<PAGE>
SCHEDULE 14A INFORMATION
Proxy Statement Pursuant to Section 14(a) of
the Securities Exchange Act of 1934 (Amendment No. 4)
Filed by the Registrant /X/
Filed by a Party other than the Registrant / /
Check the appropriate box:
/ / Preliminary Proxy Statement
/ / Confidential, for Use of the Commission Only (as permitted by Rule
14a-6(e)(2))
/X/ Definitive Proxy Statement
/ / Definitive Additional Materials
/ / Soliciting Material Pursuant to Section 240.14a-11(c) or 240.14a-12
STAR TELECOMMUNICATIONS, INC.
- --------------------------------------------------------------------------------
(Name of Registrant as Specified In Its Charter)
- --------------------------------------------------------------------------------
(Name of Person(s) Filing Proxy Statement, if other than the Registrant)
Payment of Filing Fee (Check the appropriate box):
/ / No fee required.
/ / Fee computed on table below per Exchange Act Rules 14a-6(i)(4)
and 0-11.
(1) Title of each class of securities to which transaction applies:
-----------------------------------------------------------------------
(2) Aggregate number of securities to which transaction applies:
-----------------------------------------------------------------------
(3) Per unit price or other underlying value of transaction computed
pursuant to Exchange Act Rule 0-11 (Set forth the amount on which the
filing fee is calculated and state how it was determined):
-----------------------------------------------------------------------
(4) Proposed maximum aggregate value of transaction:
-----------------------------------------------------------------------
(5) Total fee paid:
-----------------------------------------------------------------------
/X/ Fee paid previously with preliminary materials.
* Set forth the amount on which the filing fee is calculated and state how
it was determined.
/ / Check box if any part of the fee is offset as provided by Exchange Act Rule
0-11(a)(2) and identify the filing for which the offsetting fee was paid
previously. Identify the previous filing by registration statement number,
or the Form or Schedule and the date of its filing.
(1) Amount Previously Paid:
-----------------------------------------------------------------------
(2) Form, Schedule or Registration Statement No.:
-----------------------------------------------------------------------
(3) Filing Party:
-----------------------------------------------------------------------
(4) Date Filed:
-----------------------------------------------------------------------
<PAGE>
[LOGO]
January 15, 1999
Dear Stockholder:
You are cordially invited to attend a Special Meeting of Stockholders (the
"Special Meeting") of STAR Telecommunications, Inc., a Delaware corporation
("STAR" or the "Company"), to be held on Wednesday, February 3, 1999 at 9:00
a.m., local time, at 801 Garden Street, Room 203, Santa Barbara, California.
On August 20, 1998, STAR entered into an Amended and Restated Agreement and
Plan of Merger with Sierra Acquisition Co., Inc., a New York corporation and
wholly-owned subsidiary of STAR ("Newco"), PT-1 Communications, Inc., a New York
corporation ("PT-1") and certain stockholders of PT-1 (the "PT-1 Stockholders")
and amended such agreement on September 1, 1998 and on December 29, 1998 (as
amended, the "Merger Agreement"), pursuant to which, among other things, Newco
will be merged with and into PT-1 (the "Merger"), PT-1 will survive as a
wholly-owned subsidiary of STAR and the holders of PT-1 common stock, par value
$0.01 per share, ("PT-1 Common Stock"), options to acquire PT-1 Common Stock and
warrants exercisable for PT-1 Common Stock, outstanding immediately prior to the
effective time of the Merger, will be entitled to receive an aggregate of 15.05
million shares of common stock, par value $0.001 per share, of STAR ("STAR
Common Stock") and an aggregate of $19.5 million. The Merger Agreement also
requires STAR to issue for no consideration 250,000 shares of STAR Common Stock
to selected independent distributors of PT-1. The Merger Agreement is attached
to this Proxy Statement as Annex A.
At the Special Meeting, stockholders will be asked to vote to approve the
Merger Agreement and the transactions contemplated thereby, including the
issuance of 15.3 million shares of STAR Common Stock (the "Share Issuance") in
connection with the Merger. The 15.3 million shares of STAR Common Stock
issuable as a result of the Merger will constitute approximately 26.6% of the
outstanding STAR Common Stock (on a fully diluted basis) after the Merger.
THE BOARD OF DIRECTORS OF STAR (THE "BOARD") BELIEVES THAT THE MERGER AND
THE TRANSACTIONS RELATED THERETO, INCLUDING, WITHOUT LIMITATION, THE SHARE
ISSUANCE, ARE IN THE BEST INTEREST OF STAR AND ITS STOCKHOLDERS AND UNANIMOUSLY
RECOMMENDS THAT YOU VOTE FOR THE APPROVAL AND ADOPTION OF THE MERGER AGREEMENT
AND THE TRANSACTIONS CONTEMPLATED THEREBY, INCLUDING THE SHARE ISSUANCE. In
connection with the Merger, the Board has received the opinions of STAR's
financial advisors, Hambrecht & Quist LLC and Credit Suisse First Boston
Corporation, to the effect that the consideration to be paid by STAR in the
Merger was fair to the stockholders of STAR from a financial point of view.
Their opinions are attached to this Proxy Statement as Annex B and Annex C,
respectively.
Consummation of the Merger is subject to certain conditions, including the
approval of the Merger Agreement and the Share Issuance by the stockholders of
STAR. The Board of Directors of PT-1 voted to approve the Merger Agreement on
August 20, 1998.
The enclosed Proxy Statement explains in detail the Merger Agreement and the
transactions contemplated thereby. Please carefully review and consider all of
this information. It is especially important that your shares be represented and
voted at the Special Meeting. Although you may currently plan to attend
<PAGE>
the meeting, please complete, sign, date and promptly return the enclosed proxy
card. If you attend the Special Meeting and vote in person, your vote will
supersede your proxy.
Only stockholders of record at the close of business on December 29, 1998
are entitled to notice of and to vote at the Special Meeting and any adjournment
thereof.
As always, all of us at STAR truly appreciate your continued support of the
Company.
Sincerely,
/s/ CHRISTOPHER E. EDGECOMB
Christopher E. Edgecomb
CHAIRMAN OF THE BOARD
<PAGE>
STAR TELECOMMUNICATIONS, INC.
223 EAST DE LA GUERRA STREET
SANTA BARBARA, CALIFORNIA 93101
------------------------
NOTICE OF SPECIAL MEETING OF STOCKHOLDERS
TO BE HELD FEBRUARY 3, 1999
------------------------
TO THE STOCKHOLDERS OF STAR TELECOMMUNICATIONS, INC.:
The Special Meeting of Stockholders (the "Special Meeting") of STAR
Telecommunications, Inc. ("STAR" or the "Company") will be held at 9:00 a.m.,
local time, on Wednesday, February 3, 1999 at 801 Garden Street, Room 203, Santa
Barbara, California, for the following purposes:
1. To vote on the approval and adoption of the Amended and Restated
Agreement and Plan of Merger dated as of August 20, 1998 by and among
STAR, Sierra Acquisition Co., Inc., a New York corporation and
wholly-owned subsidiary of STAR ("Newco"), PT-1 Communications, Inc., a
New York corporation ("PT-1"), and certain stockholders of PT-1, as
amended by the First Amendment dated September 1, 1998, and by the Second
Amendment dated December 29, 1998, and the transactions contemplated
thereby, pursuant to which, among other things: (i) Newco will merge with
and into PT-1 (the "Merger") and PT-1 will survive as a wholly-owned
subsidiary of STAR, (ii) the holders of common stock, $0.01 par value per
share, of PT-1 ("PT-1 Common Stock"), options to acquire PT-1 Common
Stock and warrants exercisable for PT-1 Common Stock outstanding
immediately prior to the effective time of the Merger will be entitled to
receive an aggregate of 15.05 million shares of common stock, $0.001 par
value per share, of STAR ("STAR Common Stock") and an aggregate of $19.5
million, and (iii) STAR will issue for no consideration 250,000 shares of
STAR Common Stock to selected independent distributors of PT-1. The
Agreement and Plan of Merger is included as Annex A to the enclosed Proxy
Statement.
2. To transact such other business as may properly come before the meeting
or any adjournment or postponement thereof.
The foregoing items of business are more fully described in the Proxy
Statement accompanying this notice. Only stockholders of record of STAR Common
Stock at the close of business on December 29, 1998 will be entitled to notice
of and to vote at the Special Meeting or any adjournment or postponement
thereof.
By Order of the Board of Directors
/s/ MARY A. CASEY
Mary A. Casey
SECRETARY
January 15, 1999
Santa Barbara, California
------------------------
YOU ARE URGED TO VOTE UPON THE MATTERS PRESENTED AND TO SIGN, DATE AND
PROMPTLY RETURN THE ENCLOSED PROXY IN THE ENVELOPE PROVIDED. IT IS IMPORTANT FOR
YOU TO BE REPRESENTED AT THE MEETING. PROXIES ARE REVOCABLE AT ANY TIME PRIOR TO
THE VOTE AND THE EXECUTION OF YOUR PROXY WILL NOT AFFECT YOUR RIGHT TO VOTE IN
PERSON IF YOU ARE PRESENT AT THE MEETING.
Requests for additional copies of proxy materials should be addressed to
Mary A. Casey,
Corporate Secretary, at the offices of the Company, 223 East De La Guerra
Street, Santa Barbara,
California 93101.
<PAGE>
STAR TELECOMMUNICATIONS, INC.
223 EAST DE LA GUERRA STREET
SANTA BARBARA, CALIFORNIA 93101
------------------------
PROXY STATEMENT
SPECIAL MEETING OF STOCKHOLDERS
TO BE HELD FEBRUARY 3, 1999
------------------------
GENERAL INFORMATION
This Proxy Statement is furnished in connection with the solicitation of
proxies by the Board of Directors (the "Board") of STAR Telecommunications,
Inc., a Delaware corporation ("STAR" or the "Company"), for use at the Special
Meeting of Stockholders (the "Special Meeting") to be held on Wednesday,
February 3, 1999 at 9:00 a.m., local time, at 801 Garden Street, Room 203, Santa
Barbara, California, and any adjournment or postponement thereof. This Proxy
Statement and the form of proxy for the Special Meeting were first mailed or
delivered to the stockholders of the Company on or about January 20, 1999.
