 order.
Second, the order required us to provide enhanced emergency dialing
capabilities, or E-911, to all of our iConnectHere customers by November 28,
2005. Under the terms of the order, we are required to use the dedicated
wireline E-911 network to transmit customers' 911 calls, callback number and
customer-provided location information to the emergency authority serving the
customer's specified location.
On November 7, 2005, the FCC's Enforcement Bureau issued a Public Notice
with respect to that requirement. The Public Notice indicated that providers who
have not fully complied with the enhanced emergency dialing capabilities
requirement are not required to discontinue the provision of services to
existing clients, but that the FCC expects that such providers will discontinue
marketing their services and accepting new customers in areas in which the
providers cannot offer enhanced emergency dialing capabilities.
We also have taken many significant steps to comply with the enhanced
emergency service rules, but we were unable to comply with all of the
requirements of the FCC's order by the November 28, 2005 deadline. Some of our
customers currently receive E-911 service in conformity wit the FCC's order, but
a number of our customers do not receive such service. We do not expect to be
able to provide E-911 service to all of our customers in the short term unless
we are granted a waiver of the requirements by the FCC. On November 28, 2005, we
filed a petition for extension of time and limited waiver of certain of the
enhanced emergency service requirements, including the limitations on marketing
and accepting new customers. The FCC has not acted on our petition, and we
cannot predict whether the FCC will grant our petition or provide other relief.
Should we be unable to obtain an extension of time to implement the requirements
of the order, we may be subject to enforcement action by the FCC that could
include monetary forfeitures, cease and desist orders, and other penalties. We
may also be required to stop serving those customers to whom we cannot provide
the required enhanced emergency dialing capabilities and may be required to stop
accepting new customers in areas in which we cannot provide these capabilities.
The FCC's June 3, 2005 order also included a notice of proposed rulemaking
that considers, among other things, whether interconnected VoIP providers must
transition to an emergency services system that would enable interconnected VoIP
providers to establish the location of their customers without the customer
providing location information. The comment period closed September 12, 2005. We
do not know when the FCC may take further action in this proceeding. If the FCC
adopts additional regulatory obligations, implementing systems to comply with
the obligations could be time consuming and expensive.
See "--Fees and Taxes" for a discussion of fees we may collect in the
future in connection with providing E-911.
Bundling of DSL and Voice Services by Incumbent Telephone Companies
In March 2005, the FCC ruled that state public utility commissions cannot
require that incumbent telecommunications carriers permit competing carriers to
provide voice service to retail customers over the same copper wires used by the
incumbent carriers to provide DSL service. As a result of this ruling, many
incumbent carriers no longer permit retail customers to purchase DSL as a
stand-alone service. This ruling makes our service much less attractive to
customers who obtain broadband Internet access through an incumbent
telecommunications carrier because the incumbent carrier can require them to buy
voice service together with DSL. While some incumbent carriers make DSL
available on a stand-alone basis, they have no legal obligation to do so and
could discontinue such offerings at any time. However, in connection with its
approval of the mergers of SBC and AT&T and Verizon and MCI, the FCC required
each of the merged companies to offer DSL service for two years from the
implementation of stand- alone DSL service, but no more than three years from
the date of the FCC's merger orders. These conditions could make our service
more attractive to our customers who obtain broadband Internet access through
the merged entities. In addition to the FCC's requirements, some states imposed
conditions on their approvals of the mergers that require the merged companies
to offer standalone DSL.
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Communications Assistance for Law Enforcement Act, or CALEA
The Communications Assistance for Law Enforcement Act, or CALEA, requires
certain communications service providers to assist law enforcement agencies in
conducting lawfully authorized electronic surveillance. On September 23, 2005,
the FCC released an order concluding that CALEA applies to VoIP providers that
offer services that allow users to receive calls from, and make calls to, the
public switched telecommunications network. The FCC established a deadline of
May 14, 2007 for VoIP providers to comply with the requirements of CALEA. The
order did not address the specific standards to be imposed on us. While we
intend to comply with the CALEA order and we continue to cooperate with law
enforcement to enable authorities to accomplish lawful wiretaps, we may be
required to expend significant resources to comply with CALEA. If we do not
comply, the FCC may subject us to fines and penalties, and we may decide to or
be required to disconnect customers.
Universal Service Fund
FCC regulations require providers of interstate telecommunications
services, but not providers of information services, to contribute to the
federal Universal Service Fund, or USF. USF contributions are currently
calculated as a percentage of interstate and international revenue. Currently,
we are not required to contribute directly to the USF, although we do contribute
indirectly to the USF through our purchase of telecommunications services from
our suppliers. If the FCC determines that VoIP services like ours should be
classified as telecommunications services, we may be required to contribute
directly to the USF. In addition, the FCC is considering a number of proposals
that could alter the way that the USF is assessed. For instance, the FCC is
considering an assessment based on the use of telephone numbers. In the future,
we may be required to contribute directly to the USF or may face additional
costs due to an increase in the contribution obligations of our suppliers.
Intercarrier Compensation
The FCC is currently seeking comment concerning proposed reforms of the
intercarrier compensation system, which is a set of FCC rules and regulations by
which telecommunications carriers compensate each other for the use of their
respective networks. These rules and regulations affect the prices we pay to our
suppliers for access to the facilities and services that they provide to us,
such as termination of calls by our customers onto the public switched telephone
network. We cannot predict what, if any, intercarrier compensation regulations
the FCC's order may impose on VoIP providers.
Other FCC Proceedings That Could Affect VoIP Services
There are several other recent or ongoing FCC proceedings initiated by
various persons that relate to VoIP and other Internet services. Certain of the
FCC's conclusions in these proceedings could have an effect on the VoIP industry
generally and on our business.
State Regulation
Despite the FCC's actions and FCC rulings to the contrary, state
regulatory authorities believe they retain jurisdiction to regulate the
provision of, and impose charges on, intrastate Internet and VoIP telephony
services. Rulings by the state commissions on the regulatory considerations
affecting Internet and IP telephony services could affect our operations and
revenues, and we cannot predict whether state commissions will be permitted to
regulate the services we offer in the future.
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Fees and Taxes
There are numerous fees and taxes assessed on traditional telephone
services that we believe have not been applicable to us and that we have not
paid in the past. However, we may begin to collect and remit some of these fees
and taxes in the future. To the extent we increase the cost of services to our
customers to recoup some of the costs of compliance, this will have the effect
of decreasing any price advantage we may have.
Calls to 911 are answered by public safety agencies supported by state and
local taxes and fees on traditional telephone companies. In the future, we may
be required to pay such fees to state and other authorities in connection with
E-911. The FCC has mandated that we provide E-911 services, but refrained from
ordering interconnected VoIP service providers from contributing to state funds.
It is reviewing the issue as part of its Further Notice of Proposed Rulemaking
concerning E911 issues. A handful of states have addressed how VoIP providers
should contribute to support public safety agencies and in these states we may
be required to remit fees to the appropriate state agencies.
In addition, it is possible that we will be required to collect and remit
sales taxes in several states where we have not done so in the past. We are in
the process of discussing the applicability of sales and other taxes with
numerous states and we may proactively enter into discussions with additional
states as conditions warrant. If we determine that we need to collect and remit
sales taxes, we will comply with the administrative rules existing in that
state.
States have or may take the position that we should have collected sales
taxes in the past. If so, they may seek to collect those past taxes from us and
impose fines, penalties or interest charges on us. Our payment of these past
taxes and related charges could have a material adverse effect on us.
In addition to sales taxes, there are various state, municipal and local
taxes and fees that are applicable to traditional telephone companies that we
believe are not and should not be applicable to us. If, contrary to our belief,
we are or become subject to these taxes or fees, we will be required to pay or
collect and remit them, which would erode our price advantage when we compete
for customers. In addition, we could be required to pay these taxes or fees, and
related charges, retroactively. Our payment of these past taxes and fines,
penalties or interest charges could have a material adverse effect on us.
International
The regulatory treatment of Internet and IP telephony or VoIP outside of
the United States varies widely from country to country. A number of countries
may prohibit Internet and IP telephony while other countries expressly permit,
but regulate Internet and IP telephony. Some countries evaluate proposed
Internet and IP telephony service on a case-by-case basis to determine whether
any regulation is necessary or whether it should be regulated as a voice service
or as another telecommunications or data service. Finally, in many countries
neither Internet nor IP telephony have been addressed by legislation or
regulatory action as of the date of this filing. Although we strive to comply
with applicable international IP telephony regulations, we cannot be certain
that we are in compliance with all of the relevant regulations at any given
point in time.
In 2003, the European Commission adopted a set of directives for a new
framework (New Regulatory Framework) for electronic communications regulation
that, in part, attempts to harmonize the regulations that apply to services
regardless of the technology used by the provider. Under the New Regulatory
Framework, there is no distinction in regulation made based upon technology
between switched or packet-based networks. As a result of this technology
neutral regulatory approach, some types of IP telephony and VoIP services may be
regulated like traditional telephony services while others may remain free from
regulation. The European Commission has published a staff working paper aimed at
clarifying the conditions applicable to providers of IP-based services. The
working paper identifies various issues that may arise in relation to IP-based
services including the regulatory classification of Internet telephony and VoIP
under the New Regulatory Framework. The European Regulators Group (consisting of
regulators from European Union Member States and the European Commission) has
adopted a Common Statement for VoIP regulation. The European Commission
currently is reviewing how IP telephony services fit into the New Regulatory
Framework. Although the European Commission it has been suggested recommended
that a "light touch" to regulation be taken, we cannot predict what future
actions the European Commission, member states, and courts reviewing the New
Regulatory Framework may take regarding towards IP telephony and related
matters, or what impact, if any, such actions may have on our business.
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Based on the European Commission's current position, we believe that most
providers of IP telephony would be subjected to no more than minimal regulation
such as a general authorizations or declaration requirements that may be imposed
by the European Union Member States, subject to the European Commission's
current review of the issue. Several Member States have issued consultations
requesting industry comments on the applicability of the New Regulatory
Framework to various IP telephony and VoIP services in their respective
countries. However, since the Commission's findings on IP telephony are not
binding on the Member States, we cannot assure you that the services provided
over our network will not be deemed "voice telephony" subject to heightened
regulation by one or more EU Member States. For example, the United Kingdom has
opened a proceeding to review the regulation of Internet-based voice services.
Although Member States are required to adhere to the New Regulatory Framework,
Member States may not take a uniform approach in regulating a particular
Internet-enabled service including IP telephony. We cannot predict the outcome
of these consultations or the manner in which Member States will implement the
New Regulatory Framework with respect to our particular services.
As we make our services available in foreign countries, and as we
facilitate sales by our network partners to end users located in foreign
countries, such countries may claim that we are required to qualify to do
business in the particular foreign country. Such countries may also claim that
we are subject to regulation, including requirements to obtain authorization for
the provision of voice telephony or other telecommunications services, or for
the operation of telecommunications networks. It is also possible that such
countries may claim that we are prohibited in all cases from providing our
services or conducting our business as conducted in those countries. Failure to
qualify as a foreign corporation in certain jurisdictions, or to comply with
foreign laws and regulations, may adversely affect our business. Nor can we
predict how a regulatory or policy change of a particular country might affect
the provision of our services.
Our network partners may also currently be, or in the future may become,
subject to requirements to qualify to do business in a particular foreign
country, comply with regulations, including requirements to obtain
authorizations for the provision of voice telephony or other telecommunications
services or for the operation of telecommunications networks, or to cease
providing services or conducting their business as conducted in that country. We
cannot be certain that our network partners either are currently in compliance
with any such requirements, will be able to comply with any such requirements,
and/or will continue in compliance with any such requirements.
Other Regulation Affecting the Internet
Congress has recently adopted legislation that affects certain aspects of
the Internet, including on-line content, user privacy, national security and
taxation. For example, the extension of the Internet Tax Freedom Act prohibited
certain taxes on Internet uses through November 1, 2003. Congress extended the
prohibition to 2007, subject to some exceptions. Congress, however, specifically
stated that nothing in the recent legislation affects the imposition of taxes on
voice or other similar services utilizing Internet Protocol or any successor
protocol. We cannot predict whether substantial new taxes will be imposed on our
services. In addition, Congress, the FCC and other federal entities are
considering other legislative and regulatory proposals that would further affect
the Internet. The European Union has also enacted several directives relating to
the Internet, one of which addresses online commerce. International governments
are adopting and implementing privacy and data protection regulations that
establish certain requirements with respect to, among other things, the
confidentiality, processing and retention of personal subscriber information.
The potential effect, if any, of these data protection rules on the development
of our business remains uncertain.
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Competition
We compete primarily in the market for enhanced VoIP telephony. This
market is highly competitive and has numerous service providers. We believe that
the primary competitive factors determining our success in the VoIP telephony
market are: quality of service and network capacity; the ability to meet and
anticipate customer needs through multiple service offerings and feature sets;
customer services, and price.
Future competition could come from a variety of companies both in the
Internet and telecommunications industries. These industries include major
companies who have greater resources and larger subscriber bases than we have,
and have been in operation for many years. We also compete in the growing market
of discount telecommunications services including "pure play" VoIP service
providers, calling cards, prepaid cards, call-back services, dial-around or
10-10 calling and collect calling services. In addition, some Internet service
providers have begun to aggressively enhance their real time interactive
communications, including instant messaging, PC-to-PC and PC-to-Phone services,
and Broadband phone services.
IP Telephony Providers. Many companies provide, or are planning to
provide, certain portions of the complete communications solution we offer,
including, Net2Phone, and Vonage.
Traditional Telecommunications Carriers and Broadband Services Providers.
Several traditional telecommunications companies, including industry leaders
such as AT&T, Sprint, Deutsche Telekom, and Qwest Communications International,
and established broadband services providers, such a Time Warner, Comcast, and
Cablevision have announced VoIP telephony services and products and/or their
intention to offer such products and services in both the United States and
internationally. All of these competitors are significantly larger than we are
and have:
o substantially greater financial, technical and marketing resources;
o larger networks;
o a broader portfolio of services;
o stronger name recognition and customer loyalty;
o well-established relationships with many of our target customers;
and
o an existing user base to which they can cross-sell their services.
These and other competitors may be able to bundle services and products
that are not offered by us together with VoIP telephony services, which could
place us at a significant competitive disadvantage. Many of our competitors
enjoy economies of scale that can result in lower cost structure for
transmission and related costs, which could cause significant pricing pressures
within the industry. At the same time, we see these potential competitors as
potential customers, and have organized our various service provider and
reseller products and services to meet the emergent needs of these companies.
Revenues and Assets by Geographic Area
For the year ended December 31, 2005, approximately $20.1 million, or
67.8%, of our revenue was derived from international customers, and $9.6
million, or 32.2%, was derived from customers in the United States. Most of our
long-lived assets are located in the United States. For more detailed
information concerning our geographic segments, see Note 12 to our financial
statements included elsewhere in this annual report.
Employees
As of December 31, 2005, we employed 115 full-time and 32 part-time
employees, of which 123 were located in Israel, and 24 were located in New York.
We consider our relationship with our employees to be good. None of our
employees is covered by collective bargaining agreements.
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Available Information
Our Internet address is www.deltathree.com. Through a link on the Investor
Relations section of our website located at www.deltathree.com, we make
available, free of charge, our annual reports on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K, and all amendments to those reports as
soon as reasonably practicable after such materials have been electronically
filed with, or furnished to, the SEC.
ITEM 1A. RISK FACTORS
Investing in our common stock involves a high degree of risk. Before you
invest in our common stock, you should understand and carefully consider the
risks below, as well as all of the other information contained in this annual
report, including our financial statements and the related notes contained
elsewhere in this report. Any of these risks could materially adversely affect
our business, financial condition and results of operations and the trading
price of our common stock, and you may lose all or part of your investment.
Additional risks and uncertainties not presently known to us or that we
currently deem immaterial also may impair our business operations.
Risks Related to our Company
We have a history of losses and we are uncertain as to our future profitability.
We have incurred significant losses since inception, and we may continue
to incur significant losses for the foreseeable future. We reported net losses
of $854,000 in 2005, approximately $3.2 million in 2004, and approximately $8.3
million in 2003. As of December 31, 2005, our accumulated deficit was
approximately $152 million. We generated positive cash flow from operations of
approximately $0.2 million during 2005 and $0.5 million during 2004. As a
percentage of revenues, our net loss was 2.9% in 2005, 15.4% in 2004, and 63.4%
in 2003. Our revenues may not grow or even continue at their current level. As a
result, while we believe we have sufficient funds to meet our working capital
requirements for at least the next fiscal year and although we attained
profitability during the fourth quarter of 2005, we will need to increase our
revenues and maintain our current cost structure to maintain profitability. If
our revenues do not increase as much as we expect or if our expenses increase at
a greater pace than revenues, we may not be able to maintain profitability. We
cannot assure you that we will be able to sustain or increase profitability on a
quarterly or annual basis in the future.
We may not be able to expand our revenue.
Our business strategy is to expand our revenue sources to include the
provision of VoIP telephony to several different customer groups. We can neither
assure you that we will be able to accomplish this nor that this strategy will
be profitable. Currently, our revenues are primarily generated by sales of VoIP
telephony through our direct consumer offering, iConnectHere, and our reseller
and service provider sales channels (including sales of our Outsourced Platform
Solution). VoIP telephony from these channels generated 96.1%, 96.02%, and 92.1%
of our total revenues in 2005, 2004, and 2003, respectively.
In the future, we intend to generate increased revenues in VoIP telephony,
from multiple sources and customer bases, many of which are unproven. We expect
that our revenues for the foreseeable future will be dependent on, among other
factors:
o sales of VoIP telephony, including sales of our Outsourced Platform
Solution;
o acceptance and use of VoIP telephony;
o expansion of service and product offerings;
o traffic levels on our network;
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o the effect of competition, regulatory environment, international
long distance rates and access and transmission costs on our prices;
and
o continued improvement of our global network quality.
We may not be able to sustain our current revenues or successfully
generate additional revenues from the sale of VoIP telephony, including our
Outsourced Platform Solution.
We may need additional capital to finance our operations and grow our business.
Due to the nature of our industry, our future capital needs are difficult
to predict. Therefore, we may require additional capital to fund some or all of
the following:
o introduction and deployment of our new, or existing, products and
services;
o enhancement and expansion of our network;
o unanticipated opportunities;
o strategic alliances, and potential acquisitions;
o changing business conditions; and
o unanticipated competitive pressures.
We intend to continue to expand our network and to introduce new products
and services. These activities require significant marketing and promotional
expenses that we often incur before we begin to receive the related revenue.
While we believe we have sufficient funds to meet our working capital
requirements for at least the next fiscal year, if our cash flow from operations
is not sufficient to meet our capital expenditure and working capital
requirements, we will need to raise additional capital. There can be no
assurance that we will be able to raise such additional capital on favorable
terms or at all. If we are unable to obtain additional capital, we may be
required to reduce the scope of our business or our anticipated growth, which
could have a material adverse effect on our business, financial condition, and
results of operations.
Decreasing telecommunications prices may cause us to lower our prices to remain
competitive, which could prevent our future profitability.
Decreasing telecommunications prices may diminish or eliminate the
competitive pricing advantage of our services. International and domestic
telecommunications prices have decreased significantly over the last few years
in most of the markets in which we operate, and we anticipate that prices will
continue to be reduced in all of the markets in which we do business or expect
to do business. Users who select our services (or our resellers' or Outsourced
Platform customers' services) to take advantage of the current pricing
differential between traditional telecommunications prices and our (or our
customers') prices may switch to traditional telecommunications carriers as such
pricing differentials diminish or disappear, and we will be unable to use such
pricing differentials to attract new customers in the future. Such competition
or continued price decreases may require us to lower our prices to remain
competitive, may result in reduced revenue, a loss or decrease of customers and
may prevent our future profitability.
We have a limited operating history upon which you can evaluate us.
Although we commenced our operations in 1996, in 2000 we began to
transform our business from a provider of wholesale minutes to carriers to our
current role as a provider of VoIP solutions. We, therefore, have only a limited
operating history upon which you can evaluate our current business and
prospects. You should consider our prospects in light of the risks, expenses and
difficulties we may encounter as an early stage company in the new and rapidly
evolving market for VoIP telephony. These risks include our ability:
o to increase acceptance of our VoIP telephony products and services
(including our Outsourced Platform Solution);
o to compete effectively; and
o to develop new products and keep pace with developing technology.
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In addition, because we expect an increasing percentage of our revenues to
be derived from our VoIP telephony products and services (including our
Outsourced Platform Solution), our past operating results may not be indicative
of our future results.
The success of our VoIP telephony products and services is dependent on the
growth and public acceptance of VoIP telephony.
The success of our VoIP telephony products and services is dependent upon
future demand for VoIP telephony systems and services. In order for the VoIP
telephony market to continue to grow, several things need to occur. Telephone
and cable service providers must continue to invest in the deployment of high
speed broadband networks to residential and business customers. VoIP networks
must improve quality of service for real-time communications, managing effects
such as packet jitter, packet loss, and unreliable bandwidth, so that
toll-quality service can be provided. VoIP telephony equipment and services must
achieve a similar level of reliability that users of the public switched
telephone network have come to expect from their telephone service. VoIP
telephony service providers must offer cost and feature benefits to their
customers that are sufficient to cause the customers to switch away from
traditional telephony service providers. Service providers and resellers must be
willing to use outsourced solutions providers for VoIP telephony. Furthermore,
end users in markets serviced by recently deregulated telecommunications
providers are not familiar with obtaining services from competitors of these
providers and may be reluctant to use new providers, such as us. We will need to
devote substantial resources to educate customers and end users about the
benefits of VoIP telephony solutions in general and our services in particular.
