<PAGE>
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
----------------
FORM 10-Q/A
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
<TABLE>
<S> <C>
FOR THE QUARTER ENDED JUNE 30, 1998 COMMISSION FILE NO. 0-21579
</TABLE>
SMARTALK TELESERVICES, INC.
<TABLE>
<S> <C>
INCORPORATED UNDER THE LAWS IRS EMPLOYER IDENTIFICATION
OF CALIFORNIA (1) NO. 95-4502740
</TABLE>
5080 TUTTLE CROSSING BLVD.
DUBLIN, OHIO 43016-3566
TELEPHONE: 614-789-8500
----------------
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months and (2) has been subject to such filing
requirements for the past 90 days.
YES [X] NO [_]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of August 14, 1998:
Voting, No par value: 27,607,219
- --------
(1) A proposal to effect the reincorporation of SmarTalk TeleServices, Inc.
(the "Company") from California to Delaware was approved by the
shareholders of the Company on December 31, 1997. Accordingly, subject to
receipt of requisite regulatory approval, the Company's state of
incorporation will change from California to Delaware and the Company will
be a Delaware corporation.
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
<PAGE>
RESTATEMENT OF FINANCIAL STATEMENTS AND CHANGES TO
CERTAIN INFORMATION
On August 10, 1998, SmarTalk TeleServices, Inc. ("SmarTalk" or the
"Company") announced that the Company's management in conjunction with the
Company's independent accountants, PricewaterhouseCoopers LLP ("PwC"), would
investigate certain matters with regard to the Company's accounting treatment
for deferred revenue recorded in conjunction with acquisitions that occurred
during 1997, the restructuring reserve taken during the fourth quarter of 1997
as well as certain other items. The Company subsequently determined to review
the charge for acquired research and development in-process taken during the
fourth quarter of 1997. The Company's investigation into these issues
ultimately resulted in the restatement of the Company's financial results for
the year ended 1997 and for the first and second quarters of 1998 (See Note 9
to the Company's consolidated financial statements.)
In addition, the Company has restructured its June 1997 acquisition of
Worldwide Direct, Inc., a Framingham, Massachusetts based prepaid cellular
communications company ("Worldwide"), to provide for the issuance of
additional equity and/or debt securities based on the occurrence of certain
conditions. As a result of this restructuring, the Company's financial results
for the quarter ended June 30, 1998 include changes made to reflect the
treatment of the acquisition of Worldwide using the purchase method of
accounting.
This Quarterly Report on Form 10-Q/A amends Items 1 and 2 of Part I and Item
1 of Part II of the Company's Quarterly Report on Form 10-Q previously filed
for the quarter ended June 30, 1998. This Quarterly Report on Form 10-Q/A is
filed in connection with the Company's restatement of its financial statements
for the quarter ended June 30, 1998. Financial statement information and
related disclosures included in this amended filing reflect where appropriate,
changes as a result of the restatement. Except as otherwise noted, information
contained in this Quarterly Report is as of June 30, 1998.
This Quarterly Report on Form 10-Q/A contains statements that constitute
"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, which generally can be identified by the use of
forward-looking terminology such as "anticipate," "believe," "target,"
"estimate," "may," "will," "expect," "plan," "project" or "continue" or the
negative thereof or other variations thereon or similar terminology. Such
statements are based on information available to management as of the time of
such statements and relate to, among other things, expectations of the
business environment in which the Company operates, projections of future
performance, perceived opportunities in the market and statements regarding
the Company's mission and vision. Such statements are not guarantees of future
performance and involve certain risks, uncertainties and assumptions,
including risks related to the highly competitive market in which the Company
operates; the need to attract and retain qualified management personnel;
uncertainty in consumer acceptance of the Company's products and services,
including its prepaid cellular product; possible difficulty in obtaining
acceptable financing for the Company's continued expansion; and difficulty in
integrating the Company's operations acquired primarily through acquisitions.
These and other risks, uncertainties and assumptions identified from time to
time in the Company's filings with the Securities and Exchange Commission,
including without limitation, its annual reports on Form 10-K and its
quarterly reports on Form 10-Q, as amended, could cause the Company's future
results to differ materially from those expressed in any forward-looking
statements made by or on behalf of the Company. Many of such factors are
beyond the Company's ability to control or predict. These forward-looking
statements speak only as of the date for which they are made. The Company
disclaims any intent or obligation to update publicly any forward-looking
statements, whether as a result of new information, future events or
otherwise.
<PAGE>
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1998 1997
--------------- ---------------
(AS RESTATED -- (AS RESTATED --
SEE NOTE 9) SEE NOTE 9)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents.................... $ 30,736,105 $ 62,900,673
Trade accounts receivable (less allowance for
doubtful accounts of $(7,794,785) and
$1,482,206, respectively)................... 24,598,273 28,012,237
Notes receivable............................. 4,383,017 --
Receivable from American Express Company..... -- 2,570,000
Inventories.................................. 5,165,136 4,301,487
Prepaid expenses............................. 1,979,386 1,377,844
Other current assets......................... 7,383,035 7,464,040
------------ ------------
Total current assets........................ 74,244,952 106,626,281
Non-current assets:
Property and equipment, net.................. 18,344,501 14,208,975
Intangibles, net............................. 288,118,106 235,506,706
Note receivable from ACMI, L.L.C., net....... -- 2,234,763
Other non-current assets..................... 10,143,176 9,724,352
------------ ------------
Total assets................................ $390,850,735 $368,301,077
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable............................. $ 22,989,250 $ 15,081,532
Deferred revenue............................. 22,338,200 28,885,002
Accrued marketing costs...................... 1,121,698 1,811,817
Accrued interest payable..................... 2,735,232 2,615,480
Other accrued expenses....................... 14,409,917 5,571,728
Excise and sales tax payable................. 3,622,094 5,565,072
Reserve for discontinued operations.......... 1,035,000 --
Accrued litigation settlement................ -- 4,500,003
Current portion of long-term debt............ 5,089,217 7,285,401
------------ ------------
Total current liabilities................... 73,340,608 71,316,035
Long-term debt less current portion............ 153,173,438 150,874,753
------------ ------------
Total liabilities........................... 226,514,046 222,190,788
Shareholders' equity:
Preferred stock, no par value; authorized
10,000,000 shares; no shares issued and
outstanding................................. -- --
Common stock, no par value; authorized
100,000,000 shares; issued and outstanding
25,342,132 and 21,350,852 shares,
respectively................................ 241,522,173 178,670,477
Accumulated deficit.......................... (77,267,694) (32,703,998)
Cumulative translation adjustment............ 82,210 143,810
------------ ------------
Total shareholders' equity.................. 164,336,689 146,110,289
------------ ------------
Total liabilities and shareholders' equity.. $390,850,735 $368,301,077
============ ============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
2
<PAGE>
SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30 SIX MONTHS ENDED JUNE 30
---------------------------- ----------------------------
1998 1997 1998 1997
------------ -------------- ------------ --------------
(AS (AS
RESTATED-- (AS RESTATED-- RESTATED-- (AS RESTATED--
SEE NOTE 9) SEE NOTE 9) SEE NOTE 9) SEE NOTE 9)
<S> <C> <C> <C> <C>
Revenue................. $ 42,927,385 $11,345,190 $ 79,308,756 $18,713,523
Cost of revenue......... 28,059,201 7,204,054 52,857,157 11,964,802
------------ ----------- ------------ -----------
Gross profit.......... 14,868,184 4,141,136 26,451,599 6,748,721
Sales and marketing..... 25,755,318 2,996,050 33,092,717 5,541,464
General and
administrative......... 16,900,296 2,906,363 31,952,871 3,807,594
------------ ----------- ------------ -----------
Operating loss........ (27,787,430) (1,761,277) (38,593,989) (2,600,337)
Interest income......... 1,245,017 580,761 2,387,328 1,109,524
Interest expense........ (2,492,887) (224,748) (4,896,930) (224,748)
Loss on disposal of