MATTERS TO BE CONSIDERED
The Special Meeting has been called (1) to vote on a proposal (the
"Proposal") to approve and adopt the Amended and Restated Agreement and Plan of
Merger dated as of August 20, 1998 by and among STAR, Sierra Acquisition Co.,
Inc., a New York corporation and wholly-owned subsidiary of STAR ("Newco"), PT-1
Communications, Inc., a New York corporation ("PT-1"), and certain stockholders
of PT-1 (the "PT-1 Stockholders"), as amended on September 1, 1998 and on
December 29, 1998 (the "Merger Agreement"), and the transactions contemplated
thereby, pursuant to which, among other things, (i) Newco will merge with and
into PT-1 (the "Merger"), PT-1 will survive as a wholly-owned subsidiary of
STAR, (ii) the holders of common stock, $0.01 par value per share, of PT-1 (the
"PT-1 Common Stock"), options to acquire PT-1 Common Stock and warrants
exercisable for PT-1 Common Stock outstanding immediately prior to the effective
time of the Merger, will be entitled to receive an aggregate of 15.05 million
shares of common stock, $0.001 par value per share, of STAR ("STAR Common
Stock") and an aggregate of $19.5 million (the "Cash Component"), and (iii) STAR
will issue for no consideration 250,000 shares of STAR Common Stock to selected
independent distributors of PT-1; and (2) to transact such other business as may
properly come before the meeting or any adjournment or postponement thereof.
RECORD DATE AND VOTING
The Board has fixed the close of business on December 29, 1998 as the record
date (the "Record Date") for the determination of stockholders entitled to vote
at the Special Meeting and any adjournment or postponement thereof. As of the
Record Date, there were outstanding 42,234,659 shares of STAR Common Stock.
QUORUM AND VOTING REQUIREMENTS
The holders of record of a majority of the outstanding shares of STAR Common
Stock entitled to vote at the Special Meeting, present in person or represented
by proxy, will constitute a quorum for the transaction of business at the
Special Meeting. Abstentions are counted for purposes of determining the
presence or absence of a quorum for the transaction of business, whereas broker
non-votes will not be counted for such purpose. As to all matters, each
stockholder is entitled to one vote for each share of STAR Common Stock held.
Abstentions and broker non-votes will have the same effect as a vote against the
proposals presented to stockholders. Approval of the Proposal requires the
affirmative vote of the holders of a majority of the outstanding shares of STAR
Common Stock entitled to vote thereon.
All proxies which are properly completed, signed and returned prior to the
Special Meeting will be voted. If a stockholder specifies how the proxy is to be
voted with respect to the Proposal, the proxy will be voted in accordance with
such specifications. Any proposal with respect to which a stockholder fails to
so specify will be voted in accordance with the following recommendations of the
Board: (a) FOR the Proposal and (b) in their discretion, upon such other
business as may properly come before the meeting. Any proxy given by a
stockholder may be revoked at any time before it is exercised, by filing with
the Secretary of the Company an instrument revoking it, by delivering a duly
executed proxy bearing a later date or by the stockholder attending the Special
Meeting and voting his or her shares in person.
Proxies for the Special Meeting are being solicited by mail directly and
through brokerage and banking institutions. The Company will pay all expenses in
connection with the solicitation of proxies. In addition to the use of mails,
proxies may be solicited by directors, officers and regular employees of the
Company personally or by telephone. The Company does not expect to pay any fees
or compensation for the solicitation of proxies (other than to U.S. Stock
Transfer Corporation, the Company's transfer agent and registrar, in connection
with its services in sending proxy materials, obtaining proxies and attending
the Special Meeting), but may reimburse brokers and other persons holding shares
of STAR Common Stock in their names, or in the names of nominees, for their
expenses in sending proxy materials to the beneficial owners of such shares and
obtaining their proxies.
The STAR Common Stock is quoted on the Nasdaq National Market ("Nasdaq")
under the symbol "STRX." On August 20, 1998, the last full day of trading prior
to the announcement of the execution of the Merger Agreement, the high and low
sale prices of STAR Common Stock, as reported on Nasdaq, was $15.625 and
$14.375, respectively, per share. On January 14, 1999, the last trading day
prior to the date of this Proxy Statement, the last reported sale price of the
STAR Common Stock on Nasdaq was $14.375 per share.
All stockholders are urged to complete, sign and promptly return the
enclosed proxy card.
--------------------------
SEE "RISK FACTORS" BEGINNING ON PAGE 21 FOR A DISCUSSION OF CERTAIN MATTERS
THAT SHOULD BE CONSIDERED BY THE STOCKHOLDERS WITH RESPECT TO
THE MERGER.
---------------------
THE DATE OF THIS PROXY STATEMENT IS JANUARY 15, 1999.
<PAGE>
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
---------
<S> <C>
AVAILABLE INFORMATION...................................................................................... 3
INCORPORATION OF CERTAIN DOCUMENTS BY REFERENCE............................................................ 3
DESCRIPTION OF FORWARD-LOOKING STATEMENTS.................................................................. 4
SUMMARY.................................................................................................... 5
The Companies............................................................................................ 5
Risks Relating to Merger Agreement....................................................................... 6
The Special Meeting...................................................................................... 7
The Merger............................................................................................... 8
The Merger Agreement..................................................................................... 10
Selected Consolidated Financial Data of STAR............................................................. 13
Selected Consolidated Financial Data of PT-1............................................................. 15
Comparative Per Share Data............................................................................... 17
Summary Unaudited Pro Forma Financial Data............................................................... 18
RISK FACTORS............................................................................................... 21
THE SPECIAL MEETING........................................................................................ 36
THE MERGER................................................................................................. 38
General Description...................................................................................... 38
Effective Time of the Merger............................................................................. 38
Background of the Merger................................................................................. 38
STAR's Reasons for the Merger............................................................................ 41
Opinions of STAR's Financial Advisors.................................................................... 43
PT-1's Reasons for the Merger............................................................................ 51
The Merger Agreement..................................................................................... 52
Related Agreements....................................................................................... 58
Accounting Treatment of the Merger....................................................................... 59
Federal Income Tax Consequences of the Merger............................................................ 59
Regulatory Approvals..................................................................................... 60
Stock Exchange Listing................................................................................... 60
Loan to PT-1............................................................................................. 60
Vote Required and Recommendation of the Board............................................................ 60
UNAUDITED PRO FORMA FINANCIAL DATA......................................................................... 61
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF STAR.............. 78
BUSINESS OF STAR........................................................................................... 89
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF PT-1.............. 105
BUSINESS OF PT-1........................................................................................... 115
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT OF STAR COMMON STOCK........................ 125
DESCRIPTION OF STAR CAPITAL STOCK.......................................................................... 126
OTHER BUSINESS............................................................................................. 128
SUBMISSION OF STOCKHOLDER PROPOSALS........................................................................ 128
EXCHANGE ACT FILINGS....................................................................................... 128
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS................................................................. F-1
ANNEXES
ANNEX A: AGREEMENT AND PLAN OF MERGER...................................................................... A-1
ANNEX B: HAMBRECHT & QUIST FAIRNESS OPINION................................................................ B-1
ANNEX C: CREDIT SUISSE FIRST BOSTON FAIRNESS OPINION....................................................... C-1
</TABLE>
2
<PAGE>
AVAILABLE INFORMATION
STAR is subject to the informational requirements of the Securities Exchange
Act of 1934, as amended (the "Exchange Act"), and, in accordance therewith,
files reports, proxy statements, registration statements and other information
with the Securities and Exchange Commission (the "Commission"). The reports,
proxy statements, registration statements and other information filed by STAR
with the Commission may be inspected and copied at the public reference
facilities maintained by the Commission at 450 Fifth Street, N.W., Washington,
D.C. 20549, and at the Commission's Regional Offices at Seven World Trade
Center, 13th Floor, New York, New York 10048 and Citicorp Center, 500 West
Madison Street, Suite 1400, Chicago, Illinois 60661-2511. Copies of such
material may be obtained by mail from the Public Reference Section of the
Commission at 450 West Fifth Street, N.W., Washington, D.C. 20549, at prescribed
rates. The Commission also maintains a Web Site at http://www.sec.gov which
contains reports, proxy statements, registration statements and other
information regarding registrants that file electronically with the Commission.
STAR's Common Stock is listed on Nasdaq under the symbol "STRX."
The information contained herein with respect to STAR and its affiliates has
been provided by STAR, and the information contained herein with respect to PT-1
and its affiliates has been provided by PT-1. Any statements contained herein
concerning the contents of any contract, agreement or other document referred to
herein and filed as an annex hereto are not necessarily complete. With respect
to each such contract, agreement or other document, reference is made to the
annex for a more complete description of the matter involved, and each such
statement is qualified in its entirety by such reference.
INCORPORATION OF CERTAIN DOCUMENTS BY REFERENCE
The following documents, which STAR has filed with the Commission pursuant
to the Exchange Act, are incorporated herein by reference:
(i) Annual Report on Form 10-K for the year ended December 31, 1997;
(ii) Annual Reports on Form 10-K/A for the year ended December 31, 1997;
(iii) Quarterly Report on Form 10-Q for the quarter ended March 31, 1998;
(iv) Quarterly Report on Form 10-Q/A for the quarter ended March 31,
1998;
(v) Quarterly Report on Form 10-Q for the quarter ended June 30, 1998;
(vi) Quarterly Report on Form 10-Q/A for the quarter ended June 30,
1998;
(vii) Quarterly Report on Form 10-Q for the quarter ended September 30,
1998;
(viii) Quarterly Report on Form 10-Q/A for the quarter ended September 30,
1998; and
(ix) Current Report on Form 8-K dated March 25, 1998.
THIS PROXY STATEMENT INCORPORATES DOCUMENTS BY REFERENCE THAT ARE NOT
PRESENTED HEREIN OR DELIVERED HEREWITH. COPIES OF ANY SUCH DOCUMENTS, OTHER THAN
EXHIBITS TO SUCH DOCUMENTS WHICH ARE NOT SPECIFICALLY INCORPORATED BY REFERENCE
THEREIN, ARE AVAILABLE WITHOUT CHARGE TO ANY PERSON TO WHOM THIS PROXY STATEMENT
IS DELIVERED, UPON WRITTEN OR ORAL REQUEST TO MARY A. CASEY, STAR
TELECOMMUNICATIONS, INC., 223 EAST DE LA GUERRA STREET, SANTA BARBARA,
CALIFORNIA 91108, (805) 899-1962. IN ORDER TO ENSURE TIMELY DELIVERY OF THE
DOCUMENTS, ANY REQUEST SHOULD BE RECEIVED BY STAR BY JANUARY 27, 1999.
NO PERSON IS AUTHORIZED BY STAR TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATION, OTHER THAN THOSE CONTAINED IN THIS PROXY STATEMENT, IN
CONNECTION WITH THE SOLICITATION MADE BY THIS PROXY STATEMENT AND, IF GIVEN OR
MADE, SUCH INFORMATION OR REPRESENTATIONS SHOULD NOT BE RELIED UPON AS HAVING
BEEN AUTHORIZED. THIS PROXY STATEMENT DOES NOT CONSTITUTE THE SOLICITATION OF A
PROXY IN ANY JURISDICTION IN WHICH SUCH SOLICITATION MAY NOT LAWFULLY BE MADE.