If any or all of these factors fail to occur, our business may decline.
Our future success depends on the growth in the use of the internet as a means
of communications.
If the market for VoIP telephony, in general, and our services in
particular, does not grow at the rate we anticipate or at all, we will not be
able to increase our number of users or generate revenues we anticipate. To be
successful, VoIP telephony requires validation as an effective, quality means of
communication and as a viable alternative to traditional telephone service.
Demand and market acceptance for recently introduced services are subject to a
high level of uncertainty. The Internet may not prove to be a viable alternative
to traditional telephone service for reasons including:
o inconsistent quality or speed of service, including power outages;
o traffic congestion on the Internet;
o potentially inadequate development of the necessary infrastructure;
o lack of acceptable security technologies;
o lack of timely development and commercialization of performance
improvements; and
o unavailability of cost-effective, high-speed access to the Internet.
If Internet usage grows, the Internet infrastructure may not be able to
support the demands placed on it by such growth, or its performance or
reliability may decline. In addition, Web sites may from time to time experience
interruptions in their service as a result of power outages and other delays
occurring throughout the Internet network infrastructure. If these outages or
delays occur frequently, customers' use of the Internet and our products and
services as a means of communications could decline or may not grow as we
anticipate.
Intense competition could reduce our market share and decrease our revenue.
The market for VoIP telephony is extremely competitive. Our competitors
include both start-up IP telephony service providers and established traditional
communications providers. Many of our existing competitors and potential
competitors have broader portfolios of services, greater financial, management
and operational resources, greater brand-name recognition, larger subscriber
bases and more experience than we have. In addition, many of our IP telephony
competitors use the Internet instead of a private network to transmit traffic.
Operating and capital costs of these providers may be less than ours,
potentially giving them a competitive advantage over us in terms of pricing.
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We also compete in the growing market of discount telecommunications
services including calling cards, prepaid cards, call-back services, dial-around
or 10-10 calling and collect calling services. In addition, some Internet
service providers have begun to aggressively enhance their real time interactive
communications, focusing on instant messaging, PC-to-PC and PC-to-phone, and/or
broadband phone services.
In addition, traditional carriers, cable companies and satellite
television providers are bundling services and products that we do not offer
together with internet telephony services. These services could include wireless
communications, voice and data services, Internet access, and cable television.
Although this provides us with the opportunity to offer these companies our
products and services as a way for them to offer internet telephony services,
these companies can also introduce these services on their own and may be able
to bundle the services at a single attractive price. This could make it more
difficult for us to compete against them with direct to consumer offerings of
our own.
If we are unable to provide competitive service offerings, we may lose
existing customers and be unable to attract additional customers. In addition,
many of our competitors, especially traditional carriers, enjoy economies of
scale that result in a lower cost structure for transmission and related costs,
which cause significant pricing pressures within the industry. To remain
competitive, we must continue to invest significant resources in research and
development, sales and marketing, and customer support. We may not have
sufficient resources to make these investments or to make the technical advances
necessary to be competitive which in turn will cause our business to suffer.
Potential fluctuations in our quarterly financial results may make it difficult
for investors to predict our future performance.
Our quarterly operating results may fluctuate significantly in the future
as a result of a variety of factors, many of which are outside our control. The
factors generally within our control include:
o the rate at which we are able to attract users to purchase our VoIP
telephony products and services, including our Outsourced Platform
Solution;
o the amount and timing of expenses to enhance marketing and promotion
efforts and to expand our infrastructure; and
o the timing of announcements or introductions of new or enhanced
services by us.
The factors outside our control include:
o the timing of announcements or introductions of new or enhanced
services by our competitors;
o technical difficulties or network interruptions in the Internet or
our privately-managed network; and
o general economic and competitive conditions specific to our
industry.
The foregoing factors also may create other risks affecting our long-term
success, as discussed in the other risk factors.
We believe that quarter-to-quarter comparisons of our historical operating
results may not be a good indication of our future performance, nor would our
operating results for any particular quarter be indicative of our future
operating results.
Our success depends on our ability to handle a large number of simultaneous
calls, which our network may not be able to accommodate.
We expect the volume of simultaneous calls to increase significantly as we
expand our operations. Our network hardware and software may not be able to
accommodate this additional volume. If we fail to maintain an appropriate level
of operating performance, or if our service is disrupted, our reputation could
be hurt, we could lose customers and our business, financial condition and
results of operations could be materially and adversely affected.
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Because we are unable to predict definitively the volume of usage and our
capacity needs, we may be forced to enter into disadvantageous contracts that
would reduce our operating margins.
We may have to enter into additional long-term agreements for leased
communications transmission capacity. To the extent that we overestimate our
call volume, we may be obligated to pay for more transmission capacity than we
actually use, resulting in costs without corresponding revenue. Conversely, if
we underestimate our capacity needs, we may be required to obtain additional
transmission capacity through more expensive means or such capacity may not be
available. As a result, our margins could be reduced and our business, financial
condition and results of operations could be materially and adversely affected.
We face a risk of failure of computer and communications systems used in our
business.
Our business depends on the efficient and uninterrupted operation of our
computer and communications systems as well as those that connect to our
network. We maintain communications systems in facilities in New York, Los
Angeles, Chicago, Atlanta, London, Amsterdam, Hong Kong and Jerusalem. Although
we have designed our network to reduce the possibility of disruptions or other
outages, our systems and those that connect to our network are subject to damage
or interruption from natural disasters, power loss, communications failure,
hardware or software malfunction, network failures, physical or electronic
break-ins, sabotage, computer viruses, intentional acts of terrorism or
vandalism and other events that may be or may not be beyond our control. Any
system interruptions that cause our services to be unavailable, including
significant or lengthy telephone network failures or difficulties for users in
communicating through our network or portal, could damage our reputation and
result in a loss of users.
Substantially all of the VoIP telephony calls made by our iConnectHere
customers, and a large percentage of our services provider and reseller
customers are connected through local telephone companies and, at least in part,
through leased facilities that may become unavailable.
We are not a local telephone company or a local exchange carrier. Our
network covers only portions of the United States. Accordingly, we must route
parts of some domestic and all international calls made by our ICH customers,
and a large percentage of our service provider and reseller customers, over
leased transmission facilities. In addition, because our network does not extend
to homes or businesses, we must generally route calls through a local telephone
company to reach our network and, ultimately, to reach their final destinations.
In many of the foreign jurisdictions in which we conduct or plan to
conduct business, the primary provider of significant in-country transmission
facilities is the national telephone company, which may be the only provider in
that country. Accordingly, we may have to lease transmission capacity at
artificially high rates from such a monopolistic provider, and consequently, we
may not be able to generate a profit on those calls. In addition, national
telephone companies may not be required by law to lease necessary transmission
lines to us or, if applicable law requires national telephone companies to lease
transmission facilities to us, we may encounter delays in negotiating leases and
interconnection agreements and commencing operations. Additionally, disputes may
result with respect to pricing, billing or other terms of these agreements, and
these disputes could affect our ability to continue to operate in these
countries, which may materially and adversely affect our business, financial
condition and results of operations.
Our computer systems and operations may be vulnerable to security breaches.
We believe that the secure transmission of confidential information over
the Internet, such as credit card numbers, is essential in maintaining user
confidence in our services. Although we have developed systems and processes
that are designed to protect consumer information and prevent fraudulent credit
card transactions and other security breaches, our computer infrastructure is
potentially vulnerable to physical or electronic computer viruses, break-ins and
similar disruptive problems and security breaches that could cause
interruptions, delays or loss of services to our users. We rely on licensed
encryption and authentication technology to effect secure transmission of
confidential information, including credit card numbers. It is possible that
advances in computer capabilities or new technologies could result in a
compromise or breach of the technology we use to protect user transaction data.
A party that is able to circumvent our security systems could misappropriate
proprietary information or cause interruptions in our operations. Security
breaches also could damage our reputation and expose us to a risk of loss,
litigation and possible liability. Although we have experienced no security
breaches to date of which we are aware, we cannot guarantee you that our
security measures will prevent security breaches.
Operating internationally exposes us to additional and unpredictable risks.
We intend to continue to enter additional foreign markets and expand our
existing operations outside the United States. We cannot assure you that we will
be successful in expanding into additional international markets. In addition to
the uncertainty regarding our ability to generate revenue from foreign
operations and expand our international presence, there are certain risks
inherent in doing business on an international basis, including:
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o political and economic instability;
o legal uncertainty regarding liability, regulations, tariffs and
other trade barriers;
o fluctuations in exchange rates;
o potentially adverse tax consequences;
o action by foreign governments or foreign telecommunications
companies to limit access to our services;
o potentially weaker protection of intellectual property rights; and
o uncertain market acceptance and difficulties in marketing efforts
due to language and cultural differences.
We have experienced losses as a result of fraud.
We have experienced losses due to fraud. While in 2005 we experienced
losses from fraud of less than 1% of our revenues, callers have obtained our
services without rendering payment by unlawfully using our access numbers and
personal identification numbers. While we have continued to implement anti-fraud
measures in order to control losses relating to these practices, and these
measures have proven to be effective today, these measures may not in the future
be sufficient to effectively limit all of our exposure in the future from fraud
and future losses could rise significantly above current levels.
We need to retain key personnel to support our products and ongoing operations.
The development and marketing of our VoIP products and services will
continue to place a significant strain on our limited personnel, management, and
other resources. Our future success depends upon the continued services of our
executive officers and other key employees who have critical industry experience
and relationships that we rely on to implement our business plan. Except for Mr.
Shimmy Zimels, our Chief Executive Officer, none of our officers or key
employees is bound by employment agreements for any specific term. The loss of
the services of any of these officers or key employees could delay the
development and introduction of, and negatively impact our ability to sell, our
products which could adversely affect our financial results and impair our
growth. We currently do not maintain key person life insurance policies on any
of our employees.
Our ability to provide our service is dependent upon third-party facilities and
equipment, the failure of which could cause delays or interruptions of our
service, damage our reputation, cause us to lose customers and limit our growth.
Our success depends on our ability to provide quality and reliable
service, which is in part dependent upon the proper functioning of facilities
and equipment owned and operated by third parties and is, therefore, beyond our
control. Unlike traditional wireline telephone service or wireless service, our
service requires our customers to have an operative broadband Internet
connection and an electrical power supply, which are provided by the customer's
Internet service provider and electric utility company, respectively, and not by
us. The quality of some broadband Internet connections may be too poor for
customers to use our services properly. In addition, if there is any
interruption to a customer's broadband Internet service or electrical power
supply, that customer will be unable to make or receive calls, including
emergency calls, using our service. We also outsource several of our network
functions to third-party providers. For example, we outsource the maintenance of
our regional data connection points, which are the facilities at which our
network interconnects with the public switched telephone network. If our
third-party service providers fail to maintain these facilities properly, or
fail to respond quickly to problems, our customers may experience service
interruptions. Our customers have experienced such interruptions in the past and
will experience interruptions in the future. In addition, our new E-911 service
is currently dependent upon a third-party provider. Interruptions in service
from this vendor could cause failures in our customers' access to E-911
services. Interruptions in our service caused by third-party facilities have in
the past caused and may in the future cause us to lose customers, or cause us to
offer substantial customer credits, which could adversely affect our revenue and
profitability. If interruptions adversely affect the perceived reliability of
our service, we may have difficulty attracting new customers and our brand,
reputation and growth will be negatively impacted.
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Third parties might infringe upon our proprietary technology.
We cannot assure you that the steps we have taken to protect our
intellectual property rights will prevent misappropriation of our proprietary
technology. To protect our rights to our intellectual property, we rely on a
combination of trademark and patent law, trade secret protection,
confidentiality agreements and other contractual arrangements with our
employees, affiliates, strategic partners and others. We may be unable to detect
the unauthorized use of, or take appropriate steps to enforce, our intellectual
property rights. Effective copyright and trade secret protection may not be
available in every country in which we offer or intend to offer our services.
Failure to adequately protect our intellectual property could materially harm
our brand, devalue our proprietary content and affect our ability to compete
effectively. Further, defending our intellectual property rights could result in
significant financial expenses and managerial resources.
Our services may infringe on the intellectual property rights of others.
Third parties may assert claims that we have violated a patent or
infringed a copyright, trademark or other proprietary right belonging to them.
We incorporate licensed third-party technology in some of our products and
services. In these license agreements, the licensors have agreed to indemnify us
with respect to any claim by a third party that the licensed software infringes
any patent or other proprietary right so long as we have not made changes to the
licensed software. We cannot assure you that these provisions will be adequate
to protect us from infringement claims. Any infringement claims, even if not
meritorious, could result in substantial monetary liability or may materially
disrupt the conduct of our business.
Risks Related to our Industry
Government regulation and legal uncertainties relating to IP telephony could
harm our business.
Historically, voice communications services have been provided by
regulated telecommunications common carriers. We offer voice communications to
the public for international and domestic calls using IP telephony, and we do
not operate as a licensed telecommunications common carrier in any jurisdiction.
Based on specific regulatory classifications and recent regulatory decisions, we
believe we should not be regulated as a telecommunications common carrier
regulation in any of our markets. However, the growth of IP telephony has led to
close examination of its regulatory treatment in many jurisdictions making the
legal status of our services uncertain and subject to change as a result of
future regulatory action, judicial decisions or legislation in any of the
jurisdictions in which we operate. Established regulated telecommunications
carriers have sought and may continue to seek regulatory actions to restrict the
ability of companies such as ours to provide services or to increase the cost of
providing such services. In addition, our services may be subject to regulation
if regulators distinguish phone-to-phone telephony service using IP technologies
over privately-managed networks such as our services from integrated PC-to-PC
and PC-originated voice services over the Internet. Some regulators may decide
to treat the former as regulated common carrier services and the latter as
unregulated enhanced or information services.
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Application of new regulatory restrictions or requirements to us could
increase our costs of doing business and prevent us from delivering our services
through our current arrangements. In such event, we would consider a variety of
alternative arrangements for providing our services, including obtaining
appropriate regulatory authorizations for our local network partners or
ourselves, changing our service arrangements for a particular country or
limiting our service offerings. Such regulations could limit our service
offerings, raise our costs and restrict our pricing flexibility, and potentially
limit our ability to compete effectively. Further, regulations and laws that
affect the growth of the Internet could hinder our ability to provide our
services over the Internet.
Our international operations are also subject to regulatory risks,
including the risk that regulations in some jurisdictions will prohibit us from
providing our services cost-effectively or at all, which could limit our growth.
Currently, there are several countries where regulations prohibit us from
offering service. These regulations have had an immaterial impact on us in 2005.
We, however, cannot assure you that these conditions will not have a material
effect on our revenues and growth in the future. In addition, because customers
can use our services almost anywhere that a broadband Internet connection is
available, including countries where providing VoIP services is illegal, the
governments of those countries may attempt to assert jurisdiction over us, which
could expose us to significant liability and regulation. For a more detailed
discussion of the regulation of IP telephony, see "Regulation."
We may not be able to keep pace with rapid technological changes in the
communications industry
Our industry is subject to rapid technological change. We cannot predict
the effect of technological changes on our business. In addition, widely
accepted standards have not yet developed for the technologies we use. We expect
that new services and technologies will emerge in the market in which we
compete. These new services and technologies may be superior to the services and
technologies that we use, or these new services may render our services and
technologies obsolete.
To be successful, we must adapt to our rapidly changing market by
continually improving and expanding the scope of services we offer and by
developing new services and technologies to meet customer needs. Our success
will depend, in part, on our ability to license leading technologies and respond
to technological advances and emerging industry standards on a cost-effective
and timely basis. We will need to spend significant amounts of capital to
enhance and expand our services to keep pace with changing technologies.
The success of our business is affected by customers' unimpeded access to
broadband service. Providers of broadband services may be able to block our
services, which could adversely affect our revenue and growth.
A portion of our customers must have broadband access to the
Internet in order to use our service. Some providers of broadband access have
taken measures that affect their customers' ability to use our service, such as
degrading the quality of the data packets we transmit over their lines, giving
those packets low priority, giving other packets higher priority than ours,
blocking our packets entirely or attempting to charge their customers more for
also using our services. It is not clear whether suppliers of broadband access
services have a legal obligation to allow their customers to access and use our
service without interference. As a result of recent decisions by the U.S.
Supreme Court and the FCC, providers of broadband services are subject to
relatively light regulation by the FCC. Consequently, federal and state
regulators might not prohibit broadband providers from limiting their customers'
access to VoIP or otherwise discriminating against VoIP providers. Interference
with our service or higher charges for using our service could cause us to lose
existing customers, impair our ability to attract new customers and harm our
revenue and growth.
If we fail to comply with new FCC regulations requiring us to provide E-911
emergency calling services, we may be subject to fines or penalties, which could
include disconnection of our service for certain customers or prohibitions on
marketing of our services and accepting new customers in certain areas.
On June 3, 2005, the FCC released an order, which we refer to as the VoIP
E-911 Order, that imposed an obligation on VoIP providers to offer enhanced
emergency calling services, or E-911, to their VoIP customers by November 28,
2005. Like other providers of nomadic VoIP services, we were unable to comply
with all of the requirements of the VoIP E-911 Order by the deadline. Some of
our customers currently receive E-911 service in conformity with the VoIP E-911
Order, but a number of our customers do not receive such service. We do not
expect to be able to provide E-911 service to all of our customers in the short
term. While the FCC did not require VoIP providers to discontinue service to
customers that could not receive E-911 service, we could be subject to
enforcement action by the FCC if we continue to be unable to provide such
service to a significant number of our customers. Such enforcement actions could
include monetary forfeitures, cease and desist orders, and other penalties.
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On November 28, 2005, we filed a request for partial waiver and extension
of time of the FCC's VoIP E-911 rules for those customers to whom we could not
provide E-911 service. Our petition remains pending. We cannot predict whether
the FCC will grant or deny our petition. See "Regulation--VoIP E-911 Matters"
for further information on the FCC's E-911 requirements.
The VoIP E-911 Order also required us to notify our customers of any
differences between our emergency calling services and those available through
wireline telephone providers and to obtain affirmative acknowledgment from each
of our customers of those notifications. We notified our customers of the
differences in our emergency calling service and have received affirmative
acknowledgement from substantially all of our customers.
We are not currently accepting customers in areas where we cannot provide
E-911 service in conformity with the FCC's rules. This has adversely impacted
the ability of our consumer division, ICH, to accept new customers and may also
have an adverse effect on our sales to customers who resell our service.
Various fees and taxes will increase our costs and our customers' cost of using
our services.
There are numerous fees and taxes assessed on traditional telephone
services that we believe have not been applicable to us and that we have not
paid in the past. However, we may begin to collect and remit some of these fees
and taxes in the future. To the extent we increase the cost of services to our
customers to recoup some of the costs of compliance, this will have the effect
of decreasing any price advantage we may have.
In addition, it is possible that we will be required to collect and remit
sales taxes in several states where we have not done so in the past. We are in
the process of discussing the applicability of sales and other taxes with
numerous states and we may proactively enter into discussions with additional
states as conditions warrant. In the states where we determine that we need to
collect and remit sales taxes, we will comply with the administrative rules
existing in that state.
States have or may take the position that we should have collected sales
taxes in the past. If so, they may seek to collect those past taxes from us and
impose fines, penalties or interest charges on us. Our payment of these past
taxes and related charges could have a material adverse effect on us.
We may be required to contribute to the Universal Service Fund, increasing our
cost of providing services. If we collect those contributions from our
customers, the cost advantage we offer customers would be reduced.
FCC regulations require providers of interstate telecommunications
services, but not providers of information services, to contribute to the
federal Universal Service Fund, or USF. Currently, we are not subject to direct
contribution to the USF, although we do contribute indirectly to the USF through
our purchase of telecommunications services from our suppliers. The FCC is
considering a number of proposals that could alter the way that the USF is
assessed. For instance, the FCC is considering an assessment based on the use of
telephone numbers, in which case we would be required to contribute directly to
the Universal Service Fund. In addition, the FCC may increase the contribution
obligations of our suppliers, which would result in an increase in the
surcharges those suppliers charge to us. We intend to collect from our customers
any additional USF contributions we are required, directly or indirectly, to
make. Many of our competitors are required to contribute directly to the USF and
already collect those USF contributions from their customers.
Risks Related to our relationship with Atarey
Atarey exercises significant control over all matters submitted to a stockholder
vote.
Atarey owns approximately 41% of the voting power and economic interest in
us, and is the largest shareholder of our stock. As long as Atarey continues to
beneficially own such a significant percentage of our capital stock and there
are no other major shareholders, Atarey will be able to exercise a significant
influence over decisions affecting us, including:
24
o composition of our board of directors and, through it, our direction
and policies, including the appointment and removal of officers;
o mergers or other business combinations;
o acquisitions or dispositions of assets by us;
o future issuances of capital stock or other securities by us;
o incurrence of debt by us;
o amendments, waivers and modifications to any agreements between us
and Atarey;
o payment of dividends on our capital stock; and
o approval of our business plans and general business development.
In addition, two of our seven directors are officers and/or directors of
Atarey, or otherwise affiliated with Atarey. As a result, the ability of any of
our other stockholders to influence the management of our company is limited,
which could have an adverse effect on the market price of our stock.
A third party may be deterred from acquiring our company.