asset.................. (431,957) -- (431,957) --
------------ ----------- ------------ -----------
Loss from continuing
operations before
income taxes........... (29,467,257) (1,405,264) (41,535,548) (1,715,561)
Provision for income
taxes.................. -- -- -- --
------------ ----------- ------------ -----------
Loss from continuing
operations............. (29,467,257) (1,405,264) (41,535,548) (1,715,561)
------------ ----------- ------------ -----------
Discontinued operations:
Loss from discontinued
operations to the
Board Resolution
Date................. -- -- (578,148) --
Income (Loss) from the
Board Resolution Date
to the date of
disposal of
discontinued
operations........... 250,000 -- (2,450,000) --
------------ ----------- ------------ -----------
Net loss................ $(29,217,257) $(1,405,264) $(44,563,696) $(1,715,561)
============ =========== ============ ===========
Per share loss--basic
and diluted:
Continuing operations. $ (1.27) $ (.10) $ (1.84) $ (.13)
Discontinued
operations........... .01 -- (.13) --
------------ ----------- ------------ -----------
Total ................ $ (1.26) $ (.10) $ (1.97) $ (.13)
============ =========== ============ ===========
Weighted average number
of shares.............. 23,240,455 13,940,285 22,574,640 13,421,860
============ =========== ============ ===========
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
3
<PAGE>
SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT)
(UNAUDITED)
<TABLE>
<CAPTION>
COMMON STOCK CUMULATIVE
----------------------- STOCK ACCUMULATED TRANSLATION
SHARES AMOUNT SUBSCRIPTION DEFICIT ADJUSTMENT TOTAL
---------- ------------ ------------ ------------ ----------- ------------
<S> <C> <C> <C> <C> <C> <C>
December 31, 1995....... 8,824,834 $ 315,000 $(300,000) $ (1,394,774) $ -- $ (1,379,774)
Issuance of subscribed
shares............... -- -- 300,000 -- -- 300,000
Purchase of assets of
related entity....... -- -- -- (2,464,028) -- (2,464,028)
Compensation under
stock options issued. -- 24,000 -- -- -- 24,000
Proceeds from sale of
stock, net of costs.. 4,000,000 50,439,595 -- -- -- 50,439,595
Stock options
exercised............ 4,625 8,186 -- -- -- 8,186
Net loss.............. -- -- -- (3,112,548) -- (3,112,548)
---------- ------------ --------- ------------ -------- ------------
December 31, 1996....... 12,829,459 50,786,781 -- (6,971,350) -- 43,815,431
Stock options
exercised............ 227,398 851,485 -- -- -- 851,485
Distribution
agreement............ 330,205 7,596,093 -- -- -- 7,596,093
Acquisitions:
ConQuest
Telecommunication
Services Corp........ 4,488,935 71,917,228 -- -- -- 71,917,228
GTI Telecom, Inc...... 2,580,001 34,259,820 -- -- -- 34,259,820
SmarTel
Communications, Inc.. 714,286 9,494,290 -- -- -- 9,494,290
Cardinal Voicecard
Limited.............. 115,000 2,170,625 -- -- -- 2,170,625
Frontier Selected
Assets............... 65,568 1,594,155 -- -- -- 1,594,155
Cumulative translation
adjustment........... -- -- -- -- 143,810 143,810
Net loss.............. -- -- -- (25,732,648) -- (25,732,648)
---------- ------------ --------- ------------ -------- ------------
December 31, 1997 (As
Restated--See Note 9).. 21,350,852 178,670,477 -- (32,703,998) 143,810 146,110,289
Licensing agreement... 100,000 3,056,300 -- -- -- 3,056,300
USA Telecommunication
Services, Inc.
acquisition.......... 81,302 2,500,037 -- -- -- 2,500,037
Litigation settlement. 215,569 4,500,003 -- -- -- 4,500,003
Stock options
exercised............ 779,409 7,692,803 -- -- -- 7,692,803
SmarTel Communications
release.............. 100,000 1,606,000 -- -- -- 1,606,000
Worldwide Direct, Inc.
acquisition.......... 2,715,000 43,496,553 -- -- -- 43,496,553
Cumulative translation
adjustment........... -- -- -- -- (61,600) (61,600)
Net loss.............. -- -- -- (44,563,696) -- (44,563,696)
---------- ------------ --------- ------------ -------- ------------
June 30, 1998 (As
Restated--See Note 9).. 25,342,132 $241,522,173 $ -- $(77,267,694) $ 82,210 $164,336,689
========== ============ ========= ============ ======== ============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
4
<PAGE>
SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
SIX MONTHS ENDED JUNE 30,
-----------------------------
1998 1997
-------------- --------------
(AS RESTATED-- (AS RESTATED--
SEE NOTE 9) SEE NOTE 9)
<S> <C> <C>
Cash flows from operating activities:
Net loss....................................... $(44,563,696) $ (1,715,561)
Adjustments to reconcile net loss to net cash
used by operating activities:
Depreciation................................... 3,318,181 158,342
Amortization................................... 11,549,938 682,934
Discontinued operations........................ 1,035,000 --
Provision for obsolete inventory............... 2,065,556 --
MDF impairment write-off....................... 7,261,219 --
Provision for bad debts........................ 9,782,272 276
Loss on disposal of fixed assets............... 431,957 --
Sublease termination fee....................... -- (325,810)
Changes in assets and liabilities, which
increase (decrease) cash:
Accounts receivable........................... (11,399,000) (2,140,172)
Inventories................................... (2,281,328) (130,114)
Receivable from related party................. 2,570,000 --
Prepaid expenses.............................. (408,214) (1,721,609)
Other current assets.......................... 2,478,964 748,843
Other non-current assets...................... (3,775,083) (362,879)
Accounts payable.............................. 4,411,228 (738,997)
Deferred revenue.............................. (8,205,432) 502,940
Accrued marketing costs....................... (690,119) (136,931)
Accrued interest.............................. 119,752 --
Other accrued expenses........................ 8,324,201 329,155
Excise and sales tax payable.................. (1,942,978) --
------------ ------------
Net cash used by operating activities.......... (19,917,582) (4,849,583)
------------ ------------
Cash flows from investing activities:
Cash paid for acquisitions, net of cash
acquired...................................... (4,007,976) (1,623,342)
Proceeds from sale of discontinued operations.. 1,000,000 --
Repayment of ACMI, L.L.C. note receivable...... 1,000,000 --
Capital expenditures........................... (6,905,228) (475,182)
License fee.................................... (3,000,000) --
------------ ------------
Net cash used by investing activities.......... (11,913,204) (2,098,524)
------------ ------------
Cash flows from financing activities:
Stock options exercised........................ 7,692,803 594,093
Repayment of note payable to WorldCom.......... -- (6,383,691)
Repayment of long-term debt.................... (652,874) --
Capital lease payments......................... (105,094) --
Repayment of Star Bank Line of Credit.......... (7,193,575) --
Payment on Century Bank Line of Credit......... (13,442) --
------------ ------------
Net cash used by financing activities.......... (272,182) (5,789,598)
------------ ------------
Effect of currency exchange rate................ (61,600) --
------------ ------------
Decrease in cash and cash equivalents........... (32,164,568) (12,737,705)
Cash and cash equivalents at beginning of
period......................................... 62,900,673 44,830,487
------------ ------------
Cash and cash equivalents at end of period...... $ 30,736,105 $ 32,092,782
============ ============
Supplemental disclosure of cash flow
information:
Cash paid for interest......................... $ 4,313,583 $ 3,915
------------ ------------
Issuance of stock for acquisitions............. $ 47,602,590 $ 43,754,110
============ ============
Issuance of debt for acquisitions.............. $ 5,500,000 $ 26,500,000
============ ============
Debt assumed at acquisition.................... $ 2,567,486 $ 6,383,691
============ ============
Issuance of stock for litigation settlement.... $ 4,500,003 $ --
============ ============
Issuance of stock for licensing agreement...... $ 3,056,300 $ --
============ ============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
5
<PAGE>
SMARTALK TELESERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. BASIS OF INTERIM PRESENTATION
The accompanying interim period consolidated financial statements are
unaudited, pursuant to certain rules and regulations of the Securities and
Exchange Commission, and include, in the opinion of management, all
adjustments (consisting of only normal recurring adjustments) necessary for a
fair presentation of the results for the periods indicated; which, however,
are not necessarily indicative of results which may be expected for the full
year. Certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted accounting
principles have been condensed or omitted pursuant to such rules and
regulations. The financial statements should be read in conjunction with the
financial statements, as restated, and the notes thereto for the year ended
December 31, 1997 and other information included in SmarTalk TeleServices,
Inc.'s (the "Company") Form 10-K, as amended, and Forms 8-K, as filed with the
Securities and Exchange Commission.