THE DELIVERY OF THIS PROXY STATEMENT SHALL NOT IMPLY THAT THERE HAS BEEN NO
CHANGE IN THE INFORMATION SET FORTH HEREIN OR IN THE AFFAIRS OF STAR OR PT-1
SINCE THE DATE HEREOF.
3
<PAGE>
DESCRIPTION OF FORWARD-LOOKING STATEMENTS
THIS PROXY STATEMENT CONTAINS CERTAIN "FORWARD-LOOKING STATEMENTS" WITHIN
THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED (THE
"SECURITIES ACT"). FORWARD-LOOKING STATEMENTS ARE STATEMENTS OTHER THAN
HISTORICAL INFORMATION OR STATEMENTS OF CURRENT CONDITION. SOME FORWARD-LOOKING
STATEMENTS MAY BE IDENTIFIED BY USE OF SUCH TERMS AS "EXPECTS," "ANTICIPATES,"
"INTENDS," "ESTIMATES," "BELIEVES" AND WORDS OF SIMILAR IMPORT. THESE
FORWARD-LOOKING STATEMENTS RELATE TO PLANS, OBJECTIVES AND EXPECTATIONS FOR
FUTURE OPERATIONS. IN LIGHT OF THE RISKS AND UNCERTAINTIES INHERENT IN ALL SUCH
PROJECTED OPERATION MATTERS, THE INCLUSION OF FORWARD-LOOKING STATEMENTS IN THIS
PROXY STATEMENT SHOULD NOT BE REGARDED AS A REPRESENTATION BY STAR OR ANY OTHER
PERSON THAT THE OBJECTIVES OR PLANS OF STAR WILL BE ACHIEVED OR THAT STAR'S
OPERATING EXPECTATIONS WILL BE REALIZED. REVENUES AND RESULTS OF OPERATIONS ARE
DIFFICULT TO FORECAST AND COULD DIFFER MATERIALLY FROM THOSE PROJECTED IN THE
FORWARD-LOOKING STATEMENTS CONTAINED IN THIS PROXY STATEMENT. FORWARD-LOOKING
STATEMENTS MAY BE DEEMED TO INCLUDE THOSE SET FORTH IN "SUMMARY," REGARDING
STAR'S INTRODUCTION INTO SERVICE OF VARIOUS INTERNATIONAL GATEWAY SWITCHES,
COMMITMENTS TO ACQUIRE UNDERSEA CABLES AND VARIOUS ASPECTS OF STAR'S STRATEGY.
SUCH FORWARD-LOOKING STATEMENTS MAY BE DEEMED TO INCLUDE STATEMENTS IN
"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATION OF STAR," REGARDING STAR'S STRATEGY TO LOWER ITS COST OF SERVICES AND
IMPROVE ITS GROSS MARGIN AND ITS BELIEF THAT PRICE DECLINES MAY BE OFFSET IN
PART BY INCREASED CALLING VOLUMES AND DECREASED COSTS AND ITS BELIEF IN THE
SUFFICIENCY OF CAPITAL RESOURCES. FORWARD-LOOKING STATEMENTS IN "BUSINESS OF
STAR" MAY BE DEEMED TO INCLUDE PROJECTED GROWTH IN INTERNATIONAL
TELECOMMUNICATIONS TRAFFIC, STAR'S STRATEGY OF MARKETING ITS SERVICES TO
FOREIGN-BASED LONG DISTANCE PROVIDERS, EXPANDING ITS U.S. AND DEVELOPING
EUROPEAN AND ASIAN SWITCHING CAPABILITIES, EXPANDING INTO COMMERCIAL MARKETS AND
PURSUING ACQUISITIONS. FORWARD-LOOKING STATEMENTS CONCERNING PT-1 AND STAR
OPERATING AS A COMBINED ENTITY AFTER CONSUMMATION OF THE MERGER, MAY BE DEEMED
TO INCLUDE STATEMENTS IN "SUMMARY," "MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF PT-1" AND "BUSINESS OF PT-1,"
INCLUDING STATEMENTS CONCERNING PT-1'S ABILITY TO INCREASE REVENUES AND GROSS
MARGINS AND TO DECREASE COST OF SERVICES AS A PERCENTAGE OF REVENUES, STATEMENTS
CONCERNING FUTURE GROWTH IN THE DEMAND FOR PREPAID CARDS, THE INTRODUCTION OF
NEW PRODUCTS AND SERVICES, THE FUTURE OF THE TELECOMMUNICATIONS INDUSTRY AND
PT-1'S PLANS TO EXPAND ITS DISTRIBUTION NETWORKS. ACTUAL RESULTS COULD DIFFER
FROM THOSE PROJECTED IN ANY FORWARD-LOOKING STATEMENTS FOR THE REASONS DETAILED
IN THE "RISK FACTORS" SECTION OF THIS PROXY STATEMENT, BEGINNING ON PAGE 21, OR
ELSEWHERE IN THIS PROXY STATEMENT. STAR DOES NOT UNDERTAKE ANY OBLIGATION TO
RELEASE PUBLICLY THE RESULTS OF ANY FUTURE REVISIONS IT MAY MAKE TO ANY OF ITS
FORWARD-LOOKING STATEMENTS TO REFLECT EVENTS OR CIRCUMSTANCES AFTER THE DATE
HEREOF, TO REFLECT THE OCCURRENCE OF UNANTICIPATED EVENTS OR TO REFLECT ANY
CHANGE IN STAR'S OPERATING STRATEGY.
4
<PAGE>
SUMMARY
THIS SUMMARY HIGHLIGHTS SELECTED INFORMATION FROM THIS PROXY STATEMENT AND
MAY NOT CONTAIN ALL OF THE INFORMATION THAT IS IMPORTANT TO YOU. TO UNDERSTAND
THE MERGER FULLY AND FOR A MORE COMPLETE DESCRIPTION OF THE LEGAL TERMS OF THE
MERGER, STOCKHOLDERS SHOULD READ CAREFULLY THIS ENTIRE DOCUMENT, INCLUDING THE
ANNEXES. STOCKHOLDERS SHOULD ALSO CAREFULLY CONSIDER THE INFORMATION SET FORTH
BELOW IN "RISK FACTORS."
THE COMPANIES
STAR AND NEWCO
STAR Telecommunications, Inc. ("STAR" or the "Company") is an emerging
multinational carrier focused primarily on the international long distance
telecommunications market. STAR offers highly reliable, low cost switched voice
services on a wholesale basis, primarily to U.S.-based long distance carriers.
STAR provides international long distance service to approximately 220 foreign
countries through a flexible network comprised of various foreign termination
relationships, international gateway switches, leased and owned transmission
facilities and resale arrangements with long distance providers. STAR has grown
its revenues rapidly by capitalizing on the deregulation of international
telecommunications markets, combining sophisticated information systems with
flexible routing and leveraging management's industry expertise. STAR has
increased its revenues and net income from $58.9 million and $3.7 million,
respectively, in 1995 to $404.6 million and $5.8 million, respectively, in 1997.
STAR markets its services to large global carriers seeking lower rates as
well as to small and medium-sized long distance companies that do not have the
critical mass to invest in their own international transmission facilities or to
obtain volume discounts from the larger facilities-based carriers. During the
fourth quarter of 1997, STAR provided switched international long distance
services to 105 customers and currently provides these services to nine of the
top forty global carriers. STAR has also recently focused on building a customer
base overseas, particularly in Europe, and has opened offices in Dusseldorf,
Frankfurt, Hamburg and Munich, Germany and London, England. In addition, STAR
has begun to market its international long distance services directly to certain
commercial customers in the U.S. and overseas.
STAR currently operates international gateway switching facilities in New
York, Los Angeles, Dallas and Miami; London, England; and Dusseldorf, Frankfurt,
Hamburg and Munich, Germany. In early 1999, STAR plans to put into service
switches in Atlanta, Chicago and Seattle; Paris, France; Geneva, Switzerland;
and Vienna, Austria. STAR's switching facilities are linked to a proprietary
reporting system, which STAR believes provides it with a competitive advantage
by permitting management on a real-time basis to determine the most
cost-effective termination alternatives, monitor customer usage and manage gross
margins by route. STAR holds ownership positions in a number of digital undersea
fiber optic cables, including TPC-5, Gemini and AC-1, has recently entered into
a commitment to acquire transmission capacity on the Qwest domestic Macro
Capacity(SM) Fiber Network, which is expected to serve over 130 cities in the
U.S., and has plans to continue to acquire transmission capacity on additional
undersea fiber optic cable systems.
STAR was incorporated in Nevada in September 1993 as STAR Vending, Inc. and
was reincorporated in Delaware as STAR Telecommunications, Inc. in April 1997.
Sierra Acquisition Co., Inc. ("Newco"), which is a wholly-owned subsidiary
of STAR, was incorporated in New York on June 8, 1998 for the purpose of
effecting the Merger. Newco has no material assets and has not engaged in any
activities except in connection with such proposed Merger.
STAR and Newco's executive offices are located at 223 East De La Guerra
Street, Santa Barbara, California 93101. Their telephone number at that location
is (805) 899-1962.
5
<PAGE>
PT-1
PT-1 is a provider of international long distance services to retail
customers and telecommunications carriers. PT-1 provides retail
telecommunications services primarily by marketing prepaid telephone calling
cards ("Prepaid Cards"), principally under the PT-1 brand name, through an
extensive network of distributors, who directly and indirectly sell PT-1's
Prepaid Cards to retail outlets throughout the United States. PT-1 targets
retail markets with substantial international long distance calling
requirements, and believes that its Prepaid Cards provide consumers with a
convenient, attractively priced alternative to traditional presubscribed long
distance services. PT-1 sells its Prepaid Cards exclusively to distributors, and
it does not maintain any sales or marketing relationship with the retail outlets
that carry PT-1's Prepaid Cards. During March 1998, PT-1 began to market both
"dial around" and presubscribed long distance service to retail customers in
certain target markets that also have substantial international long distance
calling needs. Over the past several months, PT-1 has also increased the amount
of resources devoted to obtaining commercial retail customers with significant
international long distance requirements. For the fiscal year ended March 31,
1998, PT-1 generated revenues and net income of $431.5 million and $11.6
million, respectively.
PT-1 was founded in April 1995 to capitalize on the growing market for
international long distance services. PT-1 initially entered the retail
international long distance market through the distribution of Prepaid Cards
targeted at ethnic communities. After building significant international
traffic, in 1996 PT-1 began to negotiate reduced transmission rates based upon
volume with underlying carriers and began to invest in switching equipment and
lease transmission capacity to further reduce its cost of service as a
percentage of revenues. In August 1996, PT-1 began to leverage its significant
volume of international traffic by selling international long distance services
on a wholesale basis to other carriers. For the fiscal year ended March 31,
1998, revenues from retail sales and from wholesale sales were $356.3 million
and $75.2 million, respectively.