Atarey's major ownership could delay, deter or prevent a third party from
attempting to acquire control of us. This may have the effect of discouraging a
third party from making a tender offer or otherwise attempting to obtain control
of us, even though such a change in ownership would be economically beneficial
to us and our stockholders.
Risks Related to our Common Stock
Volatility of our stock price could adversely affect our stockholders.
Since trading commenced in November 1999, the market price of our common
stock has been highly volatile and may continue to be volatile and could be
subject to wide fluctuations in response to factors such as:
o variations in our actual or anticipated quarterly operating results
or those of our competitors;
o announcements by us or our competitors of technological innovations;
o introduction of new products or services by us or our competitors;
o changes in financial estimates by securities analysts;
o conditions or trends in the Internet industry;
o changes in the market valuations of other Internet companies;
o announcements by us or our competitors of significant acquisitions;
o our entry into strategic partnerships or joint ventures; and
o sales of our common stock by Atarey.
All of these factors are, in whole or part, beyond our control and may
materially adversely affect the market price of our common stock regardless of
our performance.
Investors may not be able to resell their shares of our common stock
following periods of volatility because of the market's adverse reaction to such
volatility. In addition, the stock market in general, and the market for
telecommunications, Internet-related and technology companies in particular, has
been dramatically decreased and is extremely depressed. We cannot assure you
that our common stock will trade at the same levels of other telecommunications
or Internet stocks or that telecommunications or Internet stocks in general will
sustain their current market prices.
The liquidity of our common stock could be adversely affected by changes in our
Nasdaq listing.
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Our common stock is currently listed on the Nasdaq Capital Market. The
listing of our common stock was transferred from the Nasdaq National Market to
the Nasdaq Capital Market effective on September 17, 2002. We currently meet all
criteria for continued inclusion in the Nasdaq Capital Market. However, based on
the volatile nature of our stock price, we can make no assurances that we will
continue to do so. Failure to meet these criteria could result in our delisting
from the Nasdaq Capital Market. If our shares were to be delisted from the
Nasdaq Capital Market, our shares would continue to trade, if at all, on the OTC
Bulletin Board, upon application by the requisite market makers. This would
adversely impact our stock price, as well as the liquidity of the market for our
shares which, as a result, would adversely affect the ability of our
stockholders to purchase and sell their shares in an orderly manner, or at all.
Furthermore, a delisting of our shares could damage our general business
reputation and impair our ability to raise additional funds. Any of the
foregoing events could have a material adverse effect on our business, financial
condition and operating results.
We do not intend to pay dividends.
We have never declared or paid any cash dividends on our common stock. We
intend to retain any future earnings to finance our operations and to expand our
business and, therefore, do not expect to pay any cash dividends in the
foreseeable future.
Risks Related to our Israel-based Office
We may be negatively impacted by changes in political, military and/or economic
conditions.
Since the establishment of the State of Israel in 1948, a number of armed
conflicts have taken place between Israel and its Arab neighbors and a state of
hostility, varying from time to time in intensity and degree, has led to
security and economic problems for Israel. A peace agreement between Israel and
Egypt was signed in 1979 and a peace agreement between Israel and Jordan was
signed in 1994. However, as of the date hereof Israel has not entered into any
peace agreement with Syria or Lebanon.
Despite peace related developments, certain countries, companies and
organizations continue to participate in a boycott of Israeli firms. We do not
believe that the boycott has had a material adverse effect on us, but there can
be no assurance that restrictive laws, policies or practices directed towards
Israel or Israeli-based businesses will not have an adverse impact on our
business or financial condition in the future.
Israel's economy has been subject to numerous destabilizing factors,
including a period of rampant inflation in the early- to mid-l980s, low foreign
exchange reserves, fluctuations in world commodity prices and military
conflicts. The Israeli Government has, for these and other reasons, intervened
in the economy by utilizing, among other means, fiscal and monetary policies,
import duties, foreign currency restrictions and control of wages, prices and
exchange rates. The Israeli Government has periodically changed its policies in
all these areas. Although we derive most of our revenues outside of Israel, a
substantial portion of our expenses are incurred in Israel and are affected by
economic conditions in the country.
All of these factors are, in whole or part, beyond our control and may
materially adversely affect on our business, financial condition and operating
results, or market price of our common stock regardless of our performance.
We may be negatively impacted by employees being called for army service
Generally, all male adult citizens and permanent residents of Israel under
the age of 41 are, unless exempt, obligated to perform up to 36 days of military
reserve duty annually. Additionally, all such residents are subject to being
called to active duty at any time under emergency circumstances. Some of our
officers and employees are currently obligated to perform annual reserve duty.
While we have operated effectively under these requirements since we began
operations, no assessment can be made as to the full impact of such requirements
on our workforce or business if conditions should change, and no prediction can
be made as to the effect on us of any expansion of such obligations.
26
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2. PROPERTIES
We lease our executive offices at 75 Broad Street, New York, New York at
an annual cost of approximately $650,000, which increases annually to $815,000
for the final year of the lease. The term of the lease is until July 2010, with
an option to extend the lease for an additional five years. In October 2003 we
entered into a sub-lease agreement with a third party to sub-lease approximately
30% of the overall the New York office space. The annual sub-lease income was
$148,830 for 2005, increasing annually to $168,000 for the final year of the
sub-lease and the term extends until July 2010.
We lease a 1,290 square meter office, which houses our research and
development facilities, in Jerusalem, Israel at an annual cost of $205,000. In
February 2003, we signed an amendment that extended the term of our lease
through February 2006. In September 2005, we signed an additional amendment that
extended our lease term through December 2009. We have an option to further
extend the term of the lease for an additional 5 years through December 2014.
ITEM 3. LEGAL PROCEEDINGS
We, as well as certain of our former officers and directors, were named as
defendants in a number of purported securities class actions in United States
District Court for the Southern District of New York, arising out of our initial
public offering in November 1999. On August 31, 2005, the United States District
Court granted preliminary approval of an omnibus settlement of the litigation
between the plaintiffs and issuer defendants. Final approval is pending. Under
the terms of the settlement, we are not conceding any liability and we presently
do not expect to make any payments under the pending settlement, other than
legal fees we may incur (which fees are being submitted to the insurance carrier
for reimbursement).
We are not a party to any other material litigation and are not aware of
any other pending or threatened litigation that could have a material adverse
effect on us or our business taken as a whole.
27
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
We held our Annual Meeting of Stockholders (the "Meeting") on December 20,
2005. The following matters were submitted to our stockholders for their vote,
and the results of the votes taken at the Meeting were as follows:
(1) Seven Directors were elected for a term of one year, serving until our
next annual meeting of stockholders:
(a) Noam Bardin 27,105,919 votes for; 122,772 votes withheld;
(b) Noam Ben-Ozer 27,106,906 votes for; 121,785 votes withheld;
(c) Ilan Biran 27,007,321 votes for; 221,370 votes withheld;
(d) Benjamin Broder 27,008,421 votes for; 220,270 votes withheld;
(e) Joshua Maor 26,827,674 votes for; 401,017 votes withheld;
(f) Lior Samuelson 27,100,006 votes for; 128,685 votes withheld; and
(g) Shimmy Zimels 27,085,034 votes for; 143,657 votes withheld.
(2) The appointment of Brightman Almagor & Co., a member firm of Deloitte
& Touche, as our independent auditors for the fiscal year ending December 31,
2005 was ratified by the following vote: 27,129,646 votes for; 31,090 votes
against; and 67,955 abstentions.
(3) Our proposal to amend our 2004 Stock Incentive Plan was approved by
the following vote: 15,143,222 votes for; 798,703 votes against; and 42,464
abstentions.
(4) Our proposal to amend our 2004 Non-Employee Director Stock Option Plan
was approved by the following vote: 15,405,327 votes for; 539,012 votes against;
and 40,051 abstentions.
28
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Market Information
Our common stock is currently listed on the Nasdaq Capital Market under
the symbol "DDDC". The listing of our common stock was transferred from the
Nasdaq National Market to the Nasdaq Capital Market effective on September 17,
2002. Our common stock had traded on the Nasdaq National Market under the symbol
"DDDC" since November 22, 1999. We currently meet all criteria for continued
inclusion in the Nasdaq Capital Market.
The following table sets forth the per share range of high and low closing
sales prices of our common stock for the periods indicated:
High Low
---- ---
Year ended December 31, 2004
First quarter 3.43 2.17
Second quarter 2.69 1.27
Third quarter 3.19 1.78
Fourth quarter 3.70 1.95
Year ended December 31, 2005
First quarter 6.67 3.20
Second quarter 4.16 2.84
Third quarter 3.44 2.55
Fourth quarter 3.11 2.43
Year ended December 31, 2006
First quarter (through March 24h, 2006) 3.50 2.51
On March 24, 2006, the last reported sale price for our common stock on
the Nasdaq Capital Market was $2.79 per share. The market price for our stock is
highly volatile and fluctuates in response to a wide variety of factors.
Holders
As of March 24, 2006, we had approximately 125 holders of record of the
30,000,982 outstanding shares of our common stock. This does not reflect persons
or entities that hold their stock in nominee or "street" name through various
brokerage firms.
Dividend Policy
We have never declared or paid any cash dividends on our capital stock. We
do not anticipate paying any cash dividends on our capital stock in the
foreseeable future. We currently intend to retain future earnings, if any, to
finance our operations and to expand our business. Any future determination to
pay cash dividends will be at the discretion of our board of directors and will
be dependent upon our financial condition, operating results, capital
requirements and other factors that our board of directors considers
appropriate.
Recent Sales of Unregistered Securities
None.
Issuer Purchases of Equity Securities
None.
29
ITEM 6. SELECTED FINANCIAL DATA
You should read the selected consolidated financial data together with our
consolidated financial statements and related notes and the section of this
annual report entitled "Management's Discussion and Analysis of Financial
Condition and Results of Operations." Brightman Almagor & Co., a member firm of
Deloitte Touche, independent certified public accountants, audited our
historical financial statements since inception and as of and for the years
ended December 31, 2001, 2002, 2003, 2004 and 2005. Their report appears
elsewhere in this annual report. The selected financial data for each of the
years in the three-year period ended December 31, 2005, and as of December 31,
2004 and 2005 is derived from our consolidated financial statements that have
been included in this annual report. The selected financial data as of December
31, 2001, 2002 and 2003, and for the years ended December 31, 2001, 2002, and
2003 is derived from consolidated financial statements that have not been
included in this annual report.
Year Ended December 31,
--------------------------------------------------------
2001 2002 2003 2004 2005
-------- -------- -------- -------- --------
(In thousands)
Statement of Operations Data:
Revenues:
Affiliates .......................................... $ 1,669 $ -- $ -- $ -- $ --
Non-affiliates ...................................... 13,991 12,929 13,162 21,069 29,714
Total revenues ......................................... 15,660 12,929 13,162 21,069 29,714
Costs and operating expenses:
Cost of revenues .................................... (13,486) (8,934) (8,393) (13,791) (18,698)
Research and development expenses ................... (5,648) (3,435) (2,326) (2,531) (3,228)
Selling and marketing expenses ...................... (7,800) (3,910) (3,325) (3,274) (4,173)
General and administrative expenses ................. (6,982) (2,158) (2,062) (2,194) (2,912)
Non-cash compensation expense ....................... (825) (270) -- -- --
Depreciation and amortization ....................... (8,996) (6,606) (5,584) (2,731) (1,931)
Write-down of fixed assets .......................... (1,003) -- -- -- --
Expenses due to cancellation of supplier agreement .. (3,628) -- -- -- --
Impairment of goodwill .............................. (4,151) -- -- -- --
Total costs and operating expenses ..................... (52,519) (25,313) (21,690) (24,521) (30,942)
Loss from operations ................................... (36,859) (12,384) (8,528) (3,452) (1,228)
Interest income, net ................................... 1,677 448 245 269 418
Income taxes ........................................... (552) (141) (57) (66) (44)
Net loss ............................................... $(35,734) $(12,077) $ (8,340) $ (3,249) $ (854)
Net loss per share - basic and diluted ................. $ (1.23) $ (0.42) $ (0.29) $ (0.11) $ (0.03)
Weighted average shares outstanding - basic and diluted 29,035 28,888 28,989 29,347 29,672
Year Ended December 31,
--------------------------------------------------------
2001 2002 2003 2004 2005
-------- -------- -------- -------- --------
(In thousands)
Balance Sheet Data:
Cash and cash equivalents ....................................... $ 13,583 $ 5,681 $ 1,682 $ 4,856 $ 3,847
Short-term investments .......................................... 14,192 15,552 16,442 10,527 10,648
Working capital ................................................. 23,374 17,675 14,820 10,285 10,264
Long-term investments ........................................... -- -- -- 1,216 1,095
Total assets .................................................... 45,869 32,197 23,643 22,273 21,504
Total stockholder's equity ...................................... 38,921 27,114 19,141 16,025 15,561
30
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion of our financial condition and results of
operations should be read together with our consolidated financial statements
and the related notes thereto included in another part of this annual report.
This discussion contains certain forward-looking statements that involve
substantial risks and uncertainties. When used in this report, words such as
"anticipate," "believe," "estimate," "expect," "target," "goal," "project,"
"intend," "plan," "believe," "seek," variations of such words and similar
expressions as they relate to our management or us are intended to identify such
forward-looking statements. Our actual results, performance or achievements
could differ materially from those expressed in, or implied by, these
forward-looking statements. Factors that might cause such a difference include,
but are not limited to, those discussed in "Risk Factors." Historical operating
results are not necessarily indicative of the trends in operating results for
any future period.
Overview
We are a leading provider of integrated VoIP telephony services, products,
hosted solutions, and infrastructure. We were founded in 1996 to capitalize on
the growth of the Internet as a communications tool by commercially offering IP
telephony services. While we began as primarily a low-cost alternative source of
wholesale minutes for carriers around the world, we have evolved into one of the
premier providers of next generation communication services in the world.
Today we support hundreds of thousands of active users around the globe
through our two primary distribution channels: our Service Provider and Reseller
channel and our iConnectHere, or ICH, direct-to-consumer channel. We offer a
broad suite of private label VoIP products and services as well as a back-office
platform for service providers, resellers, and corporate customers. Based on our
customizable VoIP solutions, these customers can offer private label
telecommunications to their own customer bases, under either their own brand
name, a white-label brand, and/or our iConnectHere or deltathree brand name. At
the same time, iConnectHere, our direct-to-consumer offering, provides
award-winning VoIP products directly to consumers and small businesses online
using the same primary platform.
In 2005, we remained focused on increasing the market penetration of our
core VoIP solutions and on continuing to diversify and expand our customer base.
As a result, we continued to sell an increasing diverse set of VoIP products and
services to our growing Service Provider and Reseller base. We also focused on
enhancing our service delivery offering suite by successfully launching a
turnkey VoIP solution for medium size cable and Internet service providers, and
we added new features to our VoIP products, launched new distribution lines for
our consumer group, and upgraded our network capacity.
Going forward, we expect to continue to devote a significant amount of our
resources to develop and expand our Service Provider and Reseller base and we
expect our revenue from this key channel to represent a growing percentage of
our total revenue over the next several years. We are actively marketing our
products and services to a large number of broadband operators, including
telecom, cable companies, Internet service providers, and consumer oriented
retailers around the world. We believe these companies may prefer to buy our
offerings instead of building their own internally developed VoIP service.
Trends in Our Industry and Business
A number of factors in our industry and business have a significant effect
on our results of operations and are important to an understanding of our
financial statements. These trends include:
Overall Economic Factors: Our operations and earnings are affected by
local, regional and global events or conditions that affect supply and demand
for telecommunications products and services. These events or conditions are
generally not predictable and include, among other things, general economic
growth rates and the occurrence of economic recessions; changes in demographics,
including population growth rates and consumer preferences. Our strategy and
execution focus is predicated on an assumption that these factors will continue
to promote strong desire for the utilization of telephony products and services
and that the cost and feature advantages of VoIP alternatives will not be
negatively impacted by unforeseen changes in these factors.
31
Industry: The telecommunications industry is highly competitive. In recent
years we have seen new sources of supply for our underlying infrastructure that
have reduced our overall costs of operation, including both advances in
telecommunications technology and advances in technology relating to
telecommunications usage, and have enjoyed the benefits of competition among
these suppliers for a relatively limited amount of viable customers. These
decreases were driven largely by reduced vendor pricing associated with our
increased purchasing power and, to a lesser extent, cost savings associated with
an increasing portion of calls between users of our own services, which have no
termination costs associated with them. A key component of our competitive
position, particularly given the number and range of competing communications
products, is our ability to manage operating expenses successfully, which
requires continuous management focus on reducing unit costs and improving
efficiency.
Consumer Demand: There is significant competition within the traditional
telecommunications marketplaces (landline and wireless) and also with other
emergent "next generation" telecommunications providers, including IP
telecommunications providers, in supplying the overall telecommunications needs
of businesses and individual consumers, and several of the larger traditional
telecommunications companies have announced intentions to merge, which will
create even larger competitors. We compete with other telecommunications firms
in the sale and purchase of various products and services in many national and
international markets and employ all methods of competition that are lawful and
appropriate for such purposes. A key component of our competitive position,
particularly given the commodity-based nature of many of our products, is our
ability to sell to a growing demand base for alternative communications
products, in both the developed and developing global marketplace.
Within the developed global marketplace, our ability to sell broadband
VoIP telephony products and services is directly linked to the significant
growth rate of broadband adoption, and we expect this trend to continue. We
benefit from this trend because our service requires a broadband Internet
connection and our potential addressable market increases as broadband adoption
increases.
Within the developing areas of the world, our ability to sell alternative
telephony products and services is linked to both the increasing baseline
economic trends within these countries as well as the growing desire for
individuals and businesses to communicate and do business outside of their own
countries. We expect these trends to continue, and benefit from them because
both the ability to afford long distance calls and the desire to make them
increases as a result.
Political Factors: Our operations and earnings have been, and may in the
future be, affected from time to time in varying degree by political instability
and by other political developments and laws and regulations, such as forced
divestiture of assets; restrictions on production, imports and exports; war or
other international conflicts; civil unrest and local security concerns that
threaten the safe operation of company facilities; price controls; tax increases
and retroactive tax claims; expropriation of property; cancellation of contract
rights; and telecommunications regulations. Both the likelihood of such
occurrences and their overall effect upon us vary greatly from country to
country and are not predictable. At the same time, VoIP is becoming legal in
more countries as governments seek to increase competition, and this affects us
in a positive manner as service providers and resellers seek to meet their
customers' telecommunications needs with newly available solutions. Both the
likelihood of VoIP legalization and its overall effect upon us vary greatly from
country to country and are not predictable.
Regulatory Factor: Our business has developed in an environment largely
free from regulation. However, the United States and other countries have begun
to examine how VoIP services should be regulated, and a number of initiatives
could have an impact on our business. These initiatives include the assertion of
state regulatory and taxing authorities over us, FCC rulemaking regarding
emergency calling services, CALEA, and Electronic Privacy, and proposed reforms
for the inter-carrier compensation system. Complying with regulatory
developments will impact our business by increasing our operating expenses,
including legal fees, requiring us to make significant capital expenditures or
increasing the taxes and regulatory fees we pay. We may impose additional fees
on our customers in response to these increased expenses. This would have the
effect of increasing our revenues per customer, but not our profitability, and
increasing the cost of our services to our customers, which would have the
effect of decreasing any price advantage we may have.
32
Project Factors: In addition to the factors cited above, the advancement,
cost and results of particular projects depend on the outcome of: negotiations
with potential partners, governments, suppliers, customers or others; changes in
operating conditions or costs; and the occurrence of unforeseen technical
difficulties or enhancements. The likelihood of these items occurring and its
overall positive or negative effect upon us vary greatly from project to project
and are not predictable.
Risk Factors: See "--Risk Factors" for a discussion of the impact of
market risks, financial risks and other uncertainties.
Revenues
Our revenues are derived from resellers, service providers, and end-users
of our VoIP telephony products and services, including PC-to-Phone, and
Broadband Phone. All revenues are recognized at the time the services are
performed. The provision of VoIP telephony products and services through our
service provider and reseller sales efforts (including sales of our Outsourced
Platform Solution) accounted for 77.5% and 61.2% of our total revenues in 2005
and 2004, respectively, while the provision of VoIP telephony (primarily
PC-to-Phone) through iConnectHere accounted for 22.36% and 33.96% of our total
revenues in 2005 and 2004, respectively.
Costs and Operating Expenses
Costs and operating expenses consist of cost of revenues, research and
development expenses, selling and marketing expenses, general and administrative
expense, depreciation and amortization of goodwill, non-cash stock compensation,
write-down of fixed assets, expenses due to cancellation of agreement with a
supplier and impairment of goodwill related expenses.
o Cost of revenues consist primarily of access, termination and
transmission costs paid to carriers that we incur when providing
services and fixed costs associated with leased transmission lines.
The term of our contracts for leased transmission lines is generally
one year or less, and either party can terminate with prior notice.
o Research and development expenses consist primarily of costs
associated with establishing our network and the initial testing of
our services and compensation expenses of software developers
involved in new product development and software maintenance. In the
future, these expenses may fluctuate as a percentage of revenue
depending on the project undertaken during the reporting period.