On August 10, 1998, the Company announced that the Company's management in
conjunction with PricewaterhouseCoopers LLP ("PwC") would investigate certain
matters with regard to the Company's accounting treatment for deferred revenue
recorded in conjunction with acquisitions that occurred during 1997, the
restructuring reserve taken during the fourth quarter of 1997 as well as
certain other items. The Company subsequently determined to review the charge
for acquired research and development in-process taken during the fourth
quarter of 1997. As a result of the Company's investigation into these issues,
the accompanying interim period consolidated financial statements as of June
30, 1998 and for the quarter then ended have been restated. (See Note 9 to the
Company's consolidated financial statements.)
In addition, the Company has restructured its June 1997 acquisition of
Worldwide Direct, Inc., a Framingham, Massachusetts based prepaid cellular
communications company ("Worldwide"), to provide for the issuance of
additional equity and/or debt securities based on the occurrence of certain
conditions. As a result of this restructuring, the Company's financial results
for the quarter ended June 30, 1998 include changes made to reflect the
treatment of the acquisition of Worldwide using the purchase method of
accounting.
2. DISCONTINUED OPERATIONS
On February 28, 1998 (the "Board Resolution Date"), the Board adopted a plan
to sell the Company's call center business located in Butler, Pennsylvania. In
the first quarter of 1998, the Company recorded a charge for the losses
associated with operating this business up to the Board Resolution Date and an
estimated charge for operating this business from the Board Resolution Date
through the anticipated disposition date plus the transaction costs associated
with the sale of the business. On June 12, 1998 (the "Sale Date"), the Company
sold the assets of the call center business for $1,000,000 in cash and a note
receivable (the "Call Center Note") of $19,067,995. Interest on the Call
Center Note is 12% per annum and is payable quarterly beginning September 12,
1998. The principal on the Call Center Note is due on June 12, 1999 (unless
this date is extended to June 12, 2000 by the obligor) or upon completion of a
financing transaction in excess of $50,000,000 by the obligor. The assets of
the obligor secure the Call Center Note. Due to the thinly capitalized
financial position of the obligor and the resulting risk of collection, a
valuation allowance was recorded against the Call Center Note approximately
equal to the difference between the sales price and net book value of the
tangible assets sold, or $14,684,978. No gain or loss was recorded on the
transaction. Operations for the business from January 1, 1998 to the Sale Date
and transaction costs associated with the disposal have been recorded against
the reserve for discontinued operations.
Revenue from the discontinued operations was $4,507,300 for the quarter
ended June 30, 1998 and $0 for the quarter ended June 30, 1997.
6
<PAGE>
Summarized financial information for the discontinued operations is as
follows:
<TABLE>
<CAPTION>
FOR THE PERIOD
JANUARY 1, 1998 TO
JUNE 12, 1998
-------------------
(AS RESTATED--
SEE NOTE 9)
<S> <C>
Revenues............................................. $10,065,127
Loss before income taxes............................. 3,028,148
Net loss............................................. 3,028,148
<CAPTION>
AS OF JUNE 12, 1998
-------------------
(AS RESTATED--
SEE NOTE 9)
<S> <C>
Current assets....................................... $ 5,502,442
Total assets......................................... 20,502,442
Current liabilities.................................. 434,447
Total liabilities.................................... 434,447
-----------
Net assets of discontinued operations................ $20,067,995
===========
</TABLE>
SmarTalk did not own the call center business at June 30, 1997.
3. LICENSING AGREEMENT
On March 30, 1998, the Company entered into a new licensing agreement with
AudioFax IP LLC to license certain voice-fax mailbox technology. The Company
paid a one-time fee to license the technology until the patents expire in
2008. The fee is being amortized over the remaining life of the patent. Prior
to this agreement, the Company licensed this technology by paying a per card
fee for cards containing voice-fax mailbox services.
4. ACQUISITIONS
On March 23, 1998, the Company acquired USA Telecommunications Services,
Inc. (d.b.a. The Debit Cellular Network) ("DCN"), a North Carolina based
prepaid cellular card company, for 81,302 shares of common stock and
$1,500,000 in cash. This acquisition was accounted for using the purchase
method of accounting. Accordingly, the operating results of the acquired
business are included in the Company's consolidated results since the date of
acquisition.
On April 30, 1998, the Company acquired the outstanding shares of Canada
Telecom Network, Inc., a Montreal, Quebec, Canada based prepaid calling card
company, for $3,000,000 in cash and $5,500,000 in a subordinated, 7.5% per
annum note which matures April 30, 2000. This acquisition was accounted for
using the purchase method of accounting. Accordingly, the results of the
acquired business are included in the Company's consolidated results since the
date of acquisition.
On June 10, 1998, the Company acquired the outstanding stock of Worldwide
for 2,715,000 shares of Common Stock. The Company has restructured this
transaction to provide for the issuance of additional equity and/or debt
securities based on the occurrence of certain conditions. As a result of this
restructuring, the acquisition required the use of the purchase method of
accounting. Accordingly, the results of the acquired business are included in
the Company's consolidated results since the date of acquisition.
7
<PAGE>
The following unaudited pro forma summary presents the Company's combined
results as if the 1998 acquisitions occurred at the beginning of the
respective periods, after giving effect to certain adjustments including
goodwill amortization, depreciation and interest expense. These pro forma
results are not necessarily indicative of those that would have occurred had
the acquisitions occurred at the beginning of the respective periods.
<TABLE>
<CAPTION>
THREE MOS. ENDED SIX MOS. ENDED
JUNE 30, 1998 JUNE 30, 1998
---------------- --------------
(AS RESTATED-- (AS RESTATED--
SEE NOTE 9) SEE NOTE 9)
<S> <C> <C>
Revenue................................. $ 49,440,886 $ 90,778,722
============ ============
Net loss from continuing operations..... $(30,283,463) $(43,742,821)
============ ============
Net loss per share from continuing
operations--basic and diluted.......... $ (1.19) $ (1.75)
============ ============
</TABLE>
The following unaudited pro forma summary presents the Company's combined
results as if the 1997 acquisitions, as referenced in the Company's Form 10-
K/A for the year ended December 31, 1997, occurred at the beginning of the
respective periods, after giving effect to certain adjustments including
goodwill amortization, depreciation and interest expense. These pro forma
results are not necessarily indicative of those that would have occurred had
the acquisitions occurred at the beginning of the respective periods.
<TABLE>
<CAPTION>
THREE MOS. ENDED SIX MOS. ENDED
JUNE 30, 1997 JUNE 30, 1997
---------------- --------------
(AS RESTATED-- (AS RESTATED--
SEE NOTE 9) SEE NOTE 9)
<S> <C> <C>
Revenue.................................. $38,748,341 $ 75,824,550
=========== ============
Net loss................................. $(9,351,384) $(17,902,981)
=========== ============
Net loss per share--basic and diluted.... $ (.44) $ (.84)
=========== ============
</TABLE>
5. REVENUE RECOGNITION
The Company's revenue originates from: (i) Company and co-branded prepaid
calling cards sold through retailers; (ii) recharges on existing calling
cards; (iii) cards sold for promotional marketing campaigns; (iv) corporate
sales to businesses; (v) prepaid calling card services provided to one of the
Company's strategic partners, West Interactive Corporation ("WIC"); (vi) call
processing; (vii) sales of prepaid cellular phones, accessories and services;
and (viii) sales commissions from postpaid cellular activations.