PT-1 believes its competitive strengths are its (i) established Prepaid Card
brand names, (ii) extensive distribution infrastructure, (iii) substantial
experience in identifying, targeting and marketing to communities and markets
with significant international long distance usage, (iv) position as a leading
provider of telecommunications traffic to various international destinations and
(v) efficient telecommunications network. PT-1 believes that its competitive
strengths will enable it to continue to profitably increase its retail customer
base and its traffic volume and negotiate lower telecommunications costs.
PT-1's retail customers can use its Prepaid Cards at any touch tone
telephone by dialing an access number, followed by a personal identification
number (a "PIN") assigned to each Prepaid Card and the telephone number the
customer wishes to reach. PT-1's switches complete the call, and its debit card
platform ("Debit Card Platform") reduces the Prepaid Card balance during the
call. PT-1 offers Prepaid Cards that can be used to access PT-1's network by
dialing an 800 number or, in specific metropolitan markets, local area calling
cards ("LAC Cards") that only require a local call. PT-1 believes that customers
typically use its Prepaid Cards as their primary means of making long distance
calls due to, among other things, (i) attractive rates, (ii) reliable service,
(iii) the ease of monitoring and budgeting their long distance spending, (iv)
the appealing variety of Prepaid Cards offered by PT-1 to different market
segments and (v) the inability of certain PT-1 customers, many of whom are
recent immigrants to the United States, to establish credit with the major
facilities-based long distance carriers.
PT-1 was incorporated on April 21, 1995 under the name PhoneTime, Inc. In
August 1997, it changed its name to PT-1 Communications, Inc. PT-1's principal
executive offices are located at 30-50 Whitestone Expressway, Flushing, New York
11354, and its telephone number at that location is (718) 939-9000.
RISKS RELATING TO MERGER AGREEMENT
The transactions contemplated by the Merger Agreement involve a high degree
of risk. Holders of STAR Common Stock should take into account, among other
things, the following summary of risks
6
<PAGE>
relating to the Merger, as well as those factors set forth in the section "Risk
Factors" beginning on page 21 of this Proxy Statement, in considering whether to
approve and adopt the Merger Agreement and the transactions contemplated
thereby.
- CONTROL OF PT-1. STAR has exercised de facto managerial and operational
control over PT-1 since September 1, 1998. If the Merger is not
consummated, STAR's involvement in the business and operations of PT-1
will need to be unraveled, resulting in the incurrence by STAR of what may
be material unanticipated costs and expenses.
- FAILURE TO REALIZE BENEFITS OF THE MERGER. There can be no assurance that
any of the anticipated cost savings, operating efficiencies or other
synergies of the Merger will be accomplished as rapidly as currently
expected or that such savings and synergies will not be offset by
increases in other expenses or operating losses, including losses due to
problems arising from the integration of STAR and PT-1.
- PREPAID CARD BUSINESS. PT-1's operations and the Prepaid Card business in
general have a number of inherent risks, including increasing competition
from other Prepaid Card vendors, low barriers to entry, reliance upon
independent distributors, reliance on consumer demand and lack of customer
loyalty. The net effect of these factors could be downward pressure on the
price that PT-1 can charge for its Prepaid Cards.
- INDEPENDENT DISTRIBUTORS. PT-1 distributes all of its Prepaid Cards
through wholesale distributors located primarily in the Northeast and does
not have an internal retail sales department. PT-1 does not have formal,
written agreements with its distributors, and it is PT-1's understanding
that no such written agreements exist in the supply chain for PT-1's
Prepaid Cards. PT-1's loss of any of its major distributors could have a
material adverse effect on PT-1's results of operations.
- UNCOLLECTIBLE ACCOUNTS. PT-1's account receivable balance at September
30, 1998 was approximately $37.4 million, an increase of more than 100%
over the last 12 months. Participants in the Prepaid Card industry, other
than PT-1, have historically experienced significant credit losses. As
PT-1 expands its commercial businesses, account receivable balances will
rise, increasing the likelihood of credit losses, which could be material.
THE SPECIAL MEETING
PURPOSE
At the Special Meeting, the stockholders will be asked to approve and adopt
the Merger Agreement and the transactions contemplated thereby, including the
issuance of 15.3 million shares of STAR Common Stock in connection with the
Merger (the "Share Issuance"), and to transact any other business that properly
may come before the meeting or any adjournments or postponements thereof.
TIME, PLACE AND DATE
The Special Meeting will be held at 801 Garden Street, Room 203, Santa
Barbara, California, on Wednesday, February 3, 1999, at 9:00 a.m. local time.
RECORD DATE; QUORUM; VOTES REQUIRED
The Board has fixed the close of business on December 29, 1998 as the Record
Date for determination of stockholders entitled to vote at the Special Meeting
and any adjournment thereof. As of the Record Date, there were outstanding
42,234,659 shares of STAR Common Stock. The presence, in person or by proxy, of
holders of record of a majority of the issued and outstanding shares of STAR
Common Stock is necessary to constitute a quorum for the transaction of business
at the Special Meeting. Approval of the Merger Agreement and the transactions
contemplated thereby, including the Share Issuance, will require
7
<PAGE>
the affirmative vote of the holders of record of a majority of all outstanding
shares of STAR Common Stock. See "The Special Meeting."
THE MERGER
REASONS FOR THE MERGER
The Board has unanimously approved the Merger Agreement and the transactions
contemplated thereby for several reasons. Among other things, the Board believes
that the acquisition of PT-1 will (a) continue STAR's expansion into the retail
segment of the commercial long distance market, and create for STAR an entrance
into the growing Prepaid Card market, (b) create one of the largest
facilities-based long distance telecommunications companies in the U.S., (c)
enable STAR to accelerate the development of its international
telecommunications network and (d) allow for the immediate use of the STAR
network by PT-1 customers. In reaching a decision to recommend the Merger, the
Board considered a number of factors in addition to those set forth above. See
"The Merger--STAR's Reasons for the Merger" and "--Vote Required and
Recommendation of the Board." No assurances can be made, however, that the
Merger will be successful for STAR or that any of the above-referenced strategic
advantages will be realized.
RECOMMENDATIONS TO STOCKHOLDERS
THE BOARD BELIEVES THAT THE MERGER IS FAIR AND IN THE BEST INTERESTS OF STAR
AND ITS STOCKHOLDERS AND UNANIMOUSLY RECOMMENDS THAT THE STOCKHOLDERS VOTE FOR
THE PROPOSAL TO APPROVE AND ADOPT THE MERGER AGREEMENT AND THE TRANSACTIONS
CONTEMPLATED THEREBY, INCLUDING THE SHARE ISSUANCE. SEE "THE MERGER--STAR'S
REASONS FOR THE MERGER" AND "--VOTE REQUIRED AND RECOMMENDATION OF THE BOARD."
OWNERSHIP OF STAR AFTER THE MERGER
In connection with the Merger, STAR will issue and reserve for issuance an
aggregate of 15.3 million shares of STAR Common Stock to the stockholders of
PT-1, selected independent distributors of PT-1 and to the holders of options
and warrants to purchase PT-1 Common Stock outstanding at the time of the Merger
(the "PT-1 Options" and "PT-1 Warrants", respectively), which will be assumed by
STAR. The number of shares of STAR Common Stock issuable as a result of the
Merger will constitute approximately 26.6% (on a fully diluted basis) of the
outstanding STAR Common Stock after the Merger. See "The Merger--The Merger
Agreement."
MANAGEMENT AND OPERATIONS OF PT-1 FOLLOWING THE MERGER
It is contemplated that after the Merger, PT-1 will continue to operate as a
separate entity. The Company does not currently intend to change the domicile,
name or material operations of PT-1. The Company has advised PT-1, however, that
Christopher E. Edgecomb, Mary A. Casey, Kelly D. Enos, Samer Tawfik and Peter M.
Vita will be named as the Directors of PT-1. The Company currently intends that
substantially all of the existing officers of PT-1 will retain their offices
with PT-1 or will be appointed as officers of STAR after the Effective Time, but
may also appoint additional officers of PT-1 from time to time.
OPINIONS OF STAR'S FINANCIAL ADVISORS
In connection with the Merger, the Board has received the opinions of its
financial advisors, Hambrecht & Quist LLC ("Hambrecht & Quist") and Credit
Suisse First Boston Corporation ("CSFB"), as to the fairness of the
consideration to be paid by STAR in the Merger to the stockholders of STAR from
a financial point of view. Their opinions are attached to this Proxy Statement
as Annex B and Annex C,
8
<PAGE>
respectively. All stockholders are encouraged to read these opinions in their
entirety as they contain the assumptions made, the procedures followed, the
other matters considered and the limits of the review conducted by Hambrecht &
Quist and CSFB in arriving at their respective opinions.
For purposes of delivering their opinions, Hambrecht & Quist and CSFB each
performed a variety of analyses, including comparing the financial multiples of
PT-1 and STAR to each other and to those of other selected public companies,
comparing the financial terms of the Merger to those of other publicly announced
transactions and analyzing the relative values and contributions of PT-1 and
STAR based upon historical and projected future financial performance and
anticipated benefits of the Merger as provided by the management of PT-1 and
STAR. See "The Merger--Opinions of STAR's Financial Advisors."
ACCOUNTING TREATMENT
The Merger will be accounted for by STAR under the purchase method of
accounting in accordance with Accounting Principles Board Opinion No. 16,
"Business Combinations" ("APB No. 16"). Under this method of accounting, the
purchase price will be allocated to assets acquired and liabilities assumed
based on their estimated fair values. A representative of Arthur Andersen LLP
("Arthur Andersen"), STAR's independent public accountants, will be available at
the Special Meeting to respond to appropriate questions. See "The
Merger--Accounting Treatment of the Merger."
FEDERAL INCOME TAX CONSEQUENCES
The Merger will not have any U.S. federal, state or local income tax effect
on STAR or any stockholder of STAR. See "The Merger--Federal Income Tax
Consequences of the Merger."
9
<PAGE>
THE MERGER AGREEMENT
A COPY OF THE MERGER AGREEMENT IS ATTACHED AS ANNEX A TO THIS PROXY
STATEMENT. STOCKHOLDERS ARE STRONGLY ENCOURAGED TO READ THE MERGER AGREEMENT AS
IT IS THE LEGAL DOCUMENT THAT GOVERNS THE MERGER AND THE TRANSACTIONS
CONTEMPLATED THEREBY. THE DISCUSSION OF THE MERGER AGREEMENT HEREIN IS QUALIFIED
IN ITS ENTIRETY BY THE FULL TEXT THEREOF.