Since our inception, we have expensed all research and development
costs in each of the periods in which they were incurred.
o Selling and marketing expenses consist primarily of expenses
associated with our direct sales force incurred to attract potential
service provider, reseller, and corporate customers and advertising
and promotional expenses incurred to attract potential consumer
users of iConnectHere. We anticipate that as we add new paid users
we will be able to spread these costs over a larger revenue base and
accordingly improve our operating margins.
o General and administrative expenses consist primarily of
compensation and benefits for management, finance and administrative
personnel, occupancy costs and legal and accounting fees, as well as
the expenses associated with being a public company, including the
costs of directors' and officers' insurance.
We have not recorded any income tax benefit for net losses and credits
incurred for any period from inception to December 31, 2005. The utilization of
these losses and credits depends on our ability to generate taxable income in
the future. Because of the uncertainty of our generating taxable income, we have
recorded a full valuation allowance with respect to these deferred assets.
33
Critical Accounting Policies
The Securities and Exchange Commission, or SEC, defines critical
accounting policies as those that are, in management's view, most important to
the portrayal of a company's financial condition and results of operations and
most demanding on their calls on judgment, often as a result of the need to make
estimates about the effect of matters that are inherently uncertain and may
change in subsequent periods. We believe our most critical accounting policies
relate to:
Revenue recognition and deferred revenue: We record revenue from Internet
telephony services based on minutes (or fractions thereof) of customer usage.
We record revenue from related services based on completion of the specific
activities associated with the services. We record payments received in
advance for prepaid services and services to be supplied under contractual
agreements as deferred revenue until such related services are provided. We
estimate the allowance for doubtful accounts by reviewing the status of
significant past due receivables and analyzing historical bad debt trends and
we then reduce accounts receivables by such allowance for doubtful accounts
to expected net realizable value.
Long-lived Assets: We assess the impairment of long-lived assets whenever
events or changes in circumstances indicate that the carrying value may not
be recoverable. Factors we consider important which could trigger an
impairment review include the following:
o significant decrease in the market price of a long-lived asset
(asset group);
o significant adverse change in the extent or manner in which a
long-lived asset (asset group) is being used or in its physical
condition;
o significant adverse change in legal factors or in the business
climate that could affect the value of a long-lived asset (asset
group), including an adverse action or assessment by a regulator;
o accumulation of costs significantly in excess of the amount
originally expected for the acquisition of the long-lived asset
(asset group);
o current period operating or cash flow loss combined with a history
of operating or cash flow losses or a projection or forecast that
demonstrates continuing losses associated with the use of a
long-lived asset (asset group); and
o current expectation that, more likely than not, a long-lived asset
(asset group) will be sold or otherwise disposed of significantly
before the end of its previously estimated useful life.
We determine the recoverability of long-lived assets based on an estimate of
undiscounted future cash flows resulting from the use of the asset and its
eventual disposition. Such estimation process is highly subjective and involves
significant management judgment. Determination of impairment loss from
long-lived assets to be disposed of are reported at the lower of carrying amount
or fair value less costs to sell.
34
Results of Operations
The following table sets forth the statement of operations data presented
as a percentage of revenues for the periods indicated:
Year Ended December 31,
-------------------------
2005 2004 2003
----- ----- -----
Revenues:
Total revenues ........................ 100.0 100.0 100.0
Costs and operating expenses:
Cost of revenues ...................... 62.9 65.5 63.8
Research and development expenses ..... 10.9 12.0 17.7
Selling and marketing expenses ........ 14.0 15.5 25.3
General and administrative expenses 9.8 10.4 15.7
Depreciation and amortization ......... 6.5 13.0 42.4
----- ----- -----
Total costs and operating expenses ...... 104.1 116.4 164.9
----- ----- -----
Loss from operations .................... (4.1) (16.4) (64.9)
Interest income, net .................... 1.4 1.3 1.9
Income taxes ............................ (0.1) (0.3) (0.4)
----- ----- -----
Net Loss ................................ (2.8)% (15.4)% (63.4)%
===== ===== =====
Comparison of 2005 and 2004
Revenues
Revenues increased approximately $8.6 million or 41% to approximately
$29.7 million in 2005 from approximately $21.1 million in 2004. Revenues from
VoIP telephony through our service provider and reseller sales efforts increased
approximately $9.3 million or 68% to approximately $23 million in 2005 from
approximately $12.9 million in 2004, due primarily to a greater number of
PC-to-Phone and Broadband Phone calls being placed by an increasing user base.
Revenues from VoIP telephony (primarily PC-to-Phone) through iConnectHere
decreased approximately $0.5 million or 7% to approximately $6.6 million in 2005
from approximately $7.1 million in 2004 due primarily to a lower number of
PC-to-Phone and Broadband Phone calls being placed by a decreasing user base. No
customer accounted for 10% or more of our sales during 2005.
Costs and Operating Expenses
Cost of revenues. Cost of revenues increased by $4.9 million or 35% to
$18.7 million in 2005 from $13.8 million in 2004, due primarily to an increase
in the amount of traffic being terminated.
Research and development expenses. Research and development expenses
increased by $0.7 million or 28% to $3.2 million in 2005 from $2.5 million in
2004, due to increased personnel costs associated with the development of new
services and enhancements to our existing services.
Selling and marketing expenses. Selling and marketing expenses increased
by $0.9 million or 28% to $4.1 million in 2005 from $3.2 million in 2004, due to
an increase in branding and promotional activities.
General and administrative expenses. General and administrative expenses
increased by $0.7 million or 32% to $2.9 million in 2005 from $2.2 million in
2004, primarily due to increased personnel and occupancy costs.
Depreciation and amortization. Depreciation and amortization decreased by
$0.8 million or 30% to $1.9 million in 2005 from $2.7 million in 2004, due to a
lower relative level of capital expenditures in 2005 compared to prior years.
35
Loss from Operations
Loss from operations decreased by $2.3 million or 66% to $1.2 million in
2005 from $3.5 million in 2004, due primarily to the decrease in costs and
operating expenses, including selling and marketing expenses.
Interest Income, Net
We earned interest income of $0.4 million in 2005 compared to $0.3 million
in 2004 due primarily to moderately higher interest rates earned on the
moderately reduced balance of the remaining proceeds from our initial public
offering.
Income Taxes, Net
We paid net income taxes of $0.1 million in 2005 compared to $0.1 million
in 2004.
Net Loss
Net loss decreased $2.2 million or 69% to $1 million in 2005 from $3.2
million in 2004, due to the foregoing factors.
Comparison of 2004 and 2003
Revenues
Revenues increased approximately $7.9 million or 60% to approximately
$21.1 million in 2004 from approximately $13.2 million in 2003. Revenues from
VoIP telephony through our service provider and reseller sales efforts
(including sales of our Outsourced Platform Solution) increased approximately
$7.0 million or 118.6% to approximately $12.9 million in 2004 from approximately
$5.9 million in 2003, due primarily to a greater number of PC-to-Phone and
Broadband Phone calls being placed by an increasing user base. Revenues from
VoIP telephony (primarily PC-to-Phone) through iConnectHere increased
approximately $0.9 million or 14.5% to approximately $7.1 million in 2004 from
approximately $6.2 million in 2003 due primarily to a greater number of
PC-to-Phone and Broadband Phone calls being placed by an increasing user base.
Three "Master Resellers" accounted for approximately 16.4% and 9.4% and
5.4% of our sales, respectively, during 2004.
Costs and Operating Expenses
Cost of revenues. Cost of revenues increased by $5.4 million or 64.3% to
$13.8 million in 2004 from $8.4 million in 2003, due primarily to an increase in
the amount of traffic being terminated.
Research and development expenses. Research and development expenses
increased by $0.2 million or 8.7% to $2.5 million in 2004 from $2.3 million in
2003, due to increased personnel costs associated with the development of new
services and enhancements to our existing services.
Selling and marketing expenses. Selling and marketing expenses decreased
by $0.1 million or 3.0% to $3.2 million in 2004 from $3.3 million in 2003, due
to a decrease in branding and promotional activities.
General and administrative expenses. General and administrative expenses
increased by $0.1 million or 4.8% to $2.2 million in 2004 from $2.1 million in
2003, primarily due to increased personnel and occupancy costs.
36
Depreciation and amortization. Depreciation and amortization decreased by
$2.9 million or 51.8% to $2.7 million in 2004 from $5.6 million in 2003, due to
a lower relative level of capital expenditures in the first three quarters of
2004 compared to prior years, somewhat offset by a higher relative level of
capital expenditures in the fourth quarter of 2004, and a lower level of certain
assets purchased in prior years being included in the computation of
depreciation expense in 2004 compared to 2003 as they have already been fully
depreciated in prior periods.
Loss from Operations
Loss from operations decreased by $5 million or 59.5% to $3.5 million in
2004 from $8.5 million in 2003, due primarily to the decrease in costs and
operating expenses, including selling and marketing expenses.
Interest Income, Net
We earned interest income of $0.3 million in 2004 compared to $0.2 million
in 2003 due primarily to moderately higher interest rates earned on the
moderately reduced balance of the remaining proceeds from our initial public
offering.
Income Taxes, Net
We paid net income taxes of $0.1 million in 2004 compared to $0.1 million
in 2003.
Net Loss
Net loss decreased $5.1 million or 61% to $3.2 million in 2004 from $8.3
million in 2003, due to the foregoing factors.
Liquidity and Capital Resources
Since our inception in June 1996, we have incurred significant operating
and net losses due in large part to the start-up and development of our
operations. As of December 31, 2005, we had an accumulated deficit of
approximately $151.9 million.
As of December 31, 2005, we had cash and cash equivalents of approximately
$3.8 million, restricted cash and short-term investments of approximately $10.7
million, long-term investments of approximately $1.2 million, and working
capital of approximately $ 10.3 million.
Cash provided by operating activities is net income adjusted for certain
non-cash items and changes in assets and liabilities. We generated positive cash
flow from operating activities of approximately $0.2 million during 2005
compared with positive cash flow from operating activities of $0.5 million
during 2004. In 2005 compared to 2004, even though we were able to reduce our
net loss by $2.4 million this was offset by the net changes we experienced in
our current assets and liabilities, a decrease of $0.9 million, and a decrease
in our depreciation charges by $0.8 million. The changes that we experienced in
our current assets and liabilities were driven by our strong growth in revenue
and our ability to continue to slow our cash burn and pay down some of our
current liabilities associated with employee related expenses. In 2004 our net
loss of $3.2 million was higher than in 2005, but this was offset by our
depreciation adjustment $2.7 million and our increase in accounts payable and
deferred revenues, which together equaled approximately $1.0 million.
Net cash used in investing activities is generally driven by our annual
capital expenditures and changes in our short and long term investments. In
2005, we spent $1.4 million on capital expenditures and increased our
investments by $0.2 million, for a net increase use of $1.6 million. During 2004
net cash provided by investing activities was $2.5 million, mainly due to $2.3
used for purchase of property and equipment offset by $4.8 million that was
taken from our investments and used to fund our ongoing losses.
37
Financing cash flows consist primarily of proceeds from exercise of
employee options. During 2005, 2004 and 2003 our employees exercised options of
$0.4 million, $0.1 million and $0.4 million, respectively.
We obtained our funding from our utilization of the remaining proceeds
from our initial public offering, offset by positive or negative cash flow from
our operations. These proceeds are maintained as cash, restricted cash, and
short and long term investments. Based on current trends in our operations,
these funds will be sufficient to meet our working capital requirements,
including operating losses, and capital expenditure requirements for at least
the next fiscal year, assuming that our business plan is implemented
successfully, and that:
o our recent revenue trends continue to increase;
o our expense trends remain at or near the rates of 2005 rates, which
were somewhat reduced compared to the previous the year, as a
percentage of revenues, through a continuous focus on maximizing our
personnel utilization, curtailment of discretionary expenditures,
and optimized network rent and termination rates from our carriers;
and
o our net cash-burn rate, which was significantly reduced compared to
the previous year due to the foregoing factors to approximately $0.8
million during 2005, continues to improve throughout 2006 and
beyond.
To the extent that these trends do not remain steady or if in the
longer-term we are not able to successfully implement our business strategy we
may be required to raise additional funds for our ongoing operations. Additional
financing may not be available when needed or, if available, such financing may
not be on terms favorable to us. If additional funds are raised through the
issuance of equity securities, our existing stockholders may experience
significant dilution. If additional funds are raised through the issuance of
debt securities, we may not be able to obtain additional subsequent financing,
if necessary, if the debt security contains certain covenants restricting our
ability to obtain additional financing while such debt security is outstanding.
We cannot assure you that any third party will be willing or able to provide
additional capital on favorable terms or at all.
Contractual Obligations and Commercial Commitments
The following table sets forth our future contractual obligations and
commercial commitments in total, for each of the next five years and thereafter.
Payments due by period (in thousands of dollars)
-----------------------------------------------------
Less than More than
Total 1 year 1-3 years 3-5 years 5 years
----- --------- --------- --------- ---------
Contractual obligations
Real Estate Leases 5,888 1,033 2,128 1,829 898
Auto Leases 410 235 175 --
Other Operating Leases 6 3 3 -- --
Purchase Obligations 2 2 -- -- --
Total 6,356 1,323 2,306 1,829 898
Off-Balance Sheet Arrangements
None.
38
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
The SEC's rule related to market risk disclosure requires that we describe
and quantify our potential losses from market risk sensitive instruments
attributable to reasonably possible market changes. Market risk sensitive
instruments include all financial or commodity instruments and other financial
instruments (such as investments and debt) that are sensitive to future changes
in interest rates, currency exchange rates, commodity prices or other market
factors. We believe our exposure to market risk is immaterial. We currently do
not invest in, or otherwise hold, for trading or other purposes, any financial
instruments subject to market risk.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Company's Consolidated Financial Statements required by this Item are
set forth in Item 15 beginning on page F-1 of this report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures. Our principal
executive officer and principal financial officer, after evaluating the
effectiveness of our disclosure controls and procedures (as defined in
Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period
covered by this Annual Report on Form 10-K, have concluded that, based on
such evaluation, our disclosure controls and procedures were adequate and
effective to ensure that material information relating to us, including
our consolidated subsidiaries, was made known to them by others within
those entities, particularly during the period in which this Annual Report
on Form 10-K was being prepared.
(b) Changes in Internal Controls. There were no changes in our internal
control over financial reporting, identified in connection with the
evaluation of such internal control that occurred during the fourth
quarter of our last fiscal year that have materially affected, or are
reasonably likely to materially affect, our internal control over
financial reporting.
ITEM 9B. OTHER INFORMATION
Listed below for our named executive officers are the salaries that were
awarded during fiscal 2005, the bonuses that were earned for performance during
2005 but awarded in 2006, and the salaries that have been established for fiscal
2006. Bonuses for fiscal 2006 have not yet been determined.
39
Executive Officer 2005 Salary 2005 Bonus (2) 2006 Salary
- --------------------------------------------------------------------------------------------
Shimmy Zimels $ 248,800(1)(3) $ 50,000 $ 258,000 (3)
Chief Executive Officer
and President
Paul C. White (4) $ 235,300(3) $0(5) ---
Chief Financial Officer
Guy Gussarsky $182,000 $ 30,000 --- (6)
Executive VP Sales and Business
Development
(1) Of such amount, Mr. Zimels deferred $48,800 to be paid to him at a time of
his choosing in 2006.
(2) Bonus shown is the aggregate amount of bonuses earned by the executive in
2005, under our 1999 Performance Incentive Plan, for his performance
during 2005.
(3) Salary shown is per the executive's employment agreement.
(4) Mr. White resigned effective as of February 28, 2006.
(5) In connection with Mr. White's resignation, Mr. White received certain
severance and benefits in lieu of any bonuses for his performance during
2005. For additional information about the severance and benefits, please
see the information under "Executive Compensation - Employment Agreements,
Termination of Employment and Change-in-Control Arrangements."
(6) Mr. Gussarsky's salary is the sum of a base amount and commission derived
from certain revenue achieved during the fiscal year. The salary cannot be
determined until the end of fiscal 2006.
40
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The Board of Directors
Our Amended and Restated Certificate of Incorporation provides that a
director shall hold office until the annual meeting for the year in which his or
her term expires except in the case of elections to fill vacancies or newly
created directorships. Each director is elected for a one-year term. Each of the
nominees is now serving as director on our Board. Set forth below are the name,
age and the positions and offices held by each of our directors, his principal
occupation and business experience during at least the past five years and the
names of other publicly-held companies of which he serves as a director.
Noam Bardin, 34, Chairman of the Board. Mr. Bardin co-founded deltathree
and served as Chief Executive Officer and President from July 2000 through June
2002. Mr. Bardin has served as Chairman of the Board since April 2002. Mr.
Bardin served as Vice President of Technology and Chief Technology Officer of
deltathree since June 1997 before being named President and Chief Executive
Officer in April 2000. He served as Global Network Director from November 1996
to May 1997. Prior to founding deltathree, he served as Director of Operations
at Ambient Corporation. Mr. Bardin earned a B.A. in Economics from the Hebrew
University (Jerusalem) and an M.P.A. from the Harvard University Kennedy School
of Government.
Noam Ben-Ozer, 42, Director. Mr. Ben-Ozer was named a director of
deltathree in September 2004. Mr. Ben-Ozer currently serves as a Director, and
is Chairman of the Audit Committee for Equity-One, Inc., a NYSE-listed real
estate investment trust. Mr. Ben-Ozer is the founder of Focal Advisory, a
consulting and mergers and acquisitions firm based in Boston, Massachusetts.
Previously, Mr. Ben-Ozer co-founded iPhrase Technologies, Inc., a privately-held
software company. From 1994 to 1999, Mr. Ben-Ozer served as a consultant for
Bain & Company, a management consulting company. From 1993 to 1994, Mr. Ben-Ozer
served as an outside consultant to Lernout & Hauspie Speech Products. Mr.
Ben-Ozer is a certified public accountant in Israel and received an M.B.A. from
the Harvard Business School.
Ilan Biran, 59, Director. Mr. Biran has served as a director of deltathree
since December 2003. Mr. Biran brings a wealth of business and management
experience from the telecom and defense industries. Since January 2004, Mr.
Biran has served as the Chairman of YES Satellite Television, one of the leading
satellite television companies in Israel. From 1999 to 2003, Mr. Biran served as
the President and CEO of Bezeq Ltd. - the Israeli PTT, with annual sales of over
$2 billion and approximately 16,000 employees. Mr. Biran holds the rank of Major
General (res.) in the Israeli Defense Force where, as Commander of the IDF's
Central Command, he played an active role in reaching the peace agreements with
Jordan. From 1996 to 1999, he served as the Director General of the Israeli
Ministry of Defense, and prior to that command, he held a wide variety of
senior-level positions in other Israeli units, since 1964. Mr. Biran holds a
B.A. in Economics and Business Administration from Bar-Ilan University, and
holds an Associate Diploma in Strategy and Political Economic Research from
Georgetown University. He is also a graduate of the U.S. Marine Corps Command
and Staff College. In addition, Mr. Biran's public activities include: serving
as the Israeli Prime Minister's Special Coordinator for POWs and MIAs, and since
1996, has served as the Chairman of the Board of Directors of the Israeli Oil
Refineries, Ltd.
Benjamin Broder, 42, Director. Mr. Broder has served as a director of
deltathree since July 24, 2005. As of 2002, Mr. Broder has served as the Finance
Director of Atarey. From 1996 to 2001, Mr. Broder worked as the chief financial
officer of a telecom start-up company and a bio-tech start-up company.
Previously, Mr. Broder also held various positions with several leading banks,
including HSBC, Bank Hapoalim, and Bank of Israel. Mr. Broder earned a B.S.
degree in Economics from University of London. Mr. Broder is a Chartered
Accountant in the U.K. and a C.P.A. in Israel.
41
Joshua Maor, 69, Director. Mr. Maor has served as a director of deltathree
since June 2001. Mr. Maor has served as the Chairman of Commutech Holding &
Investments Ltd., an investment holding company which engages primarily in
investments in high tech companies, since January 2002, and as the Chairman of
the board of Mofet Venture Capital since 2001. Mr. Maor served as both the
Chairman and Chief Executive Officer Green Venture Capital Ltd from 1997 to
January 2002. From 1996 through 1997, Mr. Maor was the Chairman of I.B.M. Israel
Ltd., which distributes and provides services for I.B.M. products, and I.B.M.
Science and Technology Ltd., a research and development company. Mr. Maor served
as a member of our Advisory Board from 1997 through 1998.
Lior Samuelson, 56, Director. Mr. Samuelson has served as a director of
deltathree since August 2001. Since August 1999, Mr. Samuelson has served as a
Co-Founder and Principal of Mercator Capital. His experience includes advising
clients in the Technology, Communications and Consumer sectors on mergers,
acquisitions and private placements. From March 1997 to August 1999, Mr.
Samuelson was the President and CEO of PricewaterhouseCoopers Securities. Prior
to that, he was the President and CEO of The Barents Group, a merchant bank
specializing in advising and investing in companies in emerging markets. Mr.
Samuelson was also the Co-Chairman of Peloton Holdings, a Private Equity
management company. Before that, he was a managing partner with KPMG and a
senior consultant at Booz, Allen & Hamilton. Mr. Samuelson earned B.S. and M.S.
degrees in Economics from Virginia Polytechnic University.
Shimmy Zimels, 40, Chief Executive Officer and President and Director. Mr.
Zimels has served as Chief Executive Office and President since June 2002, and
served as Vice President of Operations and Chief Operating Officer of deltathree
since June 1997, before being named President and Chief Executive Officer in
June 2002. Prior to joining deltathree, Mr. Zimels was the Controller and Vice
President of Finance at Net Media Ltd., a leading Israel based Internet Service
Provider, from June 1995 to June 1997. From April 1991 to May 1995, Mr. Zimels
was a senior tax auditor for the Income Tax Bureau of the State of Israel. Mr.