Under the majority of agreements with retailers, the Company sells cards to
the retailer at a fixed price with normal credit terms. When the retailer is
invoiced, deferred revenue is recorded. The Company recognizes revenue and
reduces the deferred revenue account as the end user utilizes calling time or
upon expiration of cards containing unused calling time, as applicable. The
Company also records deferred revenue upon recharge of existing phone cards
and recognizes such revenue upon usage or expiration of the recharge minutes.
With respect to deferred revenue on the books of an acquired entity, the
obligation to provide future service relating to unused minutes is revalued as
of the date of acquisition. The fair value of the service obligation
represents management's best estimate of the cost to service acquired unused
minutes plus a normal profit margin for this service element (such margin
intended to cover indirect costs and provide a reasonable return). Deferred
revenue is not recorded for acquired unused minutes for which no future usage
is anticipated. The acquired deferred revenue obligation is periodically
remeasured to reflect actual used and unused minutes which may vary from
original estimates. A reduction in acquired deferred revenue is recorded based
on actual minutes used during the post-acquisition period.
Substantially all prepaid phone cards sold by the Company have expiration
dates and expire as of that date, if never activated, or six months after the
initial activation unless recharged. For cards that have no printed
8
<PAGE>
expiration date, revenue for unused minutes is recognized when cards have been
dormant for greater than 12 months.
Revenue for prepaid cellular phones, accessories, and services is recognized
upon shipment. For postpaid cellular sales the Company recognizes a sales
commission upon activation of individual customer accounts by the ultimate
carrier. In a postpaid cellular sale, the Company remains liable to refund
commissions paid by carriers for varying periods of time after activation in
the event a customer discontinues service. The Company records a reserve for
these returns at the time the related revenue is recognized.
6. NOTE RECEIVABLE FROM ACMI, L.L.C.
On June 19, 1998, the Company received payment for the ACMI, L.L.C. note
receivable. The note receivable had a net book value of $2,234,763 on such
date and the repayment amount was $1,000,000 in cash. Since this note was
acquired through the ConQuest acquisition, the devaluation of the note was
recorded as a reduction of goodwill. Additionally, the Company was required to
release 106,816 shares of its Common Stock that was held in escrow and used as
collateral to secure the note. The value of these shares had previously been
recorded as an increase to goodwill.
7. DIVIDENDS
There were no dividends declared or paid during the six months ended June
30, 1998 or 1997.
8. SUBSEQUENT EVENTS
As of July 1, 1998, the Company issued a promissory note in the amount of
$5,000,000 and agreed to issue 1,000,000 shares of Common Stock to acquire a
distribution arrangement with a former distributor of Worldwide and certain
contractual relationships. The arrangement also provides for the issuance of
additional equity and/or debt securities upon the occurrence of certain
conditions.
On July 9, 1998, the Company completed a private placement of 1,751,824
shares of its Common Stock, realizing proceeds before transaction costs of
$29,999,986. On August 28, 1998, the terms of the private placement were
restructured. In the event that the Company's Common Stock trades below the
initial purchase price during specified periods, the Company will be obligated
to issue up to $18,500,000 of additional Common Stock for no additional
consideration. In addition, the Company granted an option exercisable for a
period of two years commencing March 1, 1999 in connection with the private
placement pursuant to which an additional $20,000,000 of the Company's Common
Stock may be purchased. In the event the aggregate amount of Common Stock
issued by the Company pursuant to the private placement would exceed 20% of
the Company's total outstanding shares as of July 9, 1998 (the "20%
Threshold"), as a result of either the exercise of the option or the initial
purchase price adjustment, the Company would be required to obtain shareholder
approval of the private placement or issue a note in a principal amount equal
to the value of the Common Stock that otherwise would exceed the 20%
Threshold. The Company expects to use the proceeds from this private placement
to accelerate its entry into the prepaid cellular market and for general
corporate purposes.
Since July 23, 1998, 19 putative class actions have been filed against the
Company and certain current and former members of its management and board of
directors in state and Federal courts alleging violations of state and Federal
securities laws with respect to certain alleged misrepresentations and/or
omissions in regard to the Company's projected and actual revenues and
earnings. These lawsuits seek unspecified damages on behalf of certain classes
of persons who purchased the Company's securities during periods between May
1997 and August 1998. The complaints generally allege that the Company made
material misrepresentations and omissions in regard to the Company's projected
and actual revenues and earnings. Although the Company intends to defend
against these lawsuits vigorously, it is not feasible to predict or determine
the final outcome of these proceedings at this time. An unfavorable outcome
with respect to such proceedings could have a material adverse effect on the
Company's financial condition and results of operations.
9
<PAGE>
9. RESTATEMENT
On August 10, 1998, SmarTalk TeleServices, Inc. ("SmarTalk" or the
"Company") announced that the Company's management in conjunction with the
Company's independent accountants, PricewaterhouseCoopers LLP ("PwC"), would
investigate certain matters with regard to the Company's accounting treatment
for deferred revenue recorded in conjunction with acquisitions that occurred
during 1997, the restructuring reserve taken during the fourth quarter of 1997
as well as certain other items. The Company subsequently determined to review
the charge for acquired research and development in-process taken during the
fourth quarter of 1997. As a result of the Company's investigation into these
issues, the accompanying consolidated financial statements as of June 30, 1998
and for the quarter and six months then ended have been restated.
In addition, the Company has restructured its June 1997 acquisition of
Worldwide to provide for the issuance of additional equity and/or debt
securities based on the occurrence of certain conditions. As a result of this
restructuring, the Company's financial results for the quarter ended June 30,
1998 include changes made to reflect the treatment of the acquisition of
Worldwide using the purchase method of accounting.
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<PAGE>
A summary of the significant effects of the restatement are as follows:
<TABLE>
<CAPTION>
THREE MOS. ENDED THREE MOS. ENDED SIX MOS. ENDED SIX MOS. ENDED
JUNE 30, 1998 JUNE 30, 1997 JUNE 30, 1998 JUNE 30, 1997
------------------------- ------------------------ ------------------------- ------------------------
AS AS AS AS
PREVIOUSLY AS PREVIOUSLY AS PREVIOUSLY AS PREVIOUSLY AS
REPORTED RESTATED REPORTED RESTATED REPORTED RESTATED REPORTED RESTATED
----------- ------------ ----------- ----------- ----------- ------------ ----------- -----------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Statement of Operations
Data:
Revenue.......... $51,830,277 $ 42,927,385 $11,796,890 $11,345,190 $94,235,441 $ 79,308,756 $19,165,223 $18,713,523
Cost of revenue.. 29,200,682 28,059,201 7,204,054 7,204,054 54,761,037 52,857,157 11,964,802 11,964,802
Gross profit..... 22,629,595 14,868,184 4,592,836 4,141,136 39,474,404 26,451,599 7,200,421 6,748,721
Operating
expenses........ 18,244,063 42,655,614 5,615,194 5,902,413 36,925,209 65,045,588 9,061,839 9,349,058
Income (loss)
from continuing
operations...... 1,918,659 (29,467,257) (666,345) (1,405,264) (1,215,495) (41,535,548) (976,642) (1,715,561)
Net income
(loss).......... 2,168,659 (29,217,257) (666,345) (1,405,264) (4,243,643) (44,563,696) (976,642) (1,715,561)
Statement of Cash
Flows Data:
Cash provided
(used) by
operating
activities...... 3,838,700 1,938,557 (1,896,521) (1,896,521) (19,304,711) (19,917,582) (4,849,583) (4,849,583)
Cash used by investing
activities...... (15,687,974) (7,034,868) (2,002,101) (2,002,101) (14,754,906) (11,913,204) (2,098,524) (2,098,524)
Cash (used)
provided by
financing
activities...... (4,733,136) (7,689,477) (6,363,894) (6,363,894) 2,782,159 (272,182) (5,789,598) (5,789,598)
<CAPTION>
JUNE 30, 1998 DECEMBER 31, 1997
------------------------- ------------------------
AS AS
PREVIOUSLY AS PREVIOUSLY
REPORTED RESTATED REPORTED AS RESTATED
----------- ------------ ----------- -----------
<S> <C> <C> <C> <C>
Balance Sheet
Data:
Trade accounts
receivable, net. $45,934,488 $ 24,598,273 $32,699,249 $28,012,237
Current assets... 114,921,082 74,244,952 111,487,102 106,626,281
Intangibles, net. 229,530,054 288,118,106 222,536,934 235,506,706
Total assets..... 381,721,252 390,850,735 360,502,826 368,301,077
Deferred revenue. 29,455,088 22,338,200 40,248,400 28,885,002
Restructuring reserve. 22,008,229 -- 23,943,070 --
Current
liabilities..... 108,148,692 73,340,608 106,622,503 71,316,035
Total
liabilities..... 259,274,511 226,514,046 257,497,256 222,190,788
Total shareholders'
equity.......... 122,446,741 164,336,689 103,005,570 146,110,289
</TABLE>
11
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
RESTATEMENT
On August 10, 1998, the Company announced that the Company's management in
conjunction with PwC would investigate certain matters with regard to the
Company's accounting treatment for deferred revenue recorded in conjunction
with acquisitions that occurred during 1997, the restructuring reserve taken
during the fourth quarter of 1997 as well as certain other items. The Company
subsequently determined to review the charge for acquired research and
development in-process taken during the fourth quarter of 1997. The Company's
investigation into these issues ultimately resulted in the restatement of the
Company's financial results for the year ended 1997 and the first and second
quarters of 1998. The financial information contained herein has been restated
to incorporate all relevant information obtained from the aforementioned
investigations. (See Note 9 to the Company's condensed consolidated financial
statements.)