TERMS OF THE MERGER AGREEMENT
The Merger Agreement provides that, following the approval and adoption of
the Merger Agreement and the transactions contemplated thereby, including the
Share Issuance, by the stockholders of STAR and the satisfaction or waiver of
certain other conditions, Newco will be merged with and into PT-1. As a result,
PT-1 will survive as a wholly-owned subsidiary of STAR after the Merger. The
Merger will become effective (the "Effective Time") when a certificate of merger
(the "Certificate of Merger") is accepted for filing by the Department of State
of the State of New York. See "The Merger--The Merger Agreement."
MERGER CONSIDERATION
In exchange for the outstanding capital stock of PT-1, STAR will issue and
reserve for issuance an aggregate of 15.05 million shares of STAR Common Stock
and will pay an aggregate of $19.5 million (collectively, the "Merger
Consideration") to the stockholders of PT-1 and to the holders of the PT-1
Options and the PT-1 Warrants. The final exchange ratio for the PT-1 Common
Stock, PT-1 Options and PT-1 Warrants to be exchanged in the Merger will be
determined immediately prior to the consummation of the Merger based on a number
of variable factors, including the market price of STAR Common Stock at the
Effective Time, the relative exercise price of the PT-1 Options and the
expiration or termination of outstanding options and warrants to acquire shares
of PT-1 Common Stock. Based on 48.4 million shares of PT-1 Common Stock
outstanding at September 30, 1998, the issuance of 15.3 million shares of STAR
Common Stock in the Merger will result in an estimated exchange ratio of
0.31607, which does not take into account the cash component of the Merger
Consideration. No fractional shares of STAR Common Stock will be issued.
Instead, stockholders of PT-1 will receive cash in lieu of any fractional shares
of STAR Common Stock. In connection with the Merger, STAR will also reserve
250,000 shares of STAR Common Stock for issuance for no consideration to
selected independent distributors of PT-1, in the form of restricted shares.
With respect to the cash component of the Merger Consideration, at the Effective
Time STAR will have the option of delivering to the PT-1 stockholders cash or
short term promissory notes in an aggregate amount equal to the cash then due.
See "The Merger--The Merger Agreement." As of September 1, 1998, based on a
closing sales price of $10.563 per share, the aggregate value of the 15.3
million shares of STAR Common Stock issuable in the Merger was approximately
$162 million.
A VOTE TO APPROVE AND ADOPT THE MERGER AGREEMENT BY THE STOCKHOLDERS WILL BE
DEEMED APPROVAL OF THE SHARE ISSUANCE.
ASSUMPTION OF PT-1 STOCK OPTIONS AND WARRANTS
At or prior to the Effective Time, STAR and PT-1 will take all action
necessary to cause the assumption by STAR as of the Effective Time of the PT-1
Options and PT-1 Warrants. Each of the PT-1 Options and PT-1 Warrants will be
converted without any action on the part of the holder thereof into an option or
warrant to purchase a certain number of shares of STAR Common Stock on
substantially equivalent terms as of the Effective Time. See "The Merger--The
Merger Agreement--Treatment of PT-1 Stock Options and Warrants."
ISSUANCE OF STAR COMMON STOCK AND OPTIONS IN CONNECTION WITH THE MERGER
It is a condition to the obligation of PT-1 and the PT-1 Stockholders to
effect the Merger that STAR reserve (i) 250,000 shares of STAR Common Stock for
issuance for no consideration to selected
10
<PAGE>
independent distributors of PT-1 in the form of restricted shares and (ii)
100,000 shares of STAR Common Stock for issuance to selected employees of PT-1
in the form of options, with such issuances to occur following the Effective
Time.
CONDITIONS TO THE MERGER
Completion of the Merger depends upon the satisfaction of a number of
conditions, including, but not limited to, the following:
(a) the approval and adoption of the Merger Agreement and the transactions
contemplated thereby by holders of record of a majority of the issued and
outstanding shares of STAR Common Stock entitled to vote thereon at the
Special Meeting;
(b) the approval for listing on Nasdaq of the STAR Common Stock issuable to
the stockholders of PT-1 pursuant to the Merger Agreement; and
(c) the approval of governmental authorities, including the Federal
Communications Commission (the "FCC"), state public utility commissions
("PUCs") and all applicable foreign telecommunications regulatory
entities (the "Foreign Agencies"), required for the transfer of ownership
or control of PT-1.
Any of the conditions to the Merger may be waived by STAR, Newco and PT-1 by
action taken by their respective Board of Directors. Additionally, the
conditions set forth in paragraph (c) above have been satisified. See "The
Merger--The Merger Agreement--Conditions" and "The Merger--Regulatory
Approvals."
REGULATORY APPROVALS
The Merger is subject to the requirements of the Hart-Scott-Rodino Antitrust
Improvements Act of 1976, as amended, and the rules and regulations promulgated
thereunder (the "HSR Act"). The HSR Act prohibits consummation of the Merger
until certain information has been furnished to the Antitrust Division of the
Department of Justice and to the Federal Trade Commission and a required waiting
period has expired. The required waiting period for STAR and PT-1's filings
under the HSR Act expired on September 14, 1998. The Department of Justice or
the Federal Trade Commission may still challenge the Merger on antitrust grounds
before or after the Merger is final. Consummation of the Merger was contingent
upon the receipt of approvals from the FCC, various PUCs and Foreign Agencies
with respect to the Merger. STAR and PT-1 have received all such necessary
approvals. See "The Merger--Regulatory Approvals."
ACQUISITION PROPOSALS
Pursuant to the Merger Agreement, and subject to certain conditions and
exceptions, PT-1 and the PT-1 Stockholders have agreed that PT-1, its subsidiary
and the PT-1 Stockholders will not, directly or indirectly, solicit, initiate or
participate in discussions or negotiations with or the submission of any offer
or proposal by or provide any information or access to, any corporation,
partnership, person or other entity or group (other than STAR or Newco)
concerning an offer or proposal for a merger or other business combination
involving PT-1 or any of its subsidiaries, or the acquisition of any equity
interest in, or a substantial portion of the assets of, PT-1 or any subsidiary,
other than the transactions contemplated by the Merger Agreement. See "The
Merger Agreement--Acquisition Proposals."
11
<PAGE>
TERMINATION OF THE MERGER AGREEMENT
STAR and PT-1 may agree, by mutual written consent, to terminate the Merger
Agreement without completing the Merger. Moreover, either STAR or PT-1 may
terminate the Merger Agreement if, among other things, any of the following
occurs:
(a) the other party breaches any of its representations and warranties or
fails to perform any of its covenants and agreements, which breaches and
failures are, in the aggregate, material in the context of the
transactions contemplated by the Merger Agreement; or
(b) the Merger is not completed on or before March 31, 1999, or on or before
June 30, 1999, provided that all other conditions to the consummation of
the Merger have been satisfied other than the receipt of all necessary
approvals with respect to all material filings made with the FCC, PUCs
and Foreign Agencies; provided that neither party may terminate the
Merger Agreement if such failure has been caused by that party's material
breach of the Merger Agreement; provided further that if such failure is
the result of an injunction or order of a court or governmental or
regulatory body resulting from an action or proceeding commenced by any
party which is not a government or governmental authority, then at the
request of either party, the deadline date shall be extended for a
reasonable period of time, not in excess of 120 days, to permit the
parties to have such injunction vacated or order reversed.
PT-1 may also terminate the Merger Agreement if there occurs a material
adverse change in the financial condition, results of operations, business or
properties of STAR, except for changes caused by a general change in the economy
of the United States or in the telecommunications industry served by STAR. STAR
may terminate the Merger Agreement if there has occurred a material adverse
change in the financial condition, results of operations, business or properties
of PT-1, other than any change arising from any action authorized, directed or
otherwise approved by STAR pursuant to the Merger Agreement or from STAR's
express refusal to approve any action proposed by PT-1 and except for any change
caused by a general change in the economy of the United States or in the
telecommunications industry served by PT-1.
TERMINATION FEE
The Merger Agreement requires PT-1 to pay to STAR, in certain instances, a
termination fee of $20 million following the termination of the Merger
Agreement. See "The Merger--The Merger Agreement--Termination Fee."
RELATED AGREEMENTS
In connection with the execution of the Merger Agreement, the parties
thereto agreed to enter into certain additional related agreements, including a
registration rights and restricted share agreement, shareholders agreement,
escrow agreement and employment and non-competition agreements. See "The
Merger--Related Agreements."
RISK FACTORS
The information set forth under "Risk Factors" should be reviewed and
carefully considered by the stockholders in evaluating the Merger Agreement and
the Share Issuance.
OTHER BUSINESS
The stockholders may be asked to vote upon such other business as may
properly come before the Special Meeting.
12
<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA OF
STAR TELECOMMUNICATIONS, INC.
The following selected consolidated financial data should be read in
conjunction with STAR's Consolidated Financial Statements and Notes thereto and
with "Management's Discussion and Analysis of Financial Condition and Results of
Operations of STAR," each of which is included elsewhere in this Proxy
Statement. The consolidated statements of operations data for the years ended
December 31, 1995, 1996 and 1997, and the balance sheet data at December 31,
1996 and 1997 are derived from audited financial statements included elsewhere
in this Proxy Statement. The consolidated statement of operations data for the
year ended December 31, 1994 and the consolidated balance sheet data at December
31, 1994 and September 30, 1997 are unaudited and are derived from unaudited
financial statements not included in this Proxy Statement. The consolidated
balance sheet data at December 31, 1995 is derived from audited financial
statements not included in this Proxy Statement. The consolidated statements of
operations data for the nine months ended September 30, 1997 and 1998 and the
consolidated balance sheet data at September 30, 1998 are unaudited and are
derived from unaudited financial statements included elsewhere in this Proxy
Statement. Although incorporated in 1993, STAR did not commence business until
1994.