Zimels graduated with distinction from Hebrew University with a degree in
Economics and Accounting and holds a Masters in Economics from Hebrew
University.
Our Board has determined that the following members of the Board qualify
as independent under the definition promulgated by the Nasdaq Stock Market: Noam
Bardin, Noam Ben-Ozer, Ilan Biran, Benjamin Broder, Joshua Maor and Lior
Samuelson.
Executive Officers
Set forth below is a brief description of the present and past business
experience of each of the persons who serve as our executive officers or key
employees who are not also serving as directors.
Guy Gussarsky, 34, Executive Vice President of Sales and Business
Development. Mr. Gussarsky joined deltathree in August 2000, and most recently
became Executive Vice President of Sales and Business Development in January
2006. Mr. Gussarsky is responsible for all aspects of the Company's worldwide
sales and business development activities. Prior to assuming this role, Mr.
Gussarsky held several other positions within deltathree, including Vice
President of Business Development for Europe, Middle East and Africa (EMEA) as
well as Director of Products. Prior to joining deltathree, Mr. Gussarsky worked
at I Gornitzky and Co., a leading Israeli law firm, and also served as an
officer in the Israeli Special Forces. Mr. Gussarsky graduated with a
distinction from Hebrew University with a degree in Law and Accounting.
Board of Directors and Committees of the Board
Our Amended and Restated Certificate of Incorporation provides that the
number of members of our Board shall be not less than three and not more than
thirteen. There are currently seven directors on the Board. At each annual
meeting of stockholders, directors will be elected to hold office for a term of
one year and until their respective successors are elected and qualified. All of
the officers identified above under "Executive Officers" serve at the discretion
of our Board.
42
The Board had six regular and no special meetings during the fiscal year
ended December 31, 2005. During the fiscal year ended December 31, 2005, each
member of the Board participated in at least 75% of all Board and applicable
committee meetings held during the period for which he was a director. None of
our directors attended our annual meeting of stockholders held in 2005. The
Board established an Audit Committee, a Compensation Committee, and a Nominating
and Governance Committee. The functions of these committees and their current
members are set forth below.
The Compensation Committee is responsible for evaluating our compensation
policies, determining our executive compensation policies and guidelines and
administering our stock option and compensation plans. The Compensation
Committee is responsible for the determination of the compensation of our Chief
Executive Officer, and conducts its decision making process with respect to that
issue without the presence of the Chief Executive Officer. All members of the
Compensation Committee qualify as independent under the definition promulgated
by the Nasdaq Stock Market. The Compensation Committee had 5 meetings during
2005. Benjamin Broder (Chairman), Noam Ben-Ozer and Joshua Maor are the current
members of the Compensation Committee. Please also see the report of the
Compensation Committee set forth elsewhere in this annual report.
The Nominating and Governance Committee is responsible for assisting,
identifying, and recommending qualified candidates for director nominees to the
Board, and leading the Board in its annual review of the Board's performance.
All members of the Nominating Committee qualify as independent under the
definition promulgated by the Nasdaq Stock Market. The Nominating and Governance
Committee had one meeting during 2005. Joshua Maor (Chairman), Noam Bardin and
Benjamin Broder are the current members of the Nominating and Governance
Committee. The Nominating and Governance Committee may consider candidates
recommended by stockholders as well as from other sources such as other
directors or officers, third party search firms or other appropriate sources.
For all potential candidates, the Nominating and Governance Committee may
consider all factors it deems relevant, such as a candidate's personal integrity
and sound judgment, business and professional skills and experience,
independence, knowledge of the industry in which we operate, possible conflicts
of interest, diversity, the extent to which the candidate would fill a present
need in the Board, and concern for the long-term interests of our stockholders.
In general, persons recommended by stockholders will be considered on the same
basis as candidates from other sources. If a stockholder wishes to nominate a
candidate to be considered for election as a director at our 2006 Annual Meeting
of Stockholders using the procedures set forth in the Company's By-laws, it must
follow the procedures described under "Nomination of Directors" in our By-laws.
If a stockholder wishes simply to propose a candidate for consideration as a
nominee by the Nominating and Governance Committee, it should submit any
pertinent information regarding the candidate to the Chairman of the Nominating
and Governance Committee by mail at 75 Broad Street, New York, New York 10004. A
copy of the Nominating Committee's written charter is publicly available on the
Company's website at www.deltathree.com.
The Audit Committee recommends to the Board the appointment of the firm
selected to serve as our independent auditors and monitors the performance of
such firm; reviews and approves the scope of the annual audit and evaluates with
the independent auditors our annual audit and annual financial statements;
reviews with management the status of internal accounting controls; evaluates
issues having a potential financial impact on us which may be brought to the
Audit Committee's attention by management, the independent auditors or the
Board; evaluates our public financial reporting documents; reviews the non-audit
services to be performed by the independent auditors, if any; and considers the
effect of such performance on the auditor's independence. Ilan Biran (Chairman),
Noam Ben-Ozer and Lior Samuelson are the current members of the Audit Committee.
All members of the Audit Committee satisfy the current independence standards
promulgated by the SEC and by the Nasdaq Stock Market, as such standards apply
specifically to members of audit committees. The Board has determined that each
of Mr. Ben-Ozer, Mr. Biran, and Mr. Samuelson are "audit committee financial
experts," as the SEC has defined that term in Item 401 of Regulation S-K. The
Audit Committee had five meetings during 2005.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934 requires our
directors and executive officers and persons who own more than 10% of a
registered class of our equity securities, to file with the SEC initial reports
of ownership and reports of changes in beneficial ownership of Common Stock and
other equity securities of us. Directors, officers and greater than 10%
stockholders are required by SEC regulations to furnish us with all Section
16(a) forms they file.
43
To our knowledge, based solely upon our review of the copies of such
reports furnished to us, we believe that all of our directors, officers and
greater than 10% stockholders have complied with the applicable Section 16(a)
reporting requirements except that: one report of change in beneficial
ownership, covering one transaction, was filed late by Noam Ben-Ozer; and one
report of change in beneficial ownership, covering one transaction, was filed
late by Benjamin Broder.
Code of Conduct and Ethics
On March 25, 2004, we adopted a Corporate Code of Conduct and Ethics
applicable to all employees and directors of deltathree, including our principal
executive officer, principal financial and accounting officer and controller.
There were no changes made to the Corporate Code of Conduct and Ethics during
2005. We intend to post on our website and include in a Current Report on Form
8-K filed with the SEC any amendments to, or waivers from, our Code of Conduct
and Ethics that apply to our principal executive officer, principal financial
and accounting officer and controller.
ITEM 11. EXECUTIVE COMPENSATION
Summary Compensation Table
The following table sets forth certain summary information concerning the
compensation paid or awarded for services rendered during each of our last three
fiscal years to our chief executive officer and each of our other most highly
compensated executive officers in 2003, 2004 and 2005 whose total salary and
bonus exceeded $100,000. These executive officers are referred to in this report
as "named executive officers".
Annual Compensation Long-Term Compensation
------------------------- --------------------------
Securities
Underlying All Other
Name and Principal Position Year Salary ($) Bonus ($) Options (#) Compensation
- ---------------------------------------- ---- ---------- --------- ----------- ------------
Shimmy Zimels 2005 $ 248,800(1) $ 50,000 0 --
President and Chief Executive Officer 2004 180,000 $ 125,050 80,000 --
and former Chief Operating Officer 2003 180,000 -- 85,000 --
Paul C. White (2) 2005 $ 235,300 --(3) -- --
Chief Financial Officer 2004 180,000 $ 94,100 75,000 --
2003 180,000 -- 65,000 --
Guy Gussarsky
Executive Vice President of Sales 2005 $ 182,000 $ 30,000 0 --
and Business Development 2004 142,000 $ 53,000 50,000 --
(1) Of such amount, $48,800 has been deferred and will be paid at a time of
Mr. Zimels' choosing in 2006.
(2) Mr. White resigned effective as of February 28, 2006.
(3) In connection with Mr. White's resignation, Mr. White received certain
severance and benefits in lieu of any bonuses for his performance during
2005. For additional information about the severance and benefits, please
see the information under "Executive Compensation - Employment Agreements,
Termination of Employment and Change-in-Control Arrangements."
44
Option Exercises in Fiscal 2005 and Year-End Option Values
The following table sets forth information for the named executive
officers with respect to option exercises during 2005 and the value as of
December 31, 2005 of unexercised in-the-money options held by each of the named
executive officers.
Number of
Securities Value of
underlying Unexercised
Unexercised In-The-Money
Options at Options at
Shares Year End (#) Year-End ($)
Acquired Value Exercisable Exercisable
Name On Exercise (#) Realized ($) /Unexercisable /Unexercisable
- ------------- --------------- ------------ -------------- --------------
Shimmy Zimels 41,000 196,775 526,271/81,667 1,599,864/248,268
Paul C. White 56,598 287,704 50,000/293,402(1) 826,074/217,868
Guy Gussarsky 39,999 155,463 58,344/46,667 177,335/141,868
(1) In connection with Mr. White's resignation, unvested stock options for
21,667 shares of our common stock were accelerated to vest on February 28, 2006,
his separation date. For additional information, please see the information
under "Executive Compensation - Employment Agreements, Termination of Employment
and Change-in-Control Arrangements."
Compensation Committee Interlocks and Insider Participation
Executive compensation decisions in 2005 were made by the Compensation
Committee. During 2005, no interlocking relationship existed between our Board
and the board of directors or compensation committee of any other company.
Director Compensation
At our Annual Meeting on December 20, 2005, each of our non-management
directors (Noam Bardin, Noam Ben-Ozer, Ilan Biran, Benjamin Broder, Joshua Maor,
and Lior Samuelson) became eligible to receive $10,000 for their services as
directors, through the next Annual Meeting date. We anticipate paying $10,000 to
each outside director in 2006. Directors are reimbursed for the expenses they
incur in attending meetings of the Board and Board committees.
2004 Non-Employee Director Stock Option Plan
The purposes of the 2004 Non-Employee Director Stock Option Plan, as
amended (the "Director Plan"), are to enable us to attract, maintain and
motivate qualified directors and to enhance a long-term mutuality of interest
between our directors and shareholders of our Common Stock by granting our
directors options to purchase our shares.
The Director Plan provides for the automatic grant of nonstatutory stock
options. Options granted under the Plan are not intended to qualify as
"incentive stock options" within the meaning of Section 422 of the Internal
Revenue Code of 1986, as amended (the "Code"). The aggregate number of shares of
Common Stock that may be issued under the Director Plan shall not exceed (a)
851,216 shares, plus (b) such additional shares of Common Stock as are
represented by Options previously granted under the 1999 Directors Plan which
are cancelled or expire after the date of stockholder approval of the Director
Plan without delivery of shares of stock by the Company.
Initial Option Awards. Each director who is not an employee of the Company
will be granted options to acquire 10,000 shares of Common Stock on the date he
or she joins the Board.
45
Subsequent Option Awards. On the first business day after each annual
meeting of stockholders of the Company occurring during the term of the Plan,
each non-employee director who meets the guidelines for Board service and who
continues to be a non-employee director following such annual meeting shall
automatically be granted an option to purchase 10,000 shares of Common Stock;
provided that no Subsequent Option Award shall be made to any non-employee
director who has not served as a director of the Company, as of the time of such
annual meeting, for at least six months.
Committee Chairman Awards. Each non-employee director who is appointed as
chairman of a standing committee of the Board (and has not served as the
chairman of such committee immediately prior to the appointment) shall be
automatically granted an option to purchase 10,000 shares of Common Stock on the
date of such appointment. Each non-employee director who serves as a chairman of
the full Board or of a standing committee of the Board other than the audit
committee, and who meets the guidelines for Board service, immediately following
each annual meeting of the Company's stockholders, shall be granted an option to
purchase an additional 10,000 shares of Common Stock; provided that no Committee
Chairman Award shall be made to any non-employee director who has not served as
a director of the Company, as of the time of such annual meeting, for at least
six months, and no Committee Chairman Award shall be made to any Eligible
Director who has received a Committee Chairman award for such service on the
same committee within the past six months.
Audit Committee Service Awards. Each non-employee director who is
appointed as a member of the audit committee of the Board (and has not served as
a member of such committee immediately prior to that appointment) shall be
automatically granted an option to purchase 10,000 shares of Common Stock on the
date of such appointment. Each non-employee director who serves as a member of
the audit committee of the Board, and who meets the guidelines for Board
service, immediately following each annual meeting of the Company's
stockholders, shall be granted an option to purchase an additional 10,000 shares
of Common Stock; provided that no Audit Committee Service Award shall be made to
any non-employee director who has not served as a director of the Company, as of
the time of such annual meeting, for at least six months, and no Audit Committee
Award shall be made to any Eligible Director who has received an Audit Committee
award for such service within the past six months. In addition, the chairman of
the audit committee of the Board shall be granted an additional option to
purchase 5,000 shares of Common Stock.
Notwithstanding the foregoing, a non-employee director shall receive a
maximum number of options to purchase 30,000 shares of Common Stock during any
single calendar year. The exercise price per share of Common Stock of each
option granted pursuant to the Plan shall be equal to the fair market value per
share on the date of grant. If not previously exercised, each option shall
expire on the earlier of (i) the tenth anniversary of the date of the grant
thereof and (ii) on the first anniversary of the termination of the non-employee
director's status as a director of the Company. Each option granted under the
Plan shall become fully vested and exercisable on the first anniversary of the
date of grant. In addition, options granted pursuant to the Plan will become
exercisable in full upon a "change in control" as defined in the Plan. The Plan
terminates at the close of business on September 23, 2014, unless sooner
terminated by action of the Board or stockholders of the Company.
Employment Agreements, Termination of Employment and Change-in-Control
Arrangements
We currently have an employment agreement in place with Mr. Zimels, with
the following principal terms:
o The agreement is effective from April 26, 2004 through August 31,
2006 and, thereafter, is automatically extended for the same
duration on the expiration date and on each expiration date
thereafter unless either party provides the other party with written
notice of non-renewal at least ninety days prior to expiration of a
term, provided that the executive provides notice of renewal to the
Compensation Committee six months prior to expiration of the term.
o Pursuant to the agreement, Mr. Zimels was entitled to receive a base
salary of $248,800 during 2005. Such base salary is increased on
each January 1, commencing January 1, 2005, by an amount equal to
the base salary then in effect, multiplied by the applicable cost of
living index during the prior year. The employee's base salary, as
adjusted for cost of living increases, may be further increased at
the option and in the discretion of our Board. As such, in 2006, Mr.
Zimels is entitled to receive a base salary of $258,000.
46
o The employee's options are immediately exercisable in full upon a
change of control. The employee's options, following any termination
of the employee's employment, other than for cause, remain
exercisable for the lesser of two years and the remaining term of
the options.
o If employee's employment is terminated by us without cause or by the
employee for good reason (which includes, without limitation, a
reduction in salary and/or bonus opportunity, a change of control
and a material reduction in duties and responsibilities), the
employee is entitled to receive previously earned, but unpaid
salary, vested benefits and a payment equal to their annual base
salary as in effect immediately prior to the termination date.
o If employee dies or is unable to perform his duties, he or his
representative, estate or beneficiary will be paid, in addition to
any previously earned but unpaid salary and vested benefits, 12
months' total base salary reduced, in the case of disability, by any
disability benefits they receive.
In connection with Paul White's resignation from our company, a Separation
and Release Agreement was approved by the Compensation Committee of our Board
and executed by us and Mr. White on February 13, 2006. The Separation Agreement
provides that Mr. White's resignation as an employee of the Company will be
effective as of February 28, 2006, or the separation date, and that Mr. White
will continue to be available to us in order to ensure a smooth transition for a
reasonable time period after the separation date. In addition, the Separation
Agreement provides that Mr. White: (i) will continue to receive his base salary
until the separation date; (ii) will receive a lump sum separation payment of
$90,000; (iii) will continue to participate in our benefit plans at his current
levels until the earlier of the date he enrolls in a comparable benefits plan
with another employer or a period of six (6) months after the separation date;
(iv) will have his unvested stock options for 21,667 shares of our common stock
at the exercise price of $1.75 accelerated to vest on the separation date; and
(v) will be entitled to expense reimbursement due through the separation date.
Mr. White will not be entitled to any other payments, bonuses, severance,
vacation pay or any other amounts that are, or may be, due to him under his
employment agreement with us, as amended, or any other agreement. Mr. White will
not be eligible for any bonus for 2005 under our 1999 Performance Incentive Plan
or under any other plan. Under the terms of the Separation Agreement, neither we
nor Mr. White have any further obligations under his employment agreement with
us other than the parties' obligations in connection with non-competition and
non-solicitation, confidentiality, company property, no disparagement, our
obligation of indemnification, and any additional items specifically provided in
the Separation Agreement. In addition, we have agreed that in the event of Mr.
White's death after the date of the Separation Agreement, his surviving spouse
shall be entitled to certain unpaid payment amounts, as long as he did not
breach of the Separation Agreement prior to his death. Pursuant to the
Separation Agreement, Mr. White has provided us with a general liability release
of all claims arising out of his employment and separation from our Company.
Compensation Committee Report on Executive Compensation
The Compensation Committee is responsible for recommending to the Board of
Directors the overall executive compensation strategy of the Company and for the
ongoing monitoring of the compensation strategy's implementation. In addition to
recommending and reviewing the compensation of the executive officers, it is the
responsibility of the Compensation Committee to recommend new incentive
compensation plans and to implement changes and improvements to existing
compensation plans, including the 1999 Performance Incentive Plan, the 2004
Stock Incentive Plan, as amended, and the 2004 Non-Employee Director's Plan, as
amended. The Compensation Committee makes its compensation determinations based
upon its own analysis of information it compiles and the business experience of
its members.
47
Overall Policy
The Compensation Committee believes that the stability of the Company's
management team, as well as the Company's ability to continue to incentivize
management and to attract and retain highly qualified executives for its
expanding operations, will be a contributing factor to the Company's continued
growth and success. In order to promote stability, growth and performance, and
to attract new executives, the Company's strategy is to compensate its
executives with an overall package that the Company believes is competitive with
those offered by similarly situated companies and which consists of (i) a stable
base salary set at a sufficiently high level to retain and motivate these
officers but generally targeted to be in the lower half of its peer group
comparables, (ii) an annual bonus linked to the Company's overall performance
each year and to the individual executive's performance each year and (iii)
equity-related compensation which aligns the financial interests of the
Company's executive officers with those of the Company's stockholders by
promoting stock ownership and stock performance through the grant of stock
options and stock appreciation rights, restricted stock and other equity and
equity-based interests under the Company's various plans.
Executive officers are also entitled to customary benefits generally
available to all employees of the Company, including group medical and life
insurance. Base salary, bonuses and benefits are paid by the Company and its
subsidiaries.
Federal Income Tax Deductibility of Executive Compensation
Section 162(m) of the Internal Revenue Code of 1986, as amended (the
"Code"), limits the amount of compensation a publicly held corporation may
deduct as a business expense for Federal income tax purposes. The limit, which
applies to a company's chief executive officer and the four other most highly
compensated executive officers, is $1 million (the "Deductibility Limit"),
subject to certain exceptions. The exceptions include the general exclusion of
performance-based compensation from the calculation of an executive officer's
compensation for purposes of determining whether his or her compensation exceeds
the Deductibility Limit. The Compensation Committee has determined that
compensation payable to the executive officers should generally meet the
conditions required for full deductibility under section 162(m) of the Code.
While the Company does not expect to pay its executive officers compensation in
excess of the Deductibility Limit, the Compensation Committee also recognizes
that in certain instances it may be in the best interest of the Company to
provide compensation that is not fully deductible.
Base Salary
The base salary for Mr. Zimels is pursuant to his employment agreement
with us. The base salary for Mr. Gussarsky is set at a level that is
commensurate with his responsibilities and competitive with similar positions at
other comparable companies.
Annual Incentive Bonuses
The Board established the 1999 Performance Incentive Plan to enable the
Company and its subsidiaries to attract, retain, motivate and reward the best
qualified executive officers and key employees by providing them with the
opportunity to earn competitive compensation directly linked to the Company's
performance. The Performance Incentive Plan is effective through and including
the year 2005, unless extended or earlier terminated by the Board of Directors.
As part of the Performance Incentive Plan, the Compensation Committee may
determine that any bonus payable under the Performance Incentive Plan be paid in
cash, in shares of Common Stock or in any combination thereof, provided that at
least 50% of such bonus is required to be paid in cash. In addition, the
Performance Incentive Plan permits a participant to elect to defer payment of
his or her bonus on terms and conditions established by the Compensation
Committee. No more than 400,000 shares of Common Stock may be issued under the
Performance Incentive Plan.
Under the 1999 Performance Incentive Plan, bonuses may be payable if the
Company meets any one or more of the following performance criteria, which are
set annually by the Compensation Committee: (i) revenues; (ii) operating income;
(iii) gross profit margin; (iv) net income; (v) earnings per share; (vi) maximum
capital or marketing expenditures; or (vii) targeted levels of customers.