In addition, the Company has restructured its acquisition of Worldwide
Direct, Inc. ("Worldwide") to provide for the issuance of additional equity
and/or debt securities based on the occurrence of certain conditions. As a
result of this restructuring, the Company's financial results for the quarter
ended June 30, 1998 include changes made to reflect the treatment of the
acquisition of Worldwide using the purchase method of accounting.
GENERAL
The Company was formed in October 1994 and had limited operations until June
1995. On October 23, 1996, the Company completed the sale of 4,000,000 shares
of its stock in a public offering. The Company's common stock, no par value
(the "Common Stock"), is listed on the NASDAQ National Market.
SmarTalk provides convenient, easy-to-use and cost-effective
telecommunications products and services to individuals and businesses
primarily through the SmarTalk prepaid phone card (the "SmarTalk Card"). The
SmarTalk Card provides customers with a single point of access to prepaid
telecommunications services at a fixed rate charge per minute regardless of
the time of day or, in the case of domestic calls, the distance of the call.
The Company's services currently include domestic calling, inbound and
outbound international long distance calling, as well as enhanced features
such as sequential calling, content delivery, speed dial and message delivery
and on selected cards, voice and fax mail services. The SmarTalk Card may be
recharged with a major credit card by calling SmarTalk's customer service
department or, in select retail locations, at point of sale, allowing the user
to add minutes as needed.
SmarTalk services are delivered through proprietary switching, application
and database access software which run on interactive call processing
platforms. The SmarTalk platforms and the Company's proprietary software allow
users in the system to access SmarTalk services, and provide the Company with
the flexibility to customize and add features to SmarTalk services on a
platform-wide basis.
SmarTalk's revenue originates from: (i) SmarTalk and co-branded prepaid
calling cards sold through retailers; (ii) recharges on existing calling
cards; (iii) cards sold for promotional marketing campaigns; (iv) corporate
sales to businesses; (v) prepaid calling card services provided to one of the
Company's strategic partners, West Interactive Corporation ("WIC"); (vi) call
processing; (vii) sales of prepaid cellular phones, accessories and services;
and (viii) sales commissions from postpaid cellular activations. The Company
operates in a highly competitive market. Future revenues and earnings may be
impacted by, among other factors, the Company's ability to address
competition, its ability to sign new accounts, its ability to introduce new
products, such as its prepaid cellular product offering and its ability to
integrate its operations successfully.
Under sales agreements with the majority of its retailers, the Company sells
cards to the retailer at a set price. The Company generally invoices the
retailer upon shipment of the cards. The Company also offers pay-on-sale and
pay-on-activation programs to certain retailers whereby the retailers are
invoiced upon sale to or activation by a retailer's customer, respectively.
The Company anticipates that its pay-on-sale and pay-on-activation programs
will be increasingly utilized by its retail customers. Deferred revenue is
recorded when the retailer is invoiced. The Company recognizes revenue and
reduces deferred revenue as the customer utilizes
12
<PAGE>
calling time or upon expiration of cards containing unused calling time
("breakage"). The Company also records deferred revenue upon recharge of
existing prepaid calling cards and recognizes such revenue upon the usage or
expiration of the recharge minutes. Call processing revenues are recognized as
these services are rendered.
SmarTalk's cost of revenue consists primarily of the cost of providing long
distance services and related enhanced services, as well as the cost of
manufacturing and delivering the cards, excise taxes, Universal Service Fund
fees and the costs of cellular phones and accessories. The cost of providing
long distance services represents obligations to carriers that provide minutes
of long distance over their networks in order to facilitate use of SmarTalk's
product.
SmarTalk seeks to leverage its competitive advantages in implementing the
key elements of its growth strategy, which include: (i) increasing penetration
of retailers; (ii) developing new products and services; and (iii) continuing
to pursue selected acquisitions.
Sales and marketing expenses consist primarily of commissions and
advertising costs. The Company pays commissions to its sales representatives
based on sales to retailers. The Company also pays commissions to its sales
representatives and retailers based on the number of minutes recharged on the
SmarTalk Cards sold by each retailer. Advertising consists primarily of trade,
consumer, cooperative advertising ("co-op"). Under the typical co-op
advertising program, the Company provides advertising funds to retailers to
promote sales of SmarTalk products and services. The amount of funds the
Company provides in co-op advertising is based on a percentage of sales of
SmarTalk products to retailers. Corporate advertising expense includes trade
and consumer advertising, trade show expenses, promotional goods and the costs
of providing to retailers the Company's turnkey merchandising materials and
services.
General and administrative expenses consist primarily of salaries and
related benefits, sales and use taxes, rent, insurance, bank card processing
fees and other general expenses including depreciation and amortization. Sales
and use taxes for the SmarTalk platforms are incurred based on customer usage
of long distance minutes which are processed through the Company's platforms.
The Company completed the following acquisitions from January 1, 1997 to
June 30, 1998 (the "Acquisitions"):
Worldwide Direct, Inc. On June 10, 1998, SmarTalk acquired the outstanding
stock of Worldwide for 2,715,000 shares of Common Stock. The Company has
restructured this transaction to provide for the issuance of additional equity
and/or debt securities based on the occurrence of certain conditions. As a
result of this restructuring, the acquisition required the use of the purchase
method of accounting and the results of the acquired business are included in
the Company's consolidated results of operations from the date of acquisition.
Canada Telecom Networks Inc. On April 30, 1998, SmarTalk acquired the
outstanding shares of Canada Telecom Network Inc. ("CTN") for $3,000,000 in
cash and $5,500,000 in a subordinated 7.5% note which matures April 30, 2000.
The note is payable in 24 monthly blended installments of principal and
interest.
USA Telecommunications Services, Inc. On March 23, 1998, SmarTalk acquired
USA Telecommunications Services, Inc. (d.b.a. The Debit Cellular Network)
("DCN"), a North Carolina-based prepaid cellular card company for $1,500,000
in cash and 81,302 shares of Common Stock.