<TABLE>
<CAPTION>
NINE MONTHS ENDED
YEAR ENDED DECEMBER 31, SEPTEMBER 30,
---------------------------------------------- ----------------------
1994 1995 1996 1997 1997 1998
----------- --------- ---------- ---------- ---------- ----------
(UNAUDITED) (UNAUDITED)
<S> <C> <C> <C> <C> <C> <C>
(IN THOUSANDS, EXCEPT PER SHARE DATA)
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
Revenues................................... $ 24,512 $ 58,937 $ 259,697 $ 404,605 $ 283,374 $ 425,531
Operating expenses:
Cost of services......................... 16,042 44,270 225,957 351,821 246,712 363,794
Selling, general and administrative...... 5,066 10,452 35,956 36,496 25,118 38,853
Depreciation and amortization............ 106 368 1,442 4,637 3,040 8,055
Merger expense........................... -- -- -- 286 -- 314
----------- --------- ---------- ---------- ---------- ----------
Total operating expenses................. 21,214 55,090 263,355 393,240 274,870 411,016
----------- --------- ---------- ---------- ---------- ----------
Income (loss) from operations............ 3,298 3,847 (3,658) 11,365 8,504 14,515
Other income (expense):
Interest income.......................... 3 22 110 492 367 3,511
Interest expense......................... -- (64) (609) (1,738) (1,289) (2,080)
Legal settlements and expenses........... -- -- (100) (1,653) -- --
Other.................................... (7) (33) 39 208 (1,499) (171)
----------- --------- ---------- ---------- ---------- ----------
Income (loss) before provision for income
taxes.................................. 3,294 3,772 (4,218) 8,674 6,083 15,775
Provision for income taxes................. 22 66 577 2,905 2,406 6,643
----------- --------- ---------- ---------- ---------- ----------
Net income (loss).......................... $ 3,272 $ 3,706 $ (4,795) $ 5,769 $ 3,677 $ 9,132
----------- --------- ---------- ---------- ---------- ----------
----------- --------- ---------- ---------- ---------- ----------
Pro forma net income (loss)
(unaudited)(1)........................... $ 1,943 $ 2,140 $ (5,738) $ 5,574 $ 3,365
----------- --------- ---------- ---------- ----------
----------- --------- ---------- ---------- ----------
Income per share(2)........................ $ 0.18 $ 0.19 $ (0.21) $ 0.19 $ 0.13 $ 0.23
----------- --------- ---------- ---------- ---------- ----------
----------- --------- ---------- ---------- ---------- ----------
Diluted income per share(2)................ $ 0.18 $ 0.19 $ (0.21) $ 0.17 $ 0.12 $ 0.22
----------- --------- ---------- ---------- ---------- ----------
----------- --------- ---------- ---------- ---------- ----------
Pro forma income (loss) per share
(unaudited)(2)........................... $ 0.11 $ 0.11 $ (0.25) $ 0.18 $ 0.12
----------- --------- ---------- ---------- ----------
----------- --------- ---------- ---------- ----------
Pro forma diluted income (loss) per share
(unaudited)(2)........................... $ 0.11 $ 0.11 $ (0.25) $ 0.17 $ 0.11
----------- --------- ---------- ---------- ----------
----------- --------- ---------- ---------- ----------
</TABLE>
13
<PAGE>
<TABLE>
<CAPTION>
NINE MONTHS ENDED
YEAR ENDED DECEMBER 31, SEPTEMBER 30,
---------------------------------------------- ----------------------
1994 1995 1996 1997 1997 1998
----------- --------- ---------- ---------- ---------- ----------
(UNAUDITED) (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C>
Weighted average number of common shares
outstanding(2)........................... 18,218 19,373 23,292 30,221 28,650 39,147
Weighted average number of diluted common
shares outstanding(2).................... 18,218 19,373 23,292 32,978 31,580 40,921
</TABLE>
<TABLE>
<CAPTION>
AS OF DECEMBER 31, AS OF SEPTEMBER 30,
----------------------------------------------- ----------------------
1994 1995 1996 1997 1997 1998
----------- ---------- ---------- ---------- ---------- ----------
(UNAUDITED) (UNAUDITED)
<S> <C> <C> <C> <C> <C> <C>
(IN THOUSANDS)
CONSOLIDATED BALANCE SHEET DATA:
Working capital (deficit).............. $ 2,135 $ 976 $ (7,729) $ 13,760 $ 20,744 $ 116,565
Total assets........................... 9,081 26,582 63,054 120,316 108,062 334,020
Total long-term liabilities, net of
current portion...................... 21 919 6,839 12,970 12,599 32,691
Retained earnings (deficit)............ 1,377 867 (3,238) 1,534 (354) 10,666
Stockholders' equity................... 2,956 3,808 6,897 43,201 40,822 205,065
</TABLE>
<TABLE>
<CAPTION>
NINE MONTHS ENDED
YEAR ENDED DECEMBER 31, SEPTEMBER 30,
----------------------------------------------- ------------------------
1994 1995 1996 1997 1997 1998
----------- ---------- ---------- ---------- ---------- ------------
(UNAUDITED) (UNAUDITED)
<S> <C> <C> <C> <C> <C> <C>
(IN THOUSANDS, EXCEPT PER MINUTE DATA)
OTHER CONSOLIDATED FINANCIAL AND
OPERATING DATA:
Capital expenditures(3)................. $ 515 $ 2,716 $ 13,646 $ 25,422 $ 16,879 $ 85,947
Wholesale billed minutes of use(4)...... -- 38,106 479,681 863,295 580,757 1,119,278
Wholesale revenue per billed minute of
use(5)................................ $ -- $ 0.4102 $ 0.4288 $ 0.3997 $ 0.4130 $ 0.3290
</TABLE>
- ------------------------
(1) The pro forma net income or loss per share assumes that both STAR and L.D.
Services, Inc. ("LDS"), which was acquired by STAR in a pooling of interests
transaction on November 30, 1997, were C-corporations for all periods
presented.
(2) See Note 2 of Notes to STAR Consolidated Financial Statements for an
explanation of the method used to determine the number of shares used in
computing income and pro forma income (loss) per share.
(3) Includes assets financed with capital leases or notes. See Note 2 of Notes
to STAR Consolidated Financial Statements.
(4) Does not include wholesale billed minutes of use from T-One Corp. ("T-One")
prior to the T-One merger in March 1998.
(5) Represents wholesale gross call usage revenue per billed minute. Amounts
exclude other revenue related items such as finance charges. This data does
not include wholesale billed minutes of use from T-One prior to the T-One
merger in March 1998.
14
<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA OF
PT-1 COMMUNICATIONS, INC.
The following selected financial data should be read in conjunction with
PT-1's Consolidated Financial Statements and Notes thereto and with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations of PT-1," each of which is included elsewhere in this Proxy
Statement. The consolidated statements of operations data for the period ended
March 31, 1996 and for the fiscal years ended March 31, 1997 and 1998, and the
balance sheet data at March 31, 1997 and 1998 have been derived from PT-1's
audited financial statements and notes thereto, which are included elsewhere in
this Proxy Statement. The consolidated statements of operations data for the six
months ended September 30, 1998 and 1997 and the consolidated balance sheet data
at September 30, 1998 and 1997 are unaudited and are derived from unaudited
financial statements included elsewhere in this Proxy Statement.
<TABLE>
<CAPTION>
PERIOD FROM
APRIL 21, 1995 FISCAL YEARS ENDED MARCH SIX MONTHS ENDED
(INCEPTION)(1) 31, SEPTEMBER 30,
TO ------------------------ ----------------------
MARCH 31, 1996 1997 1998 1997 1998
--------------- ---------- ------------ ---------- ----------
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
Revenues(2)................................... $ 11,922 $ 169,635 $ 431,520 $ 187,044 $ 268,919
Operating expenses:
Cost of services............................ 13,812 166,184 395,501 170,753 248,222
Selling, general and administrative......... 1,017 4,300 15,063 5,551 15,326
Depreciation and amortization............... 5 75 1,535 386 1,714
Merger costs................................ -- -- -- -- 975
Stock based compensation(3)................. -- 7,300 2,661 1,856 382
------- ---------- ------------ ---------- ----------
Total operating expenses.................. 14,834 177,859 414,760 178,546 266,619
Operating profit (loss)....................... (2,912) (8,224) 16,760 8,498 2,300
Earnings (loss) before income taxes........... (2,910) (8,120) 16,730 8,527 1,724
Income tax provision (benefit)................ -- -- 5,150 2,018 355
Net earnings (loss)........................... $ (2,910) $ (8,120) $ 11,580 $ 6,509 $ 1,369
------- ---------- ------------ ---------- ----------
------- ---------- ------------ ---------- ----------
Net earnings (loss) per share(4)
Basic....................................... $ (.05) $ (.13) $ .25 $ .14 $ .03
Diluted..................................... $ (.05) $ (.13) $ .24 $ .14 $ .03
Weighted average number of common shares and
common share equivalents(4):
Basic....................................... 60,900 60,681 46,922 45,708 48,407
Diluted..................................... 60,900 60,681 47,720 46,987 48,587
</TABLE>
<TABLE>
<CAPTION>
AS OF MARCH 31, AS OF SEPTEMBER 30,
------------------------------------ ------------------------
1996 1997 1998 1997 1998
--------- ---------- ------------- ---------- ------------
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER MINUTE DATA)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents......................... $ 694 $ 5,577 $ 12,390 $ 11,546 $ 5,382
Working capital (deficit)......................... (3,064) (17,426) (21,720) (20,456) (38,484)
Property and equipment, net....................... 69 1,484 22,609 9,152 43,480
Total assets...................................... 2,186 18,899 87,677 48,678 106,952
Long term debt, less current portion.............. -- 5,000 -- 5,000 --
Total shareholders' equity (deficiency)........... (2,907) (18,727) (1,221) (10,363) 395
</TABLE>
15
<PAGE>
<TABLE>
<CAPTION>
AS OF MARCH 31, AS OF SEPTEMBER 30,
------------------------------------ ------------------------
1996 1997 1998 1997 1998
--------- ---------- ------------- ---------- ------------
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER MINUTE DATA)
<S> <C> <C> <C> <C> <C>
OTHER FINANCIAL AND OPERATING DATA:
Capital expenditures.............................. $ 74 $ 1,489 $ 11,255 $ 7,949 $ 22,086
Number of PINs activated.......................... N/A 31,087 60,688 28,694 30,660
Billed minutes of use(5).......................... 38,977 615,006 1,676,619 687,007 1,215,280
Revenues per billed minute of use(2).............. .31 .28 .26 .27 .22
</TABLE>
- ------------------------
(1) PT-1 was incorporated in New York on April 21, 1995 and had limited
operations until July 1995.
(2) Revenues are recorded net of distributor discounts and are not necessarily
comparable to other telecommunications carriers.
(3) Relates to (i) the grant to Joseph Pannullo, an executive officer of PT-1,
on May 9, 1997, of options to purchase 1,048,600 shares of PT-1 Common Stock
exercisable at a nominal price; (ii) the grant to certain other employees of
PT-1 of options to purchase shares of PT-1 Common Stock with a value of
$850,000, exercisable at a nominal price; (iii) the grant to Helene Kidary,
an employee, on September 30, 1997, of options to purchase 10,000 shares of
PT-1 Common Stock exercisable at a nominal price; (iv) warrants issued to
certain employees of InterExchange, Inc. ("InterExchange") to acquire shares
of PT-1 Common Stock with a fair value of $3 million at an aggregate
exercise price of $1.0 million, and (v) the issuance of shares on March 31,
1997 to two officers of PT-1 in accordance with commitments made in July
1995 and March 1996, the dates they joined PT-1. Such shares were issued in
connection with the settlement agreement dated March 27, 1997. See Notes 5
and 8 of Notes to PT-1's Consolidated Financial Statements.