48
Under the 1999 Performance Incentive Plan, bonus amounts are determined as
follows: if 100% of such targets are achieved, the bonus potentially payable to
participants will generally equal 35% of their base salary (45% in the case of
the Chief Executive Officer) for such year, if 80% of such targets are achieved,
the bonus potentially payable to participants will generally equal 25% of their
base salary for such year, and if less than 80% of such targets are achieved,
the participants will generally not be entitled to receive any bonus for such
year. To the extent the Company's results exceed 80% of the targets but is less
that 100% of the targets, the amount of the bonus payable to participants will
be adjusted proportionately based on where such results fall within the ranges
set forth above. Any such bonus will consist of two components. Fifty percent of
the amount determined pursuant to the formula described above will be payable if
the targets are achieved. Up to an additional 50% of such amount will be payable
in the discretion of the Compensation Committee. In addition, the 1999
Performance Incentive Plan permits the Compensation Committee to grant
discretionary bonuses to participants, notwithstanding that a bonus would not
otherwise be payable under the 1999 Performance Incentive Plan, to recognize
extraordinary individual performance.
With respect to 2005, a bonus in the amount of $50,000 was awarded to Mr.
Zimels, under the 1999 Performance Incentive Plan. Pursuant to the terms of the
1999 Performance Incentive Plan, awards will be paid in the current year,
following the completion of the audit of the Company's 2005 financial
statements.
Long-Term Incentive Compensation
The Company reinforces the importance of producing satisfactory returns to
stockholders over the long-term through the operation of the 2004 Stock
Incentive Plan and the 2004 Non-Employee Director Stock Option Plan. For a
discussion relating to the Director Plan, refer to the section entitled "2004
Non-Employee Director Stock Option Plan" in this annual report. Grants of stock,
stock options, stock unit awards and stock appreciation rights under such plans
provide executives with the opportunity to acquire an equity interest in the
Company and align the executive's interest with that of the stockholders to
create stockholder value as reflected in growth in the market price of the
Common Stock.
2004 Stock Incentive Plan
The purposes of the 2004 Stock Incentive Plan, as amended, are to foster
and promote the long-term financial success of the Company and materially
increase stockholder value by (i) motivating superior performance by means of
performance-related incentives, (ii) encouraging and providing for the
acquisition of an ownership interest in the Company by executive officers and
other key employees and (iii) enabling the Company to attract and retain the
services of an outstanding management team upon whose judgment, interest and
special effort the successful conduct of its operations is largely dependent.
Under the 2004 Stock Incentive Plan, the Compensation Committee is
authorized to grant options for 2,759,732 shares of Common Stock, plus (b) such
additional shares of Common Stock as are represented by awards previously
granted under the 1999 Stock Incentive Plan which are cancelled or without
delivery of shares of stock by the Company. Options granted under the 2004 Stock
Incentive Plan are to be granted to certain officers of the Company and to other
employees and consultants of the Company. Directors who are non-employees of the
Company are prohibited from participating in the 2004 Stock Incentive Plan.
The 2004 Stock Incentive Plan is administered by the Compensation
Committee and provides for the grant of (i) incentive and non-incentive stock
options to purchase Common Stock; (ii) stock appreciation rights, which may be
granted in tandem with or independently of stock options; (iii) restricted stock
and restricted units; (iv) incentive stock and incentive units; (v) deferred
stock units; and (vi) stock in lieu of cash. The maximum number of shares for
which options or stock appreciation rights may be granted to any one participant
in a calendar year is 500,000. As of December 31, 2005, the Company has
outstanding options to acquire an aggregate of 2,762,686 shares of Common Stock,
of which 2,155,852 were granted under the 1999 Plans and 606,834 were granted
under the 2004 Plans.
49
Chief Executive Officer's Fiscal 2005 Compensation
Mr. Shimmy Zimels was our chief executive officer for all of 2005. Under
the terms of his employment agreement, Mr. Zimels was entitled to receive an
annual base salary of $248,800 in 2005. However, during 2005, Mr. Zimels
received an aggregate annual base salary of $200,000, and he deferred the
payment of $48,800 to a time of his choosing in 2006. Mr. Zimels received a
bonus for 2005 in the amount of $50,000 under the 1999 Performance Incentive
Plan.
Submitted by:
The Compensation Committee
Benjy Broder
Joshua Maor
Noam Ben-Ozer
50
STOCK PERFORMANCE CHART
The graph depicted below shows a comparison of cumulative total
shareholder returns for our common stock over our company's past five fiscal
years as compared with the cumulative total return on The Nasdaq Stock Market
(U.S.) Index and the Nasdaq Telecommunications Index. Shareholder returns over
the indicated period are based on historical data and should not be considered
indicative of future shareholder returns.
COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
[Line Chart]
[GRAPHIC OMITTED]
Cumulative Total Return
---------------------------------------------------------------
12/00 12/01 12/02 12/03 12/04 12/05
---------- --------- --------- ---------- --------- ---------
deltathree, Inc. $100.00 $75.80 $40.01 $245.96 $279.65 $245.09
Nasdaq Stock Market (U.S.) Index 100.00 79.21 54.46 82.12 89.65 91.54
Nasdaq Telecommunications Index 100.00 66.55 30.63 50.95 54.33 51.62
51
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The following table sets forth information with respect to the beneficial
ownership of shares of our Common Stock as of March 24, 2006 by:
o each person who we know owns beneficially more than 5% of our Common
Stock;
o each of our directors individually;
o each of our named executive officers individually; and
o all of our executive officers and directors as a group.
Unless otherwise indicated, to our knowledge, all persons listed below
have sole voting and investment power with respect to their shares of Common
Stock. Each person listed below disclaims beneficial ownership of their shares,
except to the extent of their pecuniary interests therein. Shares of Common
Stock that an individual or group has the right to acquire within 60 days of
March 24, 2006 pursuant to the exercise of options are deemed to be outstanding
for the purpose of computing the percentage ownership of such person or group,
but are not deemed outstanding for the purpose of calculating the percentage
owned by any other person listed.
Number Percentage(1)
------ -------------
Shares of deltathree Class A Common Stock
Beneficially Owned
------------------
Principal Stockholder:
Atarey Hasharon Chevra Lepituach Vehashkaot Benadlan (1991)
Ltd...................................................... 12,260,377 40.8%
7 Giborey Israel St., P.O. Box 8468.
South Netanya Industrial Zone 42504, Israel.
Executive Officers and Directors:
Noam Bardin(2)(3)........................................... 716,304 2.4%
Shimmy Zimels(2)(4)......................................... 672,407 2.2%
Paul C. White(5)(8) ........................................ 343,402 1.1%
Guy Gussarsky(2)(5) ........................................ 105,011 *
Noam Ben-Ozer (2)(5)........................................ 44,848 *
Ilan Biran (2)(5)........................................... 74,849 *
Benjamin Broder (2)(5)...................................... 20,000 *
Joshua Maor (2)(6).......................................... 90,999 *
Lior Samuelson (2)(5)....................................... 50,000 *
All Directors and Executive Officers as a group
(8 persons)(7)........................................... 1,774,418 5.9%
- -----------
* Less than 1%.
(1) Percentage of beneficial ownership is based on 30,000,982 shares of Common
Stock outstanding as of March 24, 2006.
(2) The address for the director or executive officer listed is c/o the
Company.
52
(3) Includes (a) 187,366 shares of Common Stock and (b) options to purchase
528,938 shares of Common Stock.
(4) Includes (a) 64,469 shares of Common Stock and (b) options to purchase
607,938 shares of Common Stock.
(5) Represents options to purchase shares of Common Stock.
(6) Includes (a) 16,151 shares of Common Stock and (b) options to purchase
74,848 shares of Common Stock.
(7) Includes (a) 267,986 shares of Common Stock and (b) options to purchase
1,506,432 shares of Common Stock. Due to Mr. White's resignation, he is
not included in this group.
(8) Mr. White resigned effective as of February 28, 2006.
Equity Compensation Plan Information
The following table provides certain aggregate information with respect to
shares of our common stock that may be issued under our equity compensation
plans in effect as of December 31, 2005.
- ----------------------------- --------------------------------- --------------------------------- -------------------------------
Plan Category Number of Securities to be Weighted Average Exercise Price Number of Securities Remaining
Issued Upon Exercise of of Outstanding Options, Available for Future Issuance
Outstanding Options, Warrants Warrants and Rights Under Equity Compensation Plans
and Rights (excluding securities reflected
in first column)
- ----------------------------- --------------------------------- --------------------------------- -------------------------------
Equity Compensation Plans
Approved by Security
Holders (1) 2,762,686 $2.58 3,114,950
- ----------------------------- --------------------------------- --------------------------------- -------------------------------
Equity Compensation Plans
not Approved by Security
Holders N/A N/A N/A
- ----------------------------- --------------------------------- --------------------------------- -------------------------------
Total 2,762,686 $2.58 3,114,950
- ----------------------------- --------------------------------- --------------------------------- -------------------------------
(1) These plans consist of our 2004 Stock Incentive Plan and 2004 Non-Employee
Director Stock Option Plan. The table also includes information for equity
compensation plans that have expired. Our 1999 Directors' Plan and our
1999 Employee Stock Incentive Plan have expired. As of December 31, 2005
under our expired 1999 Employee Stock Incentive Plan, a total of 1,935,284
shares of our common stock were issuable upon the exercise of outstanding
vested options, and 101,176 shares of our common stock will be issuable
upon vesting of such options. As of December 31, 2005 under our expired
1999 Directors' Plan, a total of 119,392 shares of our common stock were
issuable upon the exercise of outstanding vested options, and 0 shares of
our common stock will be issuable upon vesting of such options.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
We are not, and have not been during the last two fiscal years, a party to
any related-party agreements. All transactions between us and our officers,
directors, principal stockholders and affiliates must be reviewed and approved
in advance by the Audit Committee.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
53
The following table presents fees for professional audit services rendered
by Brightman Almagor & Co. for the audit of the Company's annual financial
statements for the years ended December 31, 2005, and December 31, 2004, and
fees billed for other services rendered by Brightman Almagor & Co. during those
periods.
2005 2004
Audit fees $ 62,000 $ 54,000
Audit related fees - 3,000
Tax fees 9,000 11,000
All Other Fees - -
- ------------------------------------------------------------------
Total $ 71,000 $ 68,000
- ------------------------------------------------------------------
In the above table, in accordance with the SEC's definitions and rules,
"audit fees" are fees we paid Brightman Almagor & Co. for professional services
for the audit of our annual financial statements and review of financial
statements included in our quarterly reports filed with the SEC, as well as for
work generally only the independent auditor can reasonably be expected to
provide, such as statutory audits and consultation regarding financial
accounting and/or reporting standards; "audit-related fees" are fees billed by
Brightman Almagor & Co. for assurance and related services that are reasonably
related to the performance of the audit or review of our financial statements;
"tax fees" are fees for tax compliance, tax advice and tax planning; and "all
other fees" are fees billed by Brightman Almagor & Co for any services not
included in the first three categories.
Policy on Audit Committee Pre-Approval of Audit and Permissible Non-audit
Services of Independent Auditors
Consistent with SEC policies regarding auditor independence, the Audit
Committee has responsibility for appointing, setting compensation and overseeing
the work of the independent auditor. In recognition of this responsibility, the
Audit Committee has established a policy to pre-approve all audit and
permissible non-audit services provided by the independent auditor.
Prior to engagement of the independent auditor for the next year's audit,
management will submit an aggregate of services expected to be rendered during
that year for each of four categories of services to the Audit Committee for
approval.
1. Audit services include audit work performed in the preparation of
financial statements, as well as work that generally only the independent
auditor can reasonably be expected to provide, including comfort letters,
statutory audits, and attest services and consultation regarding financial
accounting and/or reporting standards.
2. Audit-Related services are for assurance and related services that are
traditionally performed by the independent auditor, including due diligence
related to mergers and acquisitions, employee benefit plan audits, and special
procedures required to meet certain regulatory requirements.
3. Tax services include all services performed by the independent
auditor's tax personnel except those services specifically related to the audit
of the financial statements, and includes fees in the areas of tax compliance,
tax planning, and tax advice.
4. Other Fees are those associated with services not captured in the other
categories. The Company generally does not request such services from the
independent auditor.
Prior to engagement, the Audit Committee pre-approves these services by
category of service. The fees are budgeted and the Audit Committee requires the
independent auditor and management to report actual fees versus the budget
periodically throughout the year by category of service. During the year,
circumstances may arise when it may become necessary to engage the independent
auditor for additional services not contemplated in the original pre-approval.
In those instances, the Audit Committee requires specific pre-approval before
engaging the independent auditor.
54
The Audit Committee may delegate pre-approval authority to one or more of
its members. The member to whom such authority is delegated must report, for
informational purposes only, any pre-approval decisions to the Audit Committee
at its next scheduled meeting.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a)(1) Financial Statements.
The Consolidated Financial Statements filed as part of this Annual Report
on Form 10-K are identified in the Index to Consolidated Financial Statements on
page F-1 hereto.
(a)(2) Financial Statement Schedules.
Financial Statement Schedules have been omitted because the information
required to be set forth therein is not applicable or is shown on the financial
statements or notes thereto.
(a)(3) Exhibits.
The following exhibits are filed herewith or are incorporated by reference
to exhibits previously filed with the SEC.
Exhibit
Number Description
- ------ -----------
3.1.1 Form of Restated Certificate of Incorporation of deltathree, Inc.
(Incorporated by reference from our registration statement on Form
S-1 (Registration No. 333-122242)).
3.1.2 Form of Amendment to Restated Certificate of Incorporation of
deltathree, Inc. (Incorporated by reference to our annual report on
Form 10-K/A, filed on April 30, 2001).
3.2 Form of Amended and Restated By-laws of deltathree, Inc.
(Incorporated by reference from our registration statement on Form
S-1 (Registration No. 333-122242)).
4.1 Specimen Certificate of Common Stock (Incorporated by reference from
our registration statement on Form S-1 (Registration No.
333-122242)).
4.2 Specimen Certificate of Class B Common Stock (Incorporated by
reference from our registration statement on Form S-1 (Registration
No. 333-122242)).
10.1 Form of deltathree, Inc. 1999 Stock Incentive Plan (Incorporated by
reference from our registration statement on Form S-1 (Registration
No. 333-122242)).+
10.2 Form of deltathree, Inc. 1999 Employee Stock Purchase Plan
(Incorporated by reference from our registration statement on Form
S-1 (Registration No. 333-122242)).
10.3 Form of deltathree, Inc. 1999 Performance Incentive Plan
(Incorporated by reference from our registration statement on Form
S-1 (Registration No. 333-122242)).+
10.4 Form of deltathree, Inc. 1999 Directors' Plan (Incorporated by
reference from our registration statement on Form S-1 (Registration
No. 333-122242)).+
10.5 Employment Agreement, effective as of April 26, 2004, between Shimmy
Zimels and deltathree, Inc. (Incorporated by reference to our annual
report on Form 10-K/A, filed on April 29, 2004).+
10.6 Employment Agreement, effective as of April 26, 2004, between Paul
White and deltathree, Inc. (Incorporated by reference to our annual
report on Form 10-K/A, filed on April 29, 2004).+
55
10.7 2004 Stock Incentive Plan (Incorporated by reference to our
registration statement on Form S-8 (Registration No. 333-86503)).+
10.8 2004 Non-Employee Director Stock Option Plan (Incorporated by
reference to our registration statement on Form S-8 (Registration No.
333-86503)).+
10.9 Form of Option Agreement Pursuant to 2004 Stock Incentive Plan
(Incorporated by reference to our annual report on Form 10-K, filed
on March 31, 2005).+
10.10 Form of Option Agreement Pursuant to 2004 Non-Employee Director Stock
Option Plan (Incorporated by reference to our annual report on Form
10-K, filed on March 31, 2005).+
10.11 Executive and Director Compensation Arrangements (Incorporated by
reference to our annual report on Form 10-K, filed on March 31,
2005).+
10.12 Separation and Release Agreement, dated February 13, 2006 between
deltathree, Inc. and Paul C. White (Incorporated by reference to
Exhibit 10.1 of our Current Report on Form 8-K, filed on February 15,
2006).+
10.13 First Amendment to the deltathree, Inc. 2004 Stock Incentive Plan,
dated as of December 20, 2005 (Incorporated by reference to Exhibit
10.1 to our Current Report on Form 8-K, filed on December 21, 2005).+
10.14 First Amendment to the deltathree, Inc. 2004 Non-Employee Director
Stock Option Plan, dated as of December 20, 2005 (Incorporated by
reference to Exhibit 10.2 of our Current Report on Form 8-K, filed on
December 21, 2005).+
14.1 deltathree, Inc. Corporate Code of Conduct and Ethics (Incorporated
by reference to our annual report on Form 10-K, filed on March 30,
2004).
21.1* Subsidiaries of deltathree, Inc.
23.1* Consent of Brightman Almagor & Co.
31.1* Certification of the Chief Executive Officer, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2* Certification of the Chief Financial Officer, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
32* Certifications of the Chief Executive Officer and Chief Financial
Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
- -------------
* Filed herewith.
+ Management contract or compensatory plan.
56
DELTATHREE, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Accounting Firm.......................... F-2
Consolidated Balance Sheets as of December 31, 2005 and 2004............. F-3
Consolidated Statements of Operations for the years ended December 31,
2005, 2004, and 2003...................................................... F-4
Statements of Stockholders' Equity for the years ended December 31, 2005,
2004, and 2003............................................................ F-5
Consolidated Statements of Cash Flows for the years ended December 31,
2005, 2004, and 2003...................................................... F-6
Notes to Consolidated Financial Statements................................ F-7
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Stockholders of
Deltathree, Inc.
We have audited the accompanying consolidated balance sheets of
Deltathree, Inc. ("the Company") and its subsidiary as of December 31, 2005 and
2004 and the related consolidated statements of operations, stockholders' equity
and cash flows for each of the three years in the period ended December 31,
2005. 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 the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. The Company is not
required to have, nor were we engaged to perform, an audit of its internal
control over financial reporting. Our audit included consideration of internal
control over financial reporting as a basis for designing audit procedures that
are appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, 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 consolidated financial position of
the Company and its subsidiary as of December 31, 2005 and 2004, and the
consolidated results of its operations and its consolidated cash flows for each
of the three years in the period ended December 31, 2005 in conformity with U.S.
generally accepted accounting principles.
/s/ Brightman Almagor & Co.
Certified Public Accountants
A member firm of Deloitte Touche Tohmatsu
Tel Aviv, Israel
February 21, 2006
F-2
DELTATHREE, INC.
CONSOLIDATED BALANCE SHEETS
December 31,
------------
2005 2004
--------- ---------
($ in thousands)
ASSETS
Current assets:
Cash and cash equivalents ........................ $ 3,847 $ 4,856*
Restricted cash and short-term investments
(Note 3) ......................................... 10,648 10,527*
Accounts receivable, net (Note 4) ................ 703 325
Prepaid expenses and other current assets (Note 5) 612 528
Inventory ........................................ 242 193
--------- ---------
Total current assets .......................... 16,052 16,429
--------- ---------
Restricted cash and long-term investments (Note 3) 1,216 1,095*
Property and equipment:
Telecommunications equipment ..................... 18,028 17,349
Furniture, fixtures and other .................... 583 535
Leasehold improvements ........................... 4,653 4,615
Computers hardware & software .................... 8,019 7,370
--------- ---------
31,283 29,869
Less accumulated depreciation .................... (27,152) (25,227)
--------- ---------
Property and equipment, net .................. 4,131 4,642
--------- ---------
Deposits .......................................... 105 107
--------- ---------
Total assets ................................. $ 21,504 $ 22,273
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ................................. $ 3,904 $ 3,657
Deferred revenues ................................ 344 453
Other current liabilities (Note 6) ............... 1,540 2,034
--------- ---------
Total current liabilities ..................... 5,788 6,144
--------- ---------
Long-term liabilities:
Severance pay obligations (Note 7) ............... 155 104
--------- ---------
Total liabilities ............................. 5,943 6,248
--------- ---------
Commitments and contingencies (Note 8)
Stockholders' equity (Note 9):
Share capital:
Class A Common stock, - par value $0.001;
authorized 75,000,000 shares;
issued and outstanding: 29,739,232 at
December 31, 2005; 29,381,313 at December
31, 2004 ....................................... 30 29
Class B Common stock - par value $0.001;
authorized 1,000; issued and outstanding: no
shares at December 31, 2005 and 2004 ........... -- --
Preferred stock, par value $0.001; authorized
25,000,000 shares; issued and outstanding:
no shares at December 31, 2005 and 2004 ........ -- --
Additional paid-in capital ....................... 167,690 167,301
Accumulated deficit .............................. (151,949) (151,095)
--------- ---------
15,771 16,235
--------- ---------
Treasury stock at cost: 257,600 shares of Class A
Common Stock as of December 31, 2005 and 2004 ... (210) (210)
--------- ---------
Total stockholder's equity ........................ 15,561 16,025
--------- ---------
Total liabilities and stockholder's equity ........ $ 21,504 $ 22,273
========= =========
* Reclassified
The accompanying notes are an integral part of these consolidated financial
statements.