American Express Telecom, Inc. On December 31, 1997, SmarTalk acquired
American Express Telecom, Inc. ("Amex Telecom") a provider of prepaid calling
products, including the FirstClass Phonecard(TM) sold through the U.S. Postal
Service and the PhoneFunds(TM) card sold through the National Park Foundation,
American Express Travel Service Offices ("AmEx TSOs"), and certain foreign
exchange offices. In consideration for the outstanding shares of Amex Telecom,
SmarTalk paid $44 million in cash, which was provided from SmarTalk's
13
<PAGE>
working capital, with a portion thereof held in escrow pending regulatory
approval to Amex Telecom's sole stockholder, American Express Travel Related
Services Company, Inc. ("Amex TRS"). Additionally, SmarTalk purchased a profit
and cost sharing agreement between Amex Telecom and the U.S. Postal Service.
The Amex Telecom acquisition secured for SmarTalk distribution rights to
certain AmEx TSOs, distribution through the U.S. Postal Service and the
National Park Foundation and an agreement with American Express to be the
exclusive provider of a co-branded prepaid calling card for American Express.
In addition, SmarTalk was granted exclusive access to the American Express
point-of-sale system for activation and recharge of prepaid phone cards. Under
the purchase agreement Amex TRS agreed to reimburse SmarTalk for the estimated
unused minutes as of December 31, 1997.
ConQuest Telecommunication Services Corp. On December 3, 1997, SmarTalk
entered into an interim operating agreement with ConQuest Telecommunication
Services Corp. ("ConQuest") which transferred all risks and rewards from
ConQuest to SmarTalk. SmarTalk assumed responsibility for operating the
ConQuest business and the employees of ConQuest became employees of SmarTalk
on this date. On December 31, 1997, SmarTalk acquired 100% of ConQuest's
outstanding common stock. In consideration for each outstanding share of
ConQuest common stock, ConQuest stockholders received 7.63 shares of Common
Stock (approximately 4.5 million shares of Common Stock in total). SmarTalk
also assumed $6,139,679 of ConQuest's debt. Additionally, in connection with
this acquisition SmarTalk paid $350,000 in cash in 1997 and issued
215,569 shares of Common Stock in January 1998 to obtain an agreement and
mutual release from a group of individuals that had brought a lawsuit against
ConQuest prior to the acquisition. ConQuest was a developer and marketer of
prepaid calling cards and other enhanced telecommunication services and
technology, including domestic and international calling services for the tour
and travel industry. The acquisition of ConQuest added significantly to
SmarTalk's technological infrastructure, customer base, platform operations
and management infrastructure.
Selected Assets of Frontier Corporation. On December 9, 1997, SmarTalk
acquired selected assets (the "Frontier Selected Assets") of the retail
prepaid phone card business of Frontier Corporation, a New York corporation
("Frontier"). In consideration for the Frontier Selected Assets, SmarTalk paid
$35 million in cash and 65,568 shares of Common Stock. The acquisition of the
Frontier Selected Assets added to SmarTalk's size, scale and scope, and helped
establish SmarTalk's presence on the East Coast.
Cardinal Voicecard Limited. On August 13, 1997, SmarTalk issued 115,000
shares of Common Stock to purchase this Toronto, Ontario based company. This
acquisition provided the Company with access to the Canadian marketplace and
added to the Company's international distribution.
GTI Telecom, Inc. On May 31, 1997, SmarTalk issued 2,580,001 shares of
Common Stock and $26,500,000 in subordinated 10% per annum term notes which
mature June 1, 2001 (the "GTI Notes"), to purchase GTI Telecom, Inc. ("GTI").
$25,970,000 of the GTI Notes were repaid in September 1997 at $20,614,686. The
difference of $5,355,314 was recorded as a reduction to goodwill. This
acquisition expanded the Company's distribution and added human resource,
technical and manufacturing infrastructure.
SmarTel Communications, Inc. On May 28, 1997, the Company acquired SmarTel
Communications, Inc. ("SmarTel"), a Boston-based prepaid promotions phone card
company, for 714,286 shares of Common Stock.
The Acquisitions have been accounted for using the purchase method of
accounting. Accordingly, the operating results of the Acquisitions have been
included in the Company's consolidated financial results since the date of
acquisition.
14
<PAGE>
RESULTS OF OPERATIONS
QUARTER ENDED JUNE 30, 1998 (AS RESTATED) COMPARED WITH QUARTER ENDED JUNE 30,
1997
Revenue. Revenue increased to $42,927,385 for the quarter ended June 30,
1998 from $11,345,190 for the same period in 1997. The substantial increase in
revenue reflects an increase in usage of SmarTalk services by users of the
SmarTalk Card, the effect of the Acquisitions, an increase in the number of
retail storefronts in which the Company's product is distributed, greater
brand awareness and consumer acceptance and revenue attributable to a
distribution and processing agreement entered into on June 1, 1996 with WIC.
Revenue attributable to the distribution and processing agreement was
$4,390,939 for the quarter ended June 30, 1998 and $4,769,342 for the same
period in 1997. In addition, 2.3% of total revenue for the quarter ended
June 30, 1998 consisted of revenue recognized on the unused portion of expired
cards (breakage revenue) as compared to 5.2% for the same period in 1997.
Recharge revenue for the quarters ended June 30, 1998 and 1997 was $2,198,338
and $745,667, respectively.
Cost of Revenue. Cost of revenue increased to $28,059,201 for the quarter
ended June 30, 1998 from $7,204,054 for the same period in 1997. The
substantial increase was primarily attributable to greater use of the
Company's services, the effect of the Acquisitions and an increase in taxes.
The gross profit percentage for the quarter ended June 30, 1998 was 34.6% as
compared to 36.5% for the same period in 1997. The gross margin percentage
decreased primarily due to the decrease in breakage revenue which has minimal
cost of revenues associated with it and the effect of the additional taxes.
Sales and Marketing Expenses. Sales and marketing expenses increased to
$25,755,318 (60.0% of revenue) for the quarter ended June 30, 1998 from
$2,996,050 (26.4% of revenue) for the same period in 1997. The increase in
dollar amount and percentage of revenue was due to the effect of the
Acquisitions and the continued expansion of the Company's marketing
activities, which include co-op advertising, consumer advertising,
manufacturer's development funds and promotional goods. In addition, the
Company revised its evaluation relating to the allowance for uncollectible
accounts receivable and increased this allowance as well as wrote off accounts
receivable in the aggregate amount of $10.9 million at June 30, 1998. For the
quarter ended June 30, 1998, the Company recorded a charge of $7.3 million
relating to certain manufacturer's development funds that had become
permanently impaired in accordance with SFAS No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets To Be Disposed of."
General and Administrative Expenses. General and administrative expenses
increased to $16,900,296 (39.4% of revenue) for the quarter ended June 30,
1998 from $2,906,363 (25.6% of revenue) for the same period in 1997. The
increase in dollar amount and percentage of revenue was primarily due to the
effect of the Acquisitions, which included intangible assets and goodwill
amortization, depreciation expense and the addition of personnel and costs
associated with the growth in the Company's business.
Interest Income and Expense. Net interest expense for the quarter ended June
30, 1998, was $1,247,870 as compared to net interest income of $356,013 for
the same period in 1997. This was primarily due to interest expense on the
Company's subordinated debt that was issued September 17, 1997. Interest
expense for the quarter ended June 30, 1998 and the same period in 1997
included $228,650 and $0, respectively, of debt issue costs and amortization.
15
<PAGE>
Income Tax. The Company had losses for the quarter ended June 30, 1998 and
the same period in 1997. Accordingly, there was no provision for income taxes.
Decremented Minutes and PIN Activations. Decremented minutes, which
represent actual call traffic over the SmarTalk platforms, were estimated at
205,365,484 for the quarter ended June 30, 1998 as compared to 54,824,541 for
the quarter ended June 30, 1997. PIN activations were estimated at 4,391,777
and 693,447 for the quarters ended June 30, 1998 and 1997, respectively. These
increases were due to increased usage of the Company's services and the effect
of the Acquisitions.
Discontinued Operations. On February 28, 1998 (the "Board Resolution Date"),
the Company's board of directors adopted a plan to sell the Company's call
center business located in Butler, Pennsylvania. The call center operations up
to the Board Resolution Date have been classified as a loss from discontinued
operations. The estimated loss from operations after the Board Resolution Date
until the date of sale have been recorded as a loss on disposal of
discontinued operations. This estimate was decreased by $250,000 in the
quarter ended June 30, 1998.