(4) See Note 1 to the PT-1 Financial Statements for an explanation of the method
used to determine the number of shares used in computing net earnings (loss)
per share and weighted average number of common shares and common share
equivalents.
(5) "Billed minutes of use" represents minutes billed by underlying carriers for
terminating PT-1's long distance traffic.
16
<PAGE>
COMPARATIVE PER SHARE DATA
The following table presents certain historical, pro forma and pro forma
equivalent per share financial data with respect to shares of STAR Common Stock
and PT-1 Common Stock. Also presented below is pro forma data assuming that
STAR's merger with United Digital Network, Inc. ("UDN") is completed and all
prior STAR financial data has been restated to show the effect of such
transaction on STAR, UDN and PT-1, collectively. See "Risk Factors--Risks
Inherent in Acquisition Strategy." The pro forma data does not purport to be
indicative of actual results that would have occurred had the mergers been
consummated on such dates or of future expected results. The information
presented herein should be read in conjunction with the unaudited pro forma
financial data and the related notes thereto, appearing elsewhere in this Proxy
Statement. See "Unaudited Pro Forma Financial Data."
<TABLE>
<CAPTION>
PRO FORMA PRO FORMA
HISTORICAL EQUIVALENT COMBINED COMBINED
---------------------- PRO FORMA STAR AND STAR, UDN
STAR(1) PT-1 PT-1(2) PT-1(3) AND PT-1(4)
----------- --------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C>
INCOME PER COMMON SHARE FOR(5):
Year ended December 31, 1997............................. $ 0.18 $ 0.25 $ 0.04 $ 0.13 $ 0.03
Nine months ended September 30, 1998..................... $ 0.23 $ 0.08 $ 0.03 $ 0.09 $ 0.05
DILUTED INCOME PER COMMON SHARE FOR(5):
Year ended December 31, 1997............................. $ 0.17 $ 0.24 $ 0.04 $ 0.13 $ 0.03
Nine months ended September 30, 1998..................... $ 0.22 $ 0.08 $ 0.03 $ 0.08 $ 0.05
BOOK VALUE PER COMMON SHARE AT(6):
September 30, 1998....................................... $ 4.86 $ 0.01 $ 1.97 $ 6.23 $ 6.04
CASH DIVIDENDS DECLARED PER COMMON SHARE(7):............. -- -- -- -- --
</TABLE>
- --------------------------
(1) The STAR historical per share financial data includes the effect of STAR's
acquisition of T-One, which was completed on March 10, 1998.
(2) The equivalent pro forma PT-1 share data is computed by multiplying the
corresponding pro forma combined STAR and PT-1 amounts by an estimated
exchange ratio of 0.31607. This exchange ratio does not give effect to the
$19.5 million cash payment to be paid by STAR in the Merger.
(3) The pro forma combined STAR and PT-1 per share data assumes that STAR's
acquisition of UDN has not been
completed and that the Merger had occurred on January 1, 1997 for the year
ended December 31, 1997 and the nine months ended September 30, 1998 and
that the Merger had occurred on September 30, 1998 in the case of book value
data at September 30, 1998. This pro forma data reflects an exchange ratio
of 0.31607 of a share of STAR Common Stock for each share of PT-1 Common
Stock acquired in the Merger.
(4) The pro forma combined equivalent per share data for STAR, UDN and PT-1
assumes that STAR's acquisitions of both UDN and PT-1 have been completed
and that all prior financial data has been restated to show the effect of
the merger with UDN and that the Merger had occurred on January 1, 1997 for
the year ended December 31, 1997 and the nine months ended September 30,
1998 and that the Merger had occurred on September 30, 1998 in the case of
book value data at September 30, 1998. This pro forma data reflects an
exchange ratio of 0.31607 of a share of STAR Common Stock for each share of
PT-1 Common Stock in the Merger and an exchange ratio of 0.86772 of a share
of STAR Common Stock for each share of UDN Common Stock in the UDN merger
(see Note 3 to Notes to Unaudited Pro Forma Condensed Combined Financial
Data).
(5) Assumes that both STAR and LDS, which was acquired by STAR in a pooling of
interests transaction on November 30, 1997, were C-corporations for all
periods presented.
(6) The historical book value per common share of each of STAR and PT-1 is
computed by dividing stockholders' equity by the number of shares of STAR
Common Stock or PT-1 Common Stock, as the case may be, outstanding at
September 30, 1998. The equivalent pro forma PT-1 book value per common
share is computed by multiplying the corresponding pro forma combined STAR
and PT-1 book value per common share by an estimated exchange ratio of
0.31607. The pro forma combined book value per common share is computed by
dividing pro forma stockholders' equity by the sum of the number of shares
of common stock of UDN outstanding at September 30, 1998 multiplied by the
conversion ratio, and the number of shares of STAR Common Stock to be issued
in the Merger, as applicable.
(7) Does not include S-corporation distributions to LDS shareholders prior to
LDS' merger with STAR on November 30, 1997.
17
<PAGE>
SUMMARY UNAUDITED PRO FORMA FINANCIAL DATA
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
The following table presents summary unaudited pro forma financial data that
was derived from the unaudited pro forma financial data included elsewhere in
this Proxy Statement and should be read in conjunction therewith and with the
related notes thereto. See "Unaudited Pro Forma Financial Data." The summary
unaudited pro forma financial data gives effect to the Merger as if it had
occurred on January 1, 1997, in case of the statements of operations data, and
as if the Merger had occurred on September 30, 1998, in case of the balance
sheet data. None of the unaudited pro forma financial data set forth below
includes any financial data regarding UDN. STAR reports its financial data on
the basis of a December 31 fiscal year and PT-1 reports its financial data on
the basis of a March 31 fiscal year.
<TABLE>
<CAPTION>
NINE MONTHS ENDED
YEAR ENDED SEPTEMBER 30,
DECEMBER 31, ----------------------
1997 1997 1998
------------ ---------- ----------
(IN THOUSANDS EXCEPT PER SHARE
AMOUNTS)
(UNAUDITED)
<S> <C> <C> <C>
STATEMENTS OF OPERATIONS DATA(1):
REVENUES................................................................. $ 786,684 $ 498,750 $ 758,208
------------ ---------- ----------
OPERATING EXPENSES:
Cost of services....................................................... 697,881 441,131 664,814
Selling, general and administrative.................................... 55,207 41,904 62,709
Depreciation and amortization.......................................... 15,223 10,267 17,328
------------ ---------- ----------
Total operating expenses:............................................ 768,311 493,302 744,851
------------ ---------- ----------
Income (loss) from operations........................................ 18,373 5,448 13,357
------------ ---------- ----------
OTHER INCOME (EXPENSE):
Interest income........................................................ -- -- 3,052
Interest expense....................................................... (2,933) (1,987) (3,281)
Legal settlement and expenses.......................................... (1,653) -- --
Other income (expense)................................................. 682 (1,256) 25
------------ ---------- ----------
Total other income (expense):........................................ (3,904) (3,243) (204)
------------ ---------- ----------
Income (loss) before provision for income taxes...................... 14,469 2,205 13,153
PROVISION FOR INCOME TAXES(1).......................................... 8,406 4,018 8,397
------------ ---------- ----------
NET INCOME (LOSS)(1)..................................................... $ 6,063 $ (1,813) $ 4,756
------------ ---------- ----------
------------ ---------- ----------
Earnings (loss) per common share:(1)
Basic.................................................................. $ 0.13 $ (0.04) $ 0.09
Diluted................................................................ $ 0.13 $ (0.04) $ 0.08
Weighted average number of common shares outstanding:
Basic.................................................................. 45,521 43,950 54,447
Diluted................................................................ 48,278 43,950 56,221
</TABLE>
<TABLE>
<CAPTION>
SEPTEMBER 30,
1998
-------------
(UNAUDITED)
<S> <C>
BALANCE SHEET DATA:
Working capital.................................................................................. $ 46,827
Total assets..................................................................................... 578,225
Long term obligations (including current portion)................................................ 47,896
Stockholders equity.............................................................................. 358,021
</TABLE>
- ------------------------
(1) Assumes that both STAR and LDS, which was acquired by STAR in a pooling of
interests transaction on November 30, 1997, were C-corporations for all
periods presented.
18
<PAGE>
SUMMARY UNAUDITED PRO FORMA FINANCIAL DATA
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
The following table presents summary unaudited pro forma financial data that
was derived from the unaudited pro forma financial data included elsewhere in
this Proxy Statement and should be read in conjunction therewith and with the
related notes thereto. See "Unaudited Pro Forma Financial Data." The following
summary unaudited pro forma financial data is presented assuming the acquisition
of PT-1 will be accounted for as a purchase and the UDN merger will be accounted
for as a pooling of interests, whereby STAR will restate its historical
consolidated financial statements to include the assets, liabilities,
stockholders' equity (deficit) and results of operations of UDN. The statements
of operations data set forth below reflects the combination of the historical
operating results of STAR for the years ended December 31, 1995, 1996 and 1997
and the nine months ended September 30, 1997 and 1998, the historical operating
results of UDN for the twelve months ended January 31, 1996, 1997 and 1998 and
the nine months ended September 30, 1997 and 1998, respectively, and the effect
of the PT-1 acquisition for the year ended December 31, 1997 and the nine month
periods ended September 30, 1997 and 1998. The balance sheet data set forth
below reflects the combination of the historical balance sheet data of STAR with
the historical balance sheet data of UDN plus the effect of the PT-1 acquisition
as of September 30, 1998. STAR reports its financial data on the basis of a
December 31 fiscal year, and PT-1 reports its financial data on the basis of a
March 31 fiscal year. Through April 30, 1997, UDN reported its financial data on
the basis of an April 30 fiscal year. Subsequently, UDN changed its fiscal year
end to December 31.