F-3
DELTATHREE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Year ended December 31,
-----------------------
2005 2004 2003
------------ ------------ ------------
($ in thousands, except share data)
Revenues (Note 12): ......................... $ 29,714 $ 21,069 $ 13,162
Costs and operating expenses:
Cost of revenues (exclusive of $822, $1,218
and $1,539 depreciation included in a
separate line below, respectively)....... 18,698 13,791 8,393
Research and development expenses (Note 10) 3,228 2,531 2,326
Selling and marketing expenses ............ 4,173 3,274 3,325
General and administrative expenses ....... 2,912 2,194 2,062
Depreciation and amortization ............. 1,931 2,731 5,584
------------ ------------ ------------
Total costs and operating expenses .......... 30,942 24,521 21,690
------------ ------------ ------------
Loss from operations ........................ (1,228) (3,452) (8,528)
Interest income, net ........................ 418 269 245
------------ ------------ ------------
Loss before income taxes .................... (810) (3,183) (8,283)
Income taxes (Note 11) ...................... 44 66 57
------------ ------------ ------------
Net loss .................................... $ (854) $ (3,249) $ (8,340)
============ ============ ============
Net loss per share - basic and diluted ...... $ (0.03) $ (0.11) $ (0.29)
============ ============ ============
Weighted average number of shares
outstanding - basic and diluted (number
of shares) ................................. 29,671,820 29,315,857 28,988,589
============ ============ ============
The accompanying notes are an integral part of these consolidated financial
statements.
F-4
DELTATHREE, INC.
STATEMENTS OF STOCKHOLDER'S EQUITY
($ in thousands, except share data)
Class A
Common stock
------------
Number of Number of Additional Treasury Total
Outstanding Treasury Paid-in Deferred Stock Accumulated Stockholders'
Shares Shares Amount Capital Compensation (at Cost) Deficit Equity
----------- --------- ------- ---------- ------------- ---------- ----------- -------------
Balance at January 1,
2003................. 28,902,172 257,600 $ 29 $ 166,801 $ -- $ (210) $ (139,506) 27,114
Exercise of employee
options............. 331,024 --* 367 367
Loss for the year... -- (8,340) (8,340)
----------- --------- ------- ---------- ------------- ---------- ----------- -------------
Balance at December
31, 2003............ 29,233,196 257,600 29 167,168 -- (210) (147,846) 19,141
Exercise of employee
options............. 148,117 --* 133 133
Loss for the year... (3,249) (3,249)
----------- --------- ------- ---------- ------------- ---------- ----------- -------------
Balance at December
31, 2004............ 29,381,313 257,600 29 167,301 -- (210) (151,095) 16,025
Exercise of employee
options............. 357,919 1 389 389
Loss for the year... (854) (854)
----------- --------- ------- ---------- ------------- ---------- ----------- -------------
Balance at December
31, 2005............ 29,739,232 257,600 $ 30 $ 167,690 $ -- $ (210) $ (151,949) $ 15,561
=========== ========= ======= ========== ============= ========== =========== =============
* - Less than $ 1 thousand.
The accompanying notes are an integral part of these consolidated financial
statements.
F-5
DELTATHREE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year ended December 31,
-----------------------
2005 2004 2003
------ ------ ------
($ in thousands)
Cash flows from operating activities:
Net loss $ (854) $(3,249) $(8,340)
Adjustments to reconcile net loss to net cash provided by (used
in) operating activities
Depreciation and amortization 1,931 2,731 5,584
Amortization of deferred compensation -- -- --
Capital gain, net -- (2) (17)
Liability for severance pay, net 51 13 (22)
Provision for losses on accounts receivable -- -- 65
Changes in operating assets and liabilities;
(Increase) decrease in accounts receivable (378) 38 224
(Increase) decrease in other current assets (84) 156 76
Increase in inventory (49) (133) (60)
Increase (decrease) in accounts payable 203 765 (269)
(Decrease) increase in deferred revenues (109) 281 (162)
Decrease in other current liabilities (494) (66) (230)
------ ------ ------
1,071 3,783 5,189
------ ------ ------
Net cash provided by (used in) operating activities 217 534 (3,151)
------ ------ ------
Cash flows from investing activities:
Purchase of property and equipment (1,376) (2,315) (368)
Proceeds from sale of property and equipment -- 4 48
Long-term investments, net (121) (61)* --
Short-term investments, net (121) 4,881* (890)
Change in deposits,net 2 (2) (5)
------ ------ ------
Net cash(used in) provided by investing activities (1,616) 2,507 (1,215)
------ ------ ------
Cash flows from financing activities:
Proceeds from exercise of employee options 390 133 367
------ ------ ------
Net cash provided by financing activities 390 133 367
------ ------ ------
(Decrease) increase in cash and cash equivalents (1,009) 3,174 (3,999)
Cash and cash equivalents at beginning of year 4,856 1,682 5,681
------ ------ ------
Cash and cash equivalents at end of year $3,847 $4,856 $1,682
------ ------ ------
Supplemental disclosures of cash flow information:
Cash paid for:
Taxes $ 21 $ 23 $ 57
Supplemental schedule of non cash investing and financing activities:
Acquisition of fixed assets on credit $ 44 $ 753 $ 102
* Reclassified
The accompanying notes are an integral part of these consolidated financial
statements.
F-6
DELTATHREE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 - The Company
Deltathree, Inc. (the "Company"), a Delaware corporation, is a global
provider of integrated Voice over Internet Protocol (VoIP) telephony
services. The Company was founded in 1996 to capitalize on the growth of the
Internet as a communication tool by commercially offering Internet Protocol
(IP) telephony services. IP telephony is the real time transmission of voice
communications in the form of digitized "packets" of information over the
public Internet or a private network, similar to the way in which e-mail and
other data is transmitted. The Company's business currently includes the
transmission of voice and data traffic for communications carriers, the
provision of enhanced Web-based and other communications services to
individual consumers and the provision of a total "Outsourced Platform
Solution" that enables corporate customers and service providers to offer
private label telecommunications to their customer bases.
Note 2 - Summary of significant accounting policies
a. Basis of presentation
The financial statements have been prepared in conformity with U.S. generally
accepted accounting principles.
b. Principles of consolidation
The consolidated financial statements include the accounts of the Company and
its subsidiary. All significant intercompany accounts and transactions have
been eliminated.
c. Financial statements in U.S. dollars
The reporting currency of the Company is the U.S. dollar ("dollar"). The
dollar is the functional currency of the Company and its subsidiary.
Transactions and balances originally denominated in dollars are presented at
their original amounts. Non-dollar transactions and balances are re-measured
into dollars in accordance with the principles set forth in Statement of
Financial Accounting Standards ("SFAS") No. 52. All exchange gains and losses
from translation of monetary balance sheet items resulting from transactions
in non-dollar currencies are recorded in the statement of operations as they
arise.
d. Use of estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions,
primarily for allowances for doubtful accounts receivable and the useful
lives of fixed assets and intangible assets, that affect the reported amounts
of assets and liabilities and disclosure of contingent assets and liabilities
at the date of the financial statements, and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ from
those estimates.
e. Cash and cash equivalents
Cash equivalents consist of short-term, highly liquid investments that are
readily convertible into cash with original maturities of three months or
less.
f. Restricted Cash
Restricted cash represents amounts held in certificates of deposit and money
market funds to support stand-by-letters of credit used as security for third
party vendors.
g. Marketable securities
The Company accounts for its investments in marketable securities using SFAS
No. 115, "Accounting for Certain Investments in Debt and Equity Securities"
("SFAS No. 115"). Management determines the appropriate classification of its
investments in marketable securities at the time of purchase and reevaluates
such determinations at each balance sheet date. Securities for which the
Company does not have the intent or ability to hold to maturity are
classified as available-for-sale. Available-for-sale securities are stated at
fair value, with the unrealized gains and losses reported as a separate
component of shareholders' equity under accumulated other comprehensive gain
or loss. The Company has not recorded any unrealized gains or losses to date.
F-7
DELTATHREE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
h. Inventory
Inventory is stated at the lower of cost (principally on a standard cost
basis which approximates FIFO) or market.
i. Property and equipment
Property and equipment are stated at cost. Depreciation is calculated using
the straight-line method over the estimated useful lives of the depreciable
assets, which range from two to five years. Leasehold improvements are
amortized based on the straight-line method over the shorter of the term of
the lease, or the estimated useful life of the improvements.
j. Long lived assets
The Company applies the provisions of SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. This statement requires that
long-lived assets and certain identifiable intangible assets be reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability of assets
to be held and used is measured by a comparison of the carrying amount of an
asset to undiscounted future net cash flows expected to be generated by the
asset. If such assets are considered to be impaired, the impairment to be
recognized is measured by the amount by which the carrying amount of the
assets exceeds the fair value of the assets.
k. Revenue recognition
The Company recognizes revenues from Internet telephony services based on
minutes (or fractions thereof) of customer usage. The Company records
payments received in advance for prepaid services and services to be supplied
under contractual agreements as deferred revenue until such related services
are provided.
l. Cost of revenues
Cost of revenues is comprised primarily of access, transmission and
termination costs based on actual minutes in addition to monthly circuit
lease costs.
m. Research and development expenses
Research and development expenses are expensed as incurred.
n. Income taxes
The Company provides for income taxes using the liability approach defined by
SFAS No. 109, Accounting for Income Taxes. Deferred tax assets and
liabilities are recognized for the expected tax consequences between the tax
bases of the assets and liabilities and their reported amounts. Valuation
allowances are established when necessary to reduce deferred tax assets to
the amount expected to be realized and are reversed at such time that
realization is believed to be more likely than not.
o. Stock-based compensation
The Company accounts for employee stock-based compensation in accordance with
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees" and in accordance with FASB Interpretation No. 44. Pursuant to
these accounting pronouncements, the Company records compensation for stock
options granted to employees over the vesting period of the options based on
the difference, if any, between the exercise price of the options and the
market price of the underlying shares at that date. Deferred compensation is
amortized to compensation expense over the vesting period of the options.
Had compensation cost for the Company's option plans been determined on the
basis of the fair value at the grant dates in accordance with the provisions
of SFAS No. 123 "Accounting for Stock-Based Compensation," as amended by SFAS
No. 148, the Company's pro forma net loss and pro forma basic and diluted net
loss per share would have been as follows:
F-8
DELTATHREE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 2 - Summary of significant accounting policies (Cont.)
o. Stock-based compensation (Cont.)
Year ended December 31,
-----------------------
2005 2004 2003
------- ------- -------
($ in thousands)
Pro forma net loss:
Net loss for the year, as reported .................... $ (854) $(3,249) $(8,340)
Add: stock-based compensation determined under SFAS 123 (367) (202) (374)
------- ------- -------
Pro forma net loss .................................... $(1,221) $(3,451) $(8,714)
======= ======= =======
Net loss per share - basic and diluted:
As reported ........................................... $ (0.03) $ (0.11) $ (0.29)
Pro forma ............................................. $ (0.04) $ (0.12) $ (0.30)
The following assumptions were used for the years 2005, 2004 and 2003:
dividend yield of 0.00% for all periods; risk-free interest rate of 4.0%,
3.2% and 2.2% respectively; an expected life of 3-years for all periods; a
volatility rate of 78%, 87% and 140% respectively.
Because the determination of the fair value of all options granted includes
an expected volatility factor and since additional option grants are expected
to be made each year, the above pro forma disclosures are not representative
of the pro forma effects of reported net income for future years.
p. Net loss per share
Basic and diluted net loss per share has been computed in accordance with
SFAS No. 128, "Earnings Per Share", using the weighted average number of
common stock outstanding. Diluted earnings per share give effect to all
potential dilutive issuances of ordinary shares that were outstanding during
the period. A total of 1,061,427, 957,369, and 222,553 incremental shares
were excluded from the calculation of diluted net loss per ordinary share for
2005, 2004 and 2003 respectively.
q. Concentration of credit risk
The Company is subject to concentrations of credit risk, which consist
principally of cash and cash equivalents, short-term investments and trade
accounts receivable.
The Company maintains its cash balances at various financial institutions.
The Company performs periodic evaluations of the relative credit standing of
these institutions.
The majority of the Company's non-carrier customers prepay for their
services. The Company establishes an allowance for doubtful accounts based
upon factors surrounding the credit risk of customers, historical trends and
other information.
r. Fair value of financial instruments
The financial instruments of the Company consist mainly of cash and cash
equivalents, short-term investments, current accounts receivable, accounts
payable and long-term liabilities. In view of their nature, the fair value of
the financial instruments included in working capital of the Company is
usually identical or close to their carrying amounts.
F-9
DELTATHREE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 2 - Summary of significant accounting policies (Cont.)
s. Derivatives
The Company applies the provisions of Statement of Financial Accounting
Standard (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging
Activities," as amended. The standard requires the Company to recognize all
derivatives on the balance sheet at fair value. Derivatives that are not
hedges must be adjusted to fair value through the statement of operations. If
the derivative is a hedge, depending on the nature of the hedge, changes in
the fair value of derivatives will either be offset against the change in
fair value of the hedged assets, liabilities or firm commitments through
earnings, or recognized in other comprehensive income (loss) until the hedged
item is recognized in earnings. The ineffective portion of a derivative's
change in fair value will be immediately recognized in earnings. The Company
use of derivatives is immaterial.
t. Reclassification
Certain prior years' amounts have been reclassified in conformity with the
current year's financial statements presentation.
u. Recently issued accounting standards
In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS
No. 123(R). SFAS No. 123(R) requires employee share-based equity awards to be
accounted for under the fair value method, and eliminates the ability to
account for these instruments under the intrinsic value method prescribed by
APB Opinion No. 25 and allowed under the original provisions of SFAS No. 123.
SFAS No. 123(R) requires the use of an option pricing model for estimating
fair value, which is then amortized to expense over the service periods. Had
the Company adopted SFAS 123(R) in prior periods, the impact of that standard
would have approximated the impact of SFAS 123 as described in the disclosure
of pro forma net income and income per share above. SFAS No. 123(R) allows
for either prospective recognition of compensation expense or retrospective
recognition. In January 2005, the SEC issued SAB No. 107, which provides
supplemental implementation guidance for SFAS No. 123(R). SFAS No. 123(R). In
the first quarter of 2006, the company began to apply the prospective
recognition method and implemented the provisions of SFAS No. 123(R)
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Corrections." SFAS No. 154 replaces APB Opinion No. 20. "Accounting Changes"
and SFAS No. 3, "Reporting Accounting Changes in Interim Financial
Statements." SFAS No. 154 requires retrospective application to prior
periods' financial statements of changes in accounting principle, unless it
is impracticable to determine either the period-specific effects or the
cumulative effect of the change. The Company does not expect the adoption of
SFAS No. 154 will have any material impact on its consolidated financial
statements.
In November 2005, the FASB issued FSP FAS 115-1 and FAS 124-1, "The Meaning
of Other-Than-Temporary Impairment and Its Application to Certain
Investments" ("FSP 115-1 and 124-1"), which clarifies when an investment is
considered impaired, whether the impairment is other than temporary, and the
measurement of an impairment loss. It also includes accounting considerations
subsequent to the recognition of an other-than-temporary impairment and
requires certain disclosures about unrealized losses that have not been
recognized as other-than-temporary impairments. FSP 115-1 and 124-1 are
effective for all reporting periods beginning after December 15, 2005. At
December 31, 2005, the Company had no unrealized investment losses that had
not been recognized as other-than-temporary impairments in its
available-for-sale securities. The Company does not anticipate that the
implementation of these statements will have a significant impact on its
financial position or results of operations.
Note 3 - Investment in marketable securities and deposits
As previously noted under Marketable Securities in Note 2, the Company
concluded that it was appropriate to classify investments in Auction Rate
Securities as short-term investments. Auction Rate Securities generally have
long-term stated maturities; however, these investments have characteristics
similar to short-term investments because at pre-determined intervals,
generally every 7 to 90 days, there is a new auction process at which these
securities are reset to current interest rates. Previously, such investments
had been classified as long-term investments based on the Company's
assessment of their underlying long-term maturities. Accordingly, the Company
has revised the classification to report these securities as short-term
investments within our classification of Restricted cash and short-term
investments in the Consolidated Balance Sheets. The Company classifies all of
its short-term investments as available-for-sale securities. The following is
a summary of our restricted cash and available-for-sale securities as of
December 31, 2005.
F-10
DELTATHREE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
a. Restricted cash and short-term investments
Comprised as follows:
December 31,
------------
2005 2004
------- -------
($ in thousands)
Restricted cash (money market funds)* .. $ 206 $ 204
Auction rate securities ................ 10,100 9,850
Bank deposits .......................... 342 473
------- -------
$10,648 $10,527
======= =======
b. Restricted cash and long-term investments
Comprised as follows:
December 31,
------------
2005 2004
------- --------
($ in thousands)
Restricted cash (money market funds)* $ 1,216 $ 1,095
------- --------
$ 1,216 $ 1,095
======= ========
* Restricted cash represents amounts held in certificates of deposit and
money market funds to support stand-by letters of credit used as security for
third party vendors.
Note 4 - Accounts receivable, net
Accounts receivable are stated net of an allowance for doubtful accounts of $
0 and $ 40,000 at December 31, 2005 and 2004, respectively.
Note 5 - Prepaid expenses and other current assets
Prepaid expenses and other current assets consist of the following:
December 31,
------------
2005 2004
----- -----
($ in thousands)
Government of Israel (VAT refund and other) ...... $ 45 $ 29
Deposits with suppliers .......................... 128 149
Prepaid expenses ................................. 317 207
Other ............................................ 122 143
----- -----
Total prepaid expenses and other current assets $612 $528
===== =====
F-11
DELTATHREE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 6 - Other current liabilities
Other current liabilities consist of the following:
December 31,
------------
2005 2004
------ ------
($ in thousands)
Accrued expenses ................... $1,029 $1,123
Employees and related expenses ..... 410 668
Other .............................. 101 243
------ ------
Total other current liabilities .. $1,540 $2,034
====== ======
Note 7 - Severance pay obligations
Deltathree Ltd., the Company's Israeli subsidiary, is subject to certain
Israeli law and labor agreements that determine the obligations of Deltathree
Ltd. to make severance payments to dismissed employees and to employees
leaving the Company under certain other circumstances. The obligation for
severance pay benefits, as determined by Israeli law, is based upon length of
service and the employee's most recent salary. This obligation is partially
funded through regular deposits made by Deltathree Ltd. into unaffiliated
companies for managers' insurance policies. Amounts funded are controlled by
the fund trustees and insurance companies and are not under the control and
management of Deltathree Ltd.
Expenses (income) relating to employee termination benefits were $62,368,
$12,338 and $(8,375) for the years ended December 31, 2005, 2004 and 2003,
respectively.
The aggregate value of the insurance policies as of December 31, 2005 and
2004 was $665,000 and $513,000 respectively.
Note 8 - Commitments and contingencies
a. Lease commitments
The Company leases offices in New York City for the headquarters of its
United States operation with an initial cost of approximately $650,000,
increasing annually to $815,000 during the final year of the lease. The lease
extends until July 2010 with an option to extend the lease for an additional
five years.
On October 2003 the company entered into a sub-lease agreement with a third
party to sub-lease approximately 30% of the overall the New York office
space. The annual sub-lease income in 2005 was $148,830, increasing annually
to $168,000 during the final year of the lease. The sub-lease extends until
July 2010.
Rent expense, net was $ 653,202, 611,000 and $ 695,067 for the years ended
December 31, 2005, 2004 and 2003, respectively.
The Company leases a 1,290 square meter office, which houses its research and
development facilities, in Jerusalem, Israel. In February 2003, the Company
signed an amendment that extended the term of our lease through February
2006. In September 2005, the Company signed an additional amendment that
extended the lease term through December 2009. The Company has the option to
further extend the term of the lease for an additional 5 years ending in
December 2014.
Rent expense, net was $ 205,000, $209,000 and $ 209,000 for the years ended
December 31, 2005, 2004 and 2003, respectively.
b. Legal proceedings
The Company and certain of its former officers and directors, were named as
defendants in a number of purported securities class actions in United States
District Court for the Southern District of New York, arising out of our
initial public offering in November 1999. On August 31, 2005, the United
States District Court granted preliminary approval of an omnibus settlement
of the litigation between the plaintiffs and issuer defendants. Final
approval is pending. Under the terms of the settlement, the Company is not
conceding any liability and presently does not expect to make any payments
under the pending settlement, other than legal fees it may incur (which fees
are being submitted to the insurance carrier for reimbursement).
F-12
DELTATHREE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company is not a party to any other material litigation and is not aware
of any other pending or threatened litigation that could have a material
adverse effect on it or its business taken as a whole.
c. Other marketing and cooperation agreements
The Company has entered into marketing and cooperation agreements with
various other companies that maintain sites on the Web. Pursuant to certain
of these agreements, the Company is obligated to pay commissions based on
revenues derived from such Web links.
d. Stand-by letters of credit
At March 27, 2006, the company had stand-by letters of credit totaling $1.4
million, which were issued to guarantee certain contractual obligations, and
are secured by certificates of deposit and money market funds at the
Company's banks. These amounts are recorded in the restricted cash and
investments line items on the consolidated balance sheets.
e. Regulation
To date, the FCC has not imposed broad-based regulatory charges or
traditional common carrier regulation upon providers of Internet
communications services, but it has begun regulating this area on a limited
basis as outlined in this section. On February 12, 2004, the FCC initiated a
rulemaking proceeding concerning the provision of voice and other services
using IP technology, including assessing whether VoIP services should be
classified as information services or telecommunications services. The
Company believes that the VoIP services that it provides constitute
information services. This proceeding, however, could result in the FCC
determining, for instance, that certain types of Internet telephony should be
regulated like basic telecommunications services. Thus, Internet telephony
could no longer be exempt from access charges, which reimburse local carriers
for use of their local telephone network and other telecommunications related
fees and regulatory obligations. The FCC could also conclude that Internet
telephony providers should contribute to the Universal Service Fund, which
provides support to ensure universal access to telephone service.