Net Loss. As a result of the above items, net loss increased to $29,217,257
($1.26 per share) for the quarter ended June 30, 1998 from $1,405,264 ($.10
per share) for the same period in 1997.
SIX MONTHS ENDED JUNE 30, 1998 (AS RESTATED) COMPARED WITH SIX MONTHS ENDED
JUNE 30, 1997
Revenue. Revenue increased to $79,308,756 for the six months ended June 30,
1998 from $18,713,523 for the same period in 1997. The substantial increase in
revenue reflects an increase in usage of SmarTalk services by users of the
SmarTalk Card, the effect of the Acquisitions, an increase in the number of
retail storefronts in which the Company's product is distributed, greater
brand awareness and consumer acceptance and revenue attributable to a
distribution and processing agreement entered into on June 1, 1996 with WIC.
Revenue attributable to the distribution and processing agreement was
$8,951,486 and $8,619,391 for the six months ended June 30, 1998 and the same
period in 1997, respectively. In addition, 4.0% of total revenue for the six
months ended June 30, 1998 consisted of breakage revenue as compared to 5.0%
for the same period in 1997. Recharge revenue was $2,055,929 and $1,182,722
for the six months ended June 30, 1998 and the same period in 1997,
respectively.
Cost of Revenue. Cost of revenue increased to $52,857,157 for the six months
ended June 30, 1998 from $11,964,802 for the same period in 1997. The increase
was primarily attributable to greater use of the Company's services, the
effect of the Acquisitions, and an increase in taxes. The gross profit
percentage for the six months ended June 30, 1998 was 33.4% as compared to
36.1% for the same period in 1997. The gross margin percentage decreased
primarily due to the decrease in breakage revenue which has minimal cost of
revenue associated with it and the effect of the additional taxes.
Sales and Marketing Expenses. Sales and marketing expenses increased to
$33,092,717 (41.7% of revenue) for the six months ended June 30, 1998 from
$5,541,464 (29.6% of revenue) for the same period in 1997. The increase in
dollar amount and percentage of revenue was primarily due to the effect of the
Acquisitions and the continued expansion of the Company's marketing
activities, which include co-op, consumer advertising, manufacturer's
development funds and promotional goods. [The Company also paid a major
retailer $2.5 million for entering into a long term agreement. This amount was
expensed during the quarter ended March 31, 1998.] In addition, the Company,
in connection with the restatement of its financial statements for the period
ended June 30, 1998, reassessed the collectibility of certain accounts
receivable as of June 30, 1998. In connection with such reassessment, the
Company revised its evaluation relating to the allowance for uncollectible
accounts receivable and increased this allowance as well as wrote off accounts
receivable in the aggregate amount of $10.9 million at June 30, 1998.
General and Administrative Expenses. General and administrative expenses
increased to $31,952,871 (40.3% of revenue) for the six months ended June 30,
1998 from $3,807,594 (20.3% of revenue) for the same
16
<PAGE>
period in 1997. The increase in dollar amount and percentage of revenue was
primarily due to the effect of the Acquisitions, which includes intangible
assets and goodwill amortization, depreciation expense, and the addition of
personnel and costs associated with the growth of the Company's business.
Interest Income and Expense. Net interest expense for the six months ended
June 30, 1998 was $2,509,602 as compared to net interest income of $884,776
for the same period in 1997. This was primarily due to interest expense on the
Company's subordinated debt that was issued September 17, 1997. Interest
expense for the quarter ended June 30, 1998 and the same period in 1997
included $453,434 and $0, respectively, of debt issue costs and amortization.
Income Tax. The Company had losses for the six months ended June 30, 1998
and the same period in 1997. Accordingly, there was no provision for income
taxes.
Decremented Minutes and Pin Activations. Decremented minutes, which
represent actual call traffic over the SmarTalk platforms, were 378,509,142
for the six months ended June 30, 1998 as compared to 90,045,627 for the six
months ended June 30, 1997. PIN activations were 7,874,900 for the six months
ended June 30, 1998 as compared to 1,130,502 for the six months ended June 30,
1997. These increases are due to increased usage of the Company's services and
the effect of the Acquisitions.
Discontinued Operations. On the Board Resolution Date, SmarTalk's board of
directors adopted a plan to sell the Company's call center business located in
Butler, Pennsylvania. The call center operations up to the Board Resolution
Date have been classified as a loss from discontinued operations. The
estimated loss from operations after the Board Resolution Date until the date
of sale has been recorded as a loss on disposal of discontinued operations.
This estimate was decreased by $250,000 in the quarter ended June 30, 1998.
Net Loss. As a result of the above items, net loss increased to $44,563,696
($1.97 per share) for the six months ended June 30, 1998 as compared to
$1,715,561 ($.13 per share) for the same period in 1997.
LIQUIDITY AND CAPITAL RESOURCES
On July 9, 1998, the Company completed a private placement of 1,751,824
shares of its Common Stock, realizing proceeds before transaction costs of
$29,999,986. On August 28, 1998, the terms of the private placement were
restructured. In the event that the Company's Common Stock trades below the
initial purchase price during specified periods, the Company will be obligated
to issue up to $18,500,000 of additional Common Stock for no additional
consideration. In addition, the Company granted an option exercisable for a
period of two years commencing March 1, 1999 in connection with the private
placement pursuant to which an additional $20,000,000 of the Company's Common
Stock may be purchased. In the event the aggregate amount of Common Stock
issued by the Company pursuant to the private placement would exceed 20% of
the Company's total outstanding shares as of July 9, 1998 (the "20%
Threshold"), as a result of either the exercise of the option or the initial
purchase price adjustment, the Company would be required to obtain shareholder
approval of the private placement or issue a note in a principal amount equal
to the value of the Common Stock that otherwise would exceed the 20%
Threshold. The Company expects to use the proceeds from this private placement
to accelerate its entry into the prepaid cellular market and for general
corporate purposes.
On December 31, 1997, the Company issued 4,488,935 shares of Common Stock to
purchase ConQuest.
On December 31, 1997, the Company purchased Amex Telecom for $44,000,000 in
cash.
On December 9, 1997, the Company purchased selected retail assets of
Frontier's prepaid phone card business for $35,000,000 in cash and 65,568
shares of Common Stock.
In November 1997, the Company acquired a distribution agreement for
$1,000,000 in cash and 326,531 shares of Common Stock. In December 1997, an
additional 3,674 shares of Common Stock were issued for a referral associated
with the distribution agreement.
17
<PAGE>
On September 17, 1997, SmarTalk issued 5 3/4% per annum convertible
subordinated notes due September, 2004, in an aggregate principal amount of
$150,000,000 (the "Notes"). The net proceeds to SmarTalk from the Notes
offering (after deducting the underwriting discounts and other expenses) was
$144,946,319. Interest on the Notes is payable semi-annually on March 15 and
September 15 of each year commencing March 15, 1998.
On August 6, 1997, ConQuest entered into a revolving credit facility with
Star Bank, N.A. ("Star Line of Credit"). Pursuant to the terms of the Star
Line of Credit, ConQuest could borrow up to $9,500,000 as secured by various
accounts receivable. Interest is based on the ninety-day LIBOR plus one
percent. This credit facility was assumed by SmarTalk upon the acquisition of
ConQuest and had an outstanding balance of $7,193,575 at April 27, 1998. This
credit facility was paid in full and terminated on April 27, 1998.
In December 1996, the Company entered into a revolving credit facility with
Southern California Bank ("SCB Line of Credit"). Pursuant to the terms of the
SCB Line of Credit, the Company can borrow up to $1,000,000 secured by an
assignment of a deposit account with Southern California Bank. Interest on the
outstanding principal balance, calculated from the date of each advance to the
repayment of each advance is at a fixed rate of 7.12%. This credit facility
was undrawn at June 30, 1998.