The imposition of access charges, regulatory fees, or universal service
contributions could substantially increase the Company's costs of serving its
customers in the U.S. The Company may have to increase its prices to cover
these costs, which could have a negative impact on the Company's ability to
compete with other telephony providers. The Company cannot predict what
regulations, or the extent of regulation, if any, the FCC may impose. The
Company also cannot predict when the FCC will issue a final decision, the
outcome of the decision, or the result of any subsequent proceedings or
actions that may arise out of the FCC's decision. As a result, the Company
cannot assure you that some or all of its products and services will not be
regulated in the future.
On June 3, 2005, the FCC released an order and notice of proposed rulemaking
concerning VoIP emergency 911 services. The order set forth two primary
requirements for providers of "interconnected VoIP services", meaning VoIP
services that can be used to send or receive calls to or from users on the
public switched telephone network. The order applies to the Company's
iConnectHere customers. The Company does not believe that it is responsible
for compliance with this order in connection with the services sold to its
customers who purchase its services for the provision of services directly to
end users. Clarification of this issue has been raised by similar providers
with the FCC, however, the FCC has not addressed it to date and the Company
cannot predict how the FCC would rule on this issue. Furthermore, depending
on the FCC's ruling on this issue, the Company cannot predict whether it
would be subject to any third-party litigation in connection with such
customers who resell the Company's services.
First, the order required the Company to notify its iConnectHere customers of
the differences between the emergency services available through the Company
and those available through traditional telephony providers. The Company also
had to receive affirmative acknowledgment from all of the iConnectHere
customers that they understand the nature of the emergency services available
through the service. On September 27, 2005, the FCC's Enforcement Bureau
released an order stating that the Enforcement Bureau will not pursue
enforcement actions against VoIP providers, like the Company, that have
received affirmative acknowledgement from at least 90% of their subscribers.
The Company is required to file a report with the FCC when it receives
affirmative acknowledgments from 100% of its customer base. The Company has
received affirmative acknowledgment from more than 94% of the iConnectHere
customers that they understand the nature of the emergency services available
through the Company's service, and thus the Company believes it is
substantially in compliance with the first aspect of the FCC's June 3 order.
F-13
DELTATHREE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Second, the order required the Company to provide enhanced emergency dialing
capabilities, or E-911, to all of the iConnectHere customers by November 28,
2005. Under the terms of the order, the Company is required to use the
dedicated wireline E-911 network to transmit customers' 911 calls, callback
number and customer-provided location information to the emergency authority
serving the customer's specified location.
On November 7, 2005, the FCC's Enforcement Bureau issued a Public Notice with
respect to that requirement. The Public Notice indicated that providers who
have not fully complied with the enhanced emergency dialing capabilities
requirement are not required to discontinue the provision of services to
existing clients, but that the FCC expects that such providers will
discontinue marketing their services and accepting new customers in areas in
which the providers cannot offer enhanced emergency dialing capabilities.
The Company also has taken many significant steps to comply with the enhanced
emergency service rules, but it was unable to comply with all of the
requirements of the FCC's order by the November 28, 2005 deadline. Some of
the Company's customers currently receive E-911 service in conformity wit the
FCC's order, but a number of its customers do not receive such service. The
Company does not expect to be able to provide E-911 service to all of its
customers in the short term unless it is granted a waiver of the requirements
by the FCC. On November 28, 2005, the Company filed a petition for extension
of time and limited waiver of certain of the enhanced emergency service
requirements, including the limitations on marketing and accepting new
customers. The FCC has not acted on our petition, and the Company cannot
predict whether the FCC will grant our petition or provide other relief.
Should the Company be unable to obtain an extension of time to implement the
requirements of the order, the Company may be subject to enforcement action
by the FCC that could include monetary forfeitures, cease and desist orders,
and other penalties. The Company may also be required to stop serving those
customers to whom it cannot provide the required enhanced emergency dialing
capabilities and may be required to stop accepting new customers in areas in
which it cannot provide these capabilities.
Note 9 - Stockholders' equity
a. Share capital
Following the Company's initial public offering, effective December 1999, the
Company's stock was listed on the NASDAQ National Market System. On September
17, 2002 the listing of the Company's common stock was transferred from the
Nasdaq National Market to the Nasdaq Capital Market.
b. Stock Options
In November 1999, the Company's Board established the 1999 Stock Incentive
Plan. Under this plan, 4,000,000 shares of Class A were reserved for issuance
upon exercise of awards to be granted. On September 23, 2004 the Board of
Directors adopted the 2004 Stock Incentive Plan and it was subsequently
approved by the stockholders at the annual meeting on November 8, 2004. This
plan replaced the 1999 Stock Incentive Plan. Under the 2004 Stock Incentive
Plan, the Compensation Committee is authorized to grant options for 759,732
shares of Common Stock (which represents 4,000,000 shares of Common Stock
reserved under the 1999 Stock Incentive Plan less the amount of shares
represented by awards previously granted under the 1999 Stock Incentive Plan
and exercised or outstanding as of September 28, 2004), plus (b) such
additional shares of Common Stock as are represented by awards previously
granted under the 1999 Stock Incentive Plan which are cancelled or without
delivery of shares of stock by the Company. In addition, the Company's
compensation committee may grant both incentive and non-incentive stock
options for shares of Class A common stock of the Company. The options
generally have a term of seven years and become exercisable in three equal
installments commencing on the first anniversary of the date of the grant.
The purchase price per share payable upon exercise of an option is no less
than the fair market value of the share at the date of grant.
F-14
DELTATHREE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In November 1999, the Company adopted the 1999 Directors' Compensation Plan.
Under this plan, 600,000 shares of Class A were reserved for issuance upon
exercise of awards to be granted to non-employee directors. On September 23,
2004 the Board of Directors adopted the 2004 Non-employee Director Stock
Option Plan and it was subsequently approved by the stockholders at the
annual meeting on November 8, 2004. This plan replaced the 1999 Director'
Plan. Under the 2004 Non-employee Director Stock Option Plan, the
Compensation Committee is authorized to grant options for 351,216 shares of
Common Stock (which represents 600,000 shares of Common Stock reserved under
the 1999 Directors' Compensation Plan less the amount of shares represented
by awards previously granted under the 1999 Directors' Compensation Plan and
exercised or outstanding as of September 28, 2004), plus (b) such additional
shares of Common Stock as are represented by awards previously granted under
the 1999 Directors' Compensation Plan which are cancelled or without delivery
of shares of stock by the Company. The options generally have a term of seven
years and become exercisable commencing on the first anniversary of the date
of the grant. The purchase price per share payable upon exercise of an option
is no less than the fair market value of the share at the date of grant.
As of December 31, 2005, options to purchase 2,279,184 shares of Class A
Common Stock were exercisable and outstanding with exercise prices ranging
between $ 0.004 and $15.00 per share.
At the Company's 2005 Annual Shareholders Meeting, the shareholders approved
an amendment to the Company's 2004 Stock Incentive Plan to increase the
number of options to purchase shares of our common stock under that plan by
2,000,000, and also approved an amendment to the Company's 2004 Non-Employee
Director Stock Option Plan to increase the number of options to purchase
shares of our common stock under that plan by 500,000.
A summary of the status of the Company's stock option plans as of December
31, 2005, 2004 and 2003 and changes during the years then ended, is presented
below:
December 31, 2005 December 31, 2004 December 31, 2003
-------------------- -------------------- --------------------
Weighted
average
Exercise Exercise Exercise
Shares price Shares price Shares price
--------- -------- --------- -------- --------- --------
Options outstanding at beginning of
year ............................ 3,066,939 $ 2.50 2,753,530 $ 2.55 3,449,520 $ 2.87
Granted during the year ......... 120,000 3.06 606,862 2.82 344,500 1.75
Exercised during the year ....... 352,253 1.10 148,117 0.90 331,024 1.088
Forfeited during the year ....... 72,000 6.72 144,936 6.80 709,866 4.39
--------- --------- ---------
Outstanding at end of year ...... 2,762,686 $ 2.58 3,066,939 $ 2.50 2,753,130 $ 2.55
========= ========= =========
Weighted average fair value of
options granted during the year.. $ 3.06 $ 2.82 $ 1.75
========= ========= =========
F-15
DELTATHREE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Additional information regarding options outstanding as of December 31, 2005
is as follows:
Options Outstanding Options Exercisable
------------------- -------------------
Weighted average
Remaining Number of
Range of Number of Contractual Weighted Average Exercisable Weighted Average
Exercise Prices Outstanding Life (Years) Exercise Price Options Exercise Price
- --------------- ----------- ---------------- ---------------- ----------- ----------------
$0.44 - $0.44 11,069 6.7 0.44 11,069 0.44
$0.74 - $0.74 29,696 1.5 0.74 29,696 0.74
$1.02 - $1.02 608,363 5.8 1.02 608,363 1.02
$1.13 - $1.13 52,000 5.2 1.13 52,000 1.13
$1.38 - $1.38 600,760 5.0 1.38 600,760 1.38
$1.75 - $1.75 297,167 7.8 1.75 192,657 1.75
$2.08 - $2.08 8,283 2.6 2.08 8,283 2.08
$2.15 - $2.15 24,848 8.7 2.15 24,848 2.15
$2.85 - $2.85 388,500 9.0 2.85 129,508 2.85
$2.88 - $2.88 95,000 8.9 2.88 95,000 2.88
$2.95 - $2.95 64,848 4.2 2.95 64,848 2.95
$3.02 - $3.02 50,000 10.0 3.02 0 0
$3.07 - $3.07 50,000 9.5 3.07 0 0
$3.11 - $3.11 10,000 9.6 3.11 0 0
$3.19 - $3.19 10,000 9.6 3.19 0 0
$5.11 - $5.11 357,152 3.2 5.11 357,152 5.11
$10.25 - $10.25 68,000 4.4 10.25 68,000 10.25
$15.00 - $15.00 37,000 3.9 15.00 37,000 15.00
--------- ---------
2,762,686 6.1 $ 2.58 2,279,184 $ 2.57
========= =========
F-16
DELTATHREE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 10 - Research and development expenses
Research and development expenses consist of the following:
Year ended December 31,
-----------------------
2005 2004 2003
------ ------ ------
($ in thousands)
Salaries and related expenses.......... $2,331 $1,775 $1,689
Consulting and advisory fees........... 101 88 96
Travel................................. 104 65 22
Other.................................. 692 603 519
------ ------ ------
Total research and development expenses $3,228 $2,531 $2,326
====== ====== ======
Note 11 - Income taxes
a. Tax loss carryforwards
As of December 31, 2005, the Company had net operating loss carryforwards
generated in the U.S. and Israel of approximately $135,339,000 and $6,281,000
respectively. The Company's U.S. net operating loss carryforwards will expire
at various dates between 2012 and 2024 if not utilized. In addition, a
portion of those net operating loss carryforwards could be subject to
limitation due to changes in ownership of the Company. The Company's net
operating losses generated in Israel may be carried forward indefinitely. The
Israeli subsidiary received final tax assessments through the tax year ended
December 31, 1999.
b. In accordance with SFAS No. 109, the components of deferred income taxes
are as follows:
December 31,
------------
2005 2004
-------- --------
($ in thousands)
Net operating losses carryforwards.... $ 50,294 $ 49,535
Less valuation allowance........... (50,294) (49,535)
-------- --------
Net deferred tax assets............ $ -- $ --
======== ========
As of December 31, 2005, and 2004, a valuation allowance of $ 50,294,000 and
$49,535,000 respectively, is provided as the realization of the deferred tax
assets are not assured.
c. Loss before income taxes:
Year ended December 31,
-----------------------
2005 2004 2003
------ ------ ------
($ in thousands)
Domestic ... $ 782 $3,145 $8,240
Foreign .... 28 38 43
------ ------ ------
Total .... $ 810 $3,183 $8,283
====== ====== ======
F-17
DELTATHREE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 12 - Segment reporting, geographical information and major customers
The Company operates in one business segment, IP Telephony services, and
makes business decisions and allocates resources accordingly.
The following table summarizes the Company's revenues and long-lived assets
by country. Revenue is attributed to geographic region based on the location
of the customers. Long-lived assets are attributed to geographic region based
on the country in which the assets are located.
Year ended December 31,
-----------------------
2005 2004 2003
------- ------- -------
($ in thousands)
Revenues:
United States ......... $ 9,573 $ 4,224 $ 4,602
Europe ................ 1,378 1,127 966
South America ......... 3,603 2,432 817
Far East .............. 5,009 4,234 540
Middle East ........... 8,551 7,239 4,040
Other ................. 1,600 1,813 2,197
------- ------- -------
Total revenues ...... $29,714 $21,069 $13,162
======= ======= =======
Revenues from major
customers exceeding 10%
of revenues:
Master Reseller - A.... --% 16% 19%
December 31,
------------
2005 2004
------ ------
($ in thousands)
Long-lived assets:
United States ............... $3,880 $4,307
Israel ...................... 212 240
Europe ...................... 36 95
Other ....................... 3 --
------ ------
Total long-lived assets .... $4,131 $4,642
====== ======
F-18
DELTATHREE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Selected Quarterly Financial Information (Unaudited)
Three Months Ended,
-------------------
March 31 June 30 September 30 December 31
------------ ------------ ------------ ------------
($ in thousands, except per share data)
2005
Total revenues ........................................ $ 6,604 $ 6,927 $ 7,105 $ 9,078
Costs and operating expenses:
Cost of revenues .................................... 4,210 4,284 4,379 5,825
Research and development expenses ................... 814 777 762 875
Selling and marketing expenses ...................... 864 1,001 1,045 1,263
General and administrative expenses ................. 610 735 744 824
Depreciation and amortization ....................... 610 534 402 385
------------ ------------ ------------ ------------
Total costs and operating expenses .................... 7,108 7,331 7,332 9,172
------------ ------------ ------------ ------------
Loss from operations .................................. (504) (404) (227) (94)
Interest income, net .................................. 94 10 198 116
------------ ------------ ------------ ------------
Profit (Loss) before income taxes ..................... (410) (394) (29) 22
Income taxes .......................................... 17 15 11 0
------------ ------------ ------------ ------------
Net Profit (loss) ..................................... $ (427) $ (409) $ (40) $ 22
============ ============ ============ ============
Net loss per share - basic and diluted ................ $ (0.01) $ (0.01) (0.00) $ 0.00)
============ ============ ============ ============
Weighted average number of shares outstanding -
basic and diluted ................................ 29,547,177 29,707,860 29,719,899 29,726,732
============ ============ ============ ============
2004
Total revenues ........................................ $ 4,606 $ 4,701 $ 5,530 $ 6,232
Costs and operating expenses:
Cost of revenues .................................... 3,009 3,047 3,665 4,070
Research and development expenses ................... 581 558 703 689
Selling and marketing expenses ...................... 803 822 737 912
General and administrative expenses ................. 597 484 546 549
Depreciation and amortization ....................... 747 719 619 656
------------ ------------ ------------ ------------
Total costs and operating expenses .................... 5,737 5,630 6,270 6,876
------------ ------------ ------------ ------------
Loss from operations .................................. (1,131) (929) (740) (644)
Interest income, net .................................. 86 49 81 53
------------ ------------ ------------ ------------
Loss before income taxes .............................. (1,045) (880) (659) (591)
Income taxes .......................................... 38 6 12 10
------------ ------------ ------------ ------------
Net loss .............................................. $ (1,083) $ (886) $ (671) $ (601)
============ ============ ============ ============
Net loss per share - basic and diluted ................ $ (0.04) $ (0.03) (0.02) $ (0.02)
============ ============ ============ ============
Weighted average number of shares outstanding -
basic and diluted ................................ 29,278,433 29,312,835 29,319,307 29,346,971
============ ============ ============ ============
F-19
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this Annual Report on Form
10-K to be signed on its behalf by the undersigned, thereunto duly authorized,
in New York, New York on March 29, 2006.
DELTATHREE, INC.
By: /s/ Shimmy Zimels
-------------------------------------
Shimmy Zimels
Chief Executive Officer and President
(Principal Executive Officer,
Principal Financial Officer and
Principal Accounting Officer)
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Shimmy Zimels his true and lawful
attorney-in-fact, acting alone, with full power of substitution, for and in the
name, place and stead of the undersigned, in any and all capacities to sign any
and all amendments to this Annual Report, and to file the same, with all
exhibits thereto, and other documents in connection therewith, with the
Securities and Exchange Commission, and hereby grants to such attorney-in-fact
and agents full power and authority to do and perform each and every act and
thing requisite and necessary to be done, as fully to all intents and purposes
as the undersigned might or could do in person, hereby ratifying and confirming
all that said attorney-in-fact and agent or his substitutes, may lawfully do or
cause to be done by virtue thereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Annual Report has been signed by the following persons in the capacities and on
the dates indicated:
Signature Title Date
--------- ----- ----
/s/ Shimmy Zimels Chief Executive Officer, President, March 29, 2006
- ------------------- Chief Financial Officer, and Director
Shimmy Zimels (Principal Executive Officer,
Principal Financial Officer and Principal
Accounting Officer)
/s/ Noam Bardin Chairman of the Board of Directors March 29, 2006
- -------------------
Noam Bardin
/s/ Noam Ben-Ozer Director March 29, 2006
- -------------------
Noam Ben-Ozer
/s/ Ilan Biran Director March 29, 2006
- -------------------
Ilan Biran
/s/ Benjamin Broder Director March 29, 2006
- -------------------
Benjamin Broder
/s/ Joshua Maor Director March 29, 2006
- -------------------
Joshua Maor
/s/ Lior Samuelson Director March 29, 2006
- -------------------
Lior Samuelson
EXHIBIT INDEX
The following documents are filed as exhibits to this report on Form 10-K or
incorporated by reference to exhibits previously filed with the Securities and
Exchange Commission.
Exhibit
Number Description
- ------ -----------
3.1.1 Form of Restated Certificate of Incorporation of deltathree, Inc.
(Incorporated by reference from our registration statement on Form
S-1 (Registration No. 333-122242)).
3.1.2 Form of Amendment to Restated Certificate of Incorporation of
deltathree, Inc. (Incorporated by reference to our annual report on
Form 10-K/A, filed on April 30, 2001).
3.2 Form of Amended and Restated By-laws of deltathree, Inc.
(Incorporated by reference from our registration statement on Form
S-1 (Registration No. 333-122242)).
4.1 Specimen Certificate of Common Stock (Incorporated by reference from
our registration statement on Form S-1 (Registration No.
333-122242)).
4.2 Specimen Certificate of Class B Common Stock (Incorporated by
reference from our registration statement on Form S-1 (Registration
No. 333-122242)).
10.1 Form of deltathree, Inc. 1999 Stock Incentive Plan (Incorporated by
reference from our registration statement on Form S-1 (Registration
No. 333-122242)).+
10.2 Form of deltathree, Inc. 1999 Employee Stock Purchase Plan
(Incorporated by reference from our registration statement on Form
S-1 (Registration No. 333-122242)).
10.3 Form of deltathree, Inc. 1999 Performance Incentive Plan
(Incorporated by reference from our registration statement on Form
S-1 (Registration No. 333-122242)).+
10.4 Form of deltathree, Inc. 1999 Directors' Plan (Incorporated by
reference from our registration statement on Form S-1 (Registration
No. 333-122242)).+
10.5 Employment Agreement, effective as of April 26, 2004, between Shimmy
Zimels and deltathree, Inc. (Incorporated by reference to our annual
report on Form 10-K/A, filed on April 29, 2004).+
10.6 Employment Agreement, effective as of April 26, 2004, between Paul
White and deltathree, Inc. (Incorporated by reference to our annual
report on Form 10-K/A, filed on April 29, 2004).+
10.7 2004 Stock Incentive Plan (Incorporated by reference to our
registration statement on Form S-8 (Registration No. 333-86503)).+
10.8 2004 Non-Employee Director Stock Option Plan (Incorporated by
reference to our registration statement on Form S-8 (Registration No.
333-86503)).+
10.9 Form of Option Agreement Pursuant to 2004 Stock Incentive Plan
(Incorporated by reference to our annual report on Form 10-K, filed
on March 31, 2005).+
10.10 Form of Option Agreement Pursuant to 2004 Non-Employee Director Stock
Option Plan (Incorporated by reference to our annual report on Form
10-K, filed on March 31, 2005).+
10.11 Executive and Director Compensation Arrangements (Incorporated by
reference to our annual report on Form 10-K, filed on March 31,
2005).+
10.12 Separation and Release Agreement, dated February 13, 2006 between
deltathree, Inc. and Paul C. White (Incorporated by reference to
Exhibit 10.1 of our Current Report on Form 8-K, filed on February 15,
2006).+
10.13 First Amendment to the deltathree, Inc. 2004 Stock Incentive Plan,
dated as of December 20, 2005 (Incorporated by reference to Exhibit
10.1 to our Current Report on Form 8-K, filed on December 21, 2005).+
10.14 First Amendment to the deltathree, Inc. 2004 Non-Employee Director
Stock Option Plan, dated as of December 20, 2005 (Incorporated by
reference to Exhibit 10.2 of our Current Report on Form 8-K, filed on
December 21, 2005).+
14.1 deltathree, Inc. Corporate Code of Conduct and Ethics (Incorporated
by reference to our annual report on Form 10-K, filed on March 30,
2004).
21.1* Subsidiaries of deltathree, Inc.
23.1* Consent of Brightman Almagor & Co.
31.1* Certification of the Chief Executive Officer, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2* Certification of the Chief Financial Officer, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
32* Certifications of the Chief Executive Officer and Chief Financial
Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
- -------------
* Filed herewith.
+ Management contract or compensatory plan.