Throughout 1997 to June 30, 1998, the Company has paid approximately
$96,000,000 in cash, paid $26,644,686 for acquisition indebtedness and has
issued approximately 12,500,000 shares of Common Stock for the Acquisitions,
distribution and licensing agreements.
From inception through June 30, 1998, the Company has funded operations
primarily from borrowings under its debt agreements and the sale of Common
Stock. The Company's operating activities used net cash of $19,917,582 for the
six months ended June 30, 1998. The cash used by operating activities is
primarily attributable to the Company's continued efforts to increase its
penetration of the retail and alternate distribution channels.
Short-term and long-term funding needs for SmarTalk relate principally to
acquisitions, additional market penetration, liquidity, operations and capital
expenditures. These requirements principally have been met through the
proceeds of the initial public offering in October 1996 and the Notes offering
in September 1997. The following table sets forth selected financial data from
the consolidated statements of cash flows. (As Restated--See Note 9 to the
Company's consolidated financial statements.)
<TABLE>
<CAPTION>
CASH (USED IN) PROVIDED BY:
---------------------------------------
SIX MONTHS ENDED JUNE 30, OPERATIONS INVESTING FINANCING
------------------------- ------------ ------------ -----------
<S> <C> <C> <C>
1998............................... $(19,917,582) $(11,913,204) $ (272,182)
1997............................... $ (4,849,583) $ (2,098,524) $(5,789,598)
Working capital, current assets and current liabilities are illustrated in
the table below:
<CAPTION>
CURRENT CURRENT WORKING
ASSETS LIABILITIES CAPITAL
------------ ------------ -----------
<S> <C> <C> <C>
June 30, 1998...................... $ 74,244,952 $ 73,340,608 $ 904,344
December 31, 1997.................. $106,626,281 $ 71,316,035 $35,310,246
</TABLE>
As of June 30, 1998, the Company believed that the net proceeds from the
Notes offering, together with existing sources of liquidity, would be
sufficient to fund its capital expenditures, working capital, selected
acquisitions, and other requirements through the next twelve months.
As described in Note 9 to the Company's consolidated financial statements,
the consolidated financial statements of the Company have been restated to
reflect, among other things, a revaluation of the Company's accounts
receivable. The ability of the Company to satisfy its cash requirements is
dependent in part on the Company's ability to timely collect its accounts
receivable. In the event that the Company is unable to collect such
receivables in a timely fashion, the Company may be required to consider other
financing sources, including
18
<PAGE>
the borrowing of additional funds or the issuance of additional debt or equity
securities of the Company. There can be no assurance that the Company would be
able to obtain such financing or that such financing would be on favorable
terms.
IMPACT OF INFLATION
SmarTalk does not consider inflation to have had a material impact on the
results of operations for the six months ended June 30, 1998 and 1997.
YEAR 2000
The Company is aware of and is addressing the issues associated with the
programming code in existing computer systems as the year 2000 approaches (the
"Year 2000 Issue"). The Year 2000 Issue is pervasive and complex, as many
computer systems will be affected in some way by the rollover of the two-digit
year value to 00. Systems that do not properly recognize such information
could generate erroneous data or cause a system to fail. The Company utilizes
some software and related computer hardware technologies in its operations
that may be affected by the Year 2000 Issue. While the Company believes that
most of its proprietary software and platforms will be unaffected by the Year
2000 Issue, the Company is currently attempting to evaluate the impact of the
Year 2000 Issue on the systems of its vendors, suppliers and key customers.
The Company is currently reviewing what actions will be necessary to make its
computer systems and those of its vendors, suppliers and key customers year
2000 compliant. The impact of these actions has yet to be fully determined,
but could materially affect the Company's business.
19
<PAGE>
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
The description of the Company's Legal Proceedings has changed substantially
since the end of the period to which this Quarterly Report on Form 10-Q/A
relates. The following is a description as of November 5, 1998.
On April 20, 1998, Intrine Communications ("Intrine"), filed a complaint
against the Company and DCN in the Superior Court of California in Los Angeles
County. In the complaint, Intrine alleges that, by virtue of the Company's
acquisition of DCN, the Company and DCN breached written and oral agreements
not to circumvent and appropriate for themselves the benefits of a purported
deal by Intrine to acquire DCN. The lawsuit seeks damages and injunctive
relief. Management of the Company believes that the claims against the Company
and DCN are without merit and does not at present expect this lawsuit to have
a material adverse effect on the Company's financial position, liquidity, cash
flow or results of operations.
Since July 23, 1998, 19 putative class actions have been filed against the
Company and certain current and former members of its management and board of
directors in state and Federal courts alleging violations of state and Federal
securities laws with respect to certain alleged misrepresentations and/or
omissions in regard to the Company's projected and actual revenues and
earnings. These lawsuits seek unspecified damages on behalf of certain classes
of persons who purchased the Company's securities during periods between May,
1997 and August, 1998. The complaints generally allege that the Company made
material misrepresentations and omissions in regard to the Company's projected
and actual revenues and earnings. Although the Company intends to defend
against these lawsuits vigorously, it is not feasible to predict or determine
the final outcome of these proceedings at this time. An unfavorable outcome
with respect to such proceedings could have a material adverse effect on the
Company's financial condition and results of operations.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits required by Item 601 of Regulation S-K.
27.1 Financial Data Schedule
(b) Reports on Form 8-K.
SmarTalk filed a Form 8-K on June 10, 1998 pertaining to the consummation
of the acquisition of Worldwide Direct, Inc. containing item 2 and item 7(c)
exhibits 2.1 and 99.1.
SmarTalk filed a Form 8-K on July 8, 1998 pertaining to the consummation
of a subscription agreement between SmarTalk and Fletcher International
Limited, containing item 5 and item 7(c) exhibits 99.1 and 99.2.
SmarTalk filed a Form 8-K on August 13, 1998 pertaining to its press
release dated August 10, 1998, containing item 5 and item 7(c) exhibit 99.1.
20
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Smartalk Teleservices, Inc.
(Registrant)
/s/ Wayne Wooddell
-------------------------------------
Wayne Wooddell
Vice President and Chief Financial
Officer
Date: November 6, 1998
21
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
27.1 Financial Data Schedule
</TABLE>
22
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<RESTATED>
<S> <C> <C>
<PERIOD-TYPE> 6-MOS 6-MOS
<FISCAL-YEAR-END> DEC-31-1998 DEC-31-1997
<PERIOD-START> JAN-01-1998 JAN-01-1997
<PERIOD-END> JUN-30-1998 JUN-30-1997
<CASH> 30,736,105 62,900,673
<SECURITIES> 0 0
<RECEIVABLES> 32,393,058 29,494,443
<ALLOWANCES> 7,794,758 1,482,206
<INVENTORY> 5,165,136 4,301,487
<CURRENT-ASSETS> 74,244,952 106,626,281
<PP&E> 22,847,491 15,403,784
<DEPRECIATION> 4,502,990 1,194,809
<TOTAL-ASSETS> 390,850,735 368,301,077
<CURRENT-LIABILITIES> 73,340,608 71,316,035
<BONDS> 0 0
0 0
0 0
<COMMON> 241,522,173 178,670,477
<OTHER-SE> 82,210 143,810
<TOTAL-LIABILITY-AND-EQUITY> 390,850,735 368,301,077
<SALES> 79,308,756 18,713,523
<TOTAL-REVENUES> 79,308,756 18,713,523
<CGS> 52,857,157 11,964,802
<TOTAL-COSTS> 52,857,157 11,964,802
<OTHER-EXPENSES> 65,045,588 9,349,058
<LOSS-PROVISION> 0 0
<INTEREST-EXPENSE> 4,896,930 224,748
<INCOME-PRETAX> (41,535,548) (1,715,561)
<INCOME-TAX> 0 0
<INCOME-CONTINUING> (41,535,548) (1,715,561)
<DISCONTINUED> (3,028,148) 0
<EXTRAORDINARY> 0 0
<CHANGES> 0 0
<NET-INCOME> (44,563,696) (1,715,561)
<EPS-PRIMARY> (1.97) (.13)
<EPS-DILUTED> (1.97) (.13)
</TABLE>