<TABLE>
<CAPTION>
NINE MONTHS ENDED
YEARS ENDED DECEMBER 31, SEPTEMBER 30,
--------------------------------- ----------------------
1995 1996 1997 1997 1998
--------- ---------- ---------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
STATEMENTS OF OPERATIONS DATA(1):
REVENUES.............................................. $ 64,605 $ 279,123 $ 816,710 $ 520,494 $ 777,812
OPERATING EXPENSES:
Cost of services.................................... 48,569 240,749 721,361 457,612 679,233
Selling, general and administrative................. 12,946 40,519 66,751 48,223 69,111
Depreciation and amortization....................... 852 2,260 16,233 10,987 18,164
--------- ---------- ---------- ---------- ----------
Total operating expenses:........................... 62,367 283,528 804,345 516,822 766,508
--------- ---------- ---------- ---------- ----------
Income (loss) from operations....................... 2,238 (4,405) 12,365 3,672 11,304
--------- ---------- ---------- ---------- ----------
OTHER INCOME (EXPENSE):
Interest income..................................... 10 114 -- -- 2,776
Interest expense.................................... (155) (1,057) (3,839) (2,667) (3,722)
Legal settlement and expenses....................... -- (100) (1,653) -- --
Other income (expense).............................. (216) 56 276 (1,256) (274)
--------- ---------- ---------- ---------- ----------
Total other income (expense):....................... (361) (987) (5,216) (3,923) (1,220)
--------- ---------- ---------- ---------- ----------
Income (loss) before provision for income taxes..... 1,877 (5,392) 7,149 (251) 10,084
PROVISION FOR INCOME TAXES............................ 813 1,470 5,790 2,921 7,105
--------- ---------- ---------- ---------- ----------
Net income (loss) before extraordinary gain......... 1,064 (6,862) 1,359 (3,172) 2,979
Extraordinary gain on debt restructuring............ -- -- -- 52 --
--------- ---------- ---------- ---------- ----------
NET INCOME (LOSS)..................................... $ 1,064 $ (6,862) $ 1,359 $ (3,120) $ 2,979
--------- ---------- ---------- ---------- ----------
--------- ---------- ---------- ---------- ----------
</TABLE>
19
<PAGE>
<TABLE>
<CAPTION>
NINE MONTHS ENDED
YEARS ENDED DECEMBER 31, SEPTEMBER 30,
--------------------------------- ----------------------
1995 1996 1997 1997 1998
--------- ---------- ---------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Earnings (loss) per common share:
Basic............................................... $ 0.05 $ (0.29) $ 0.03 $ (0.07) $ 0.05
Diluted............................................. $ 0.05 $ (0.29) $ 0.03 $ (0.07) $ 0.05
Weighted average number of common shares outstanding:
Basic............................................... 19,662 23,730 46,071 44,473 55,052
Diluted............................................. 19,662 23,730 48,828 44,473 56,826
</TABLE>
<TABLE>
<CAPTION>
SEPTEMBER 30,
1998
-------------
(UNAUDITED)
<S> <C>
BALANCE SHEET DATA:
Working capital.................................................................................. $ 32,793
Total assets..................................................................................... 585,461
Long term obligations (including current portion)................................................ 49,171
Stockholders equity.............................................................................. 351,259
</TABLE>
- ------------------------
(1) Assumes that both STAR and LDS, which was acquired by STAR in a pooling of
interests transaction on November 30, 1997, were C-corporations for all
periods presented.
20
<PAGE>
RISK FACTORS
THE FOLLOWING RISK FACTORS SHOULD BE CONSIDERED CAREFULLY IN ADDITION TO THE
OTHER INFORMATION CONTAINED IN THIS PROXY STATEMENT IN CONSIDERING WHETHER TO
APPROVE AND ADOPT THE MERGER AGREEMENT AND THE TRANSACTIONS CONTEMPLATED
THEREBY. THIS PROXY STATEMENT CONTAINS, IN ADDITION TO HISTORICAL INFORMATION,
"FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES
ACT THAT INVOLVE RISKS AND UNCERTAINTIES. STAR'S ACTUAL RESULTS MAY DIFFER
MATERIALLY FROM THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS. FACTORS THAT
MAY CAUSE SUCH A DIFFERENCE INCLUDE, BUT ARE NOT LIMITED TO, THOSE SET FORTH
BELOW AND ELSEWHERE IN THIS PROXY STATEMENT. SEE "DESCRIPTION OF FORWARD-LOOKING
STATEMENTS." REFERENCES HEREIN TO THE PRODUCTS, BUSINESS, RESULTS OF OPERATIONS,
FINANCIAL CONDITION OR OTHER FACTORS AFFECTING THE OPERATIONS OF STAR OR PT-1
SHOULD BE CONSIDERED TO REFER TO STAR AND PT-1 OPERATING AS A COMBINED ENTITY
AFTER THE CONSUMMATION OF THE MERGER.
RISKS RELATING TO CONTROL OF PT-1
In accordance with the terms and conditions of the Merger Agreement, as
amended on September 1, 1998, STAR has exercised de facto managerial and
operational control over PT-1 since that date. Notwithstanding such
circumstances, the completion of the Merger depends upon the satisfaction of a
number of material conditions, such as the adoption of the Merger Agreement by
the holders of record of a majority of the issued and outstanding shares of STAR
Common Stock and the approval by applicable governmental authorities of the
Merger Agreement. If, for any reason, the conditions to the Merger are not
satisfied and the Merger is not consummated, STAR's involvement in the business
and operations of PT-1 will need to be unraveled, resulting in STAR's incurrence
of what may be material unanticipated costs and expenses. On August 17, 1998
STAR loaned to PT-1 $10 million to allow for the expansion of PT-1's dial around
program and for working capital purposes (the "PT-1 Loan"). If the Merger
Agreement was terminated, STAR would become no more than an unsecured creditor
of PT-1 with respect to the PT-1 Loan.
NO ASSURANCE THAT STAR WILL REALIZE ANTICIPATED BENEFITS FROM THE MERGER
STAR's acquisition of PT-1 through the Merger is the most significant
transaction in the history of STAR. The Merger involves the combination of
certain aspects of two companies that have operated independently. The process
of integrating the STAR and PT-1 businesses, operations and employees will
present a significant challenge to STAR's management and may lead to
unanticipated costs. Accordingly, there can be no assurance that PT-1 can be
successfully integrated into STAR or that STAR and its stockholders (including
persons who become stockholders as a result of the Merger) will ultimately
realize any of the anticipated benefits of the Merger.
STAR's business has historically focused on providing switched voice
services on a wholesale basis, primarily to U.S.-based long distance carriers.
Alternatively, PT-1's operations are primarily focused on the marketing of
Prepaid Cards to the retail marketplace of individual end-users. Thus, STAR and
PT-1 operate in fundamentally different business segments of the
telecommunications market. These differences create real challenges to the
ability of STAR to integrate PT-1 operations and personnel. Difficulties in the
integration process may occur due to, among other things, PT-1's emphasis on
marketing of particular Prepaid Cards to specific segments of the retail market,
its need to maintain strong ties to a network of independent distributors,
PT-1's need for the continual introduction of new products into the domestic
market to achieve desired growth and the distance between STAR's Santa Barbara
headquarters and PT-1's New York-based operations. Their can be no assurance
that STAR will be able to overcome these challenges to integration.
In addition, the integration of the STAR and PT-1 accounting and personnel
administrative functions involves the risk that key employees in those
operations, who can not be easily replaced, will leave even when offered
continuing employment. The integration approach adopted by STAR with respect to
PT-1 requires the devotion of a significant amount of time by senior executives,
which may detract from business operations and the development of the combined
companies.
21
<PAGE>
In considering the Merger, the Board considered, among other things, the
cost savings, operating efficiencies and other synergies expected to result
following the consummation thereof. See "The Merger--STAR's Reasons for the
Merger" and "--Vote Required and Recommendation of the Board." There can be no
assurance that any of such cost savings, operating efficiencies or other
synergies will be accomplished as rapidly as currently expected or at all or
that such savings and synergies will not be offset by increases in other
expenses or operating losses, including losses due to problems arising from the
integration of STAR and PT-1.
RISKS RELATING TO THE PREPAID CARD BUSINESS
PT-1's operations and the Prepaid Card business in general have a number of
inherent risks, which can be summarized to include the following: (a) the
increased penetration into the market by competitive Prepaid Card vendors,
including those that are substantially larger than PT-1 or STAR, (b) the
relatively low barriers to entry for start-up Prepaid Card operators, (c) the
reliance on independent distributors to place Prepaid Cards in retail outlets,
coupled with the inability to create exclusive phone card distribution
arrangements, (d) the lack of formalized written agreements between PT-1 and its
distributors and among PT-1's distributors and any other party in the PT-1
Prepaid Card chain of supply, (e) the price-sensitive, fickle nature of consumer
demand and (f) the relative lack of customer loyalty to any particular Prepaid
Card company.
The relative lack of customer loyalty to any particular Prepaid Card company
and the increasing penetration into the Prepaid Card market by various
competitors, including those substantially larger than PT-1 or STAR, could place
downward pressure on industry wide Prepaid Card pricing. Due to PT-1's
dependence on informal relationships with independent distributors for the
marketing and sale of its products, increased competition and downward price
pressure could force PT-1 to provide Prepaid Cards that are more price
competitive in order to continue to sell Prepaid Cards to these distributors.
There can be no assurance that PT-1 will continue to provide competitively
priced Prepaid Cards to its distributors or that downward price pressure in the
Prepaid Card marketplace will not adversely affect PT-1's results of operations.
RISKS INHERENT IN ACQUISITION STRATEGY
An important component to STAR's strategy is to grow and expand through
acquisitions. This growth strategy is dependent on the continued availability of
suitable acquisition candidates and subjects STAR to a number of risks. STAR has
recently completed two acquisitions, LDS on November 30, 1997, and T-One on
March 10, 1998. On November 19, 1997, STAR entered into an agreement to acquire
UDN. The acquisition of UDN is subject to the approval of UDN's stockholders and
to various regulatory approvals, and the completion of this acquisition is not a
certainty. On August 20, 1998, STAR entered into the Merger Agreement to acquire
PT-1. The acquisition of PT-1 is subject to the satisfaction of certain
conditions, including the approval of STAR's stockholders and to various
regulatory approvals, any of which could prevent the consummation of the Merger.
These acquisitions, and, most particularly, the Merger, have placed, and will
continue to place, significant demands on STAR's financial and management
resources, as the process for integrating acquired operations presents a
significant challenge to STAR's management and may lead to unanticipated costs
or a diversion of management's attention from day-to-day operations. Integrating
acquisitions may require integration of financial and call routing systems,
network and other physical facilities and personnel. Difficulties in integrating
these and other acquisitions can cause system degradation, added costs and loss
of personnel or customers. Additionally, STAR may incur unknown liabilities
despite management's efforts to investigate the operations of the acquired
business. The impact of the risks arising as a result of STAR's acquisition
strategy could adversely affect STAR's operating results.
22
<PAGE>
OPERATING RESULTS SUBJECT TO SIGNIFICANT FLUCTUATIONS; LIMITED HISTORY
STAR
STAR's quarterly operating results are difficult to forecast with any degree
of accuracy because a number of factors subject these results to significant
fluctuations. As a result, STAR believes that period-to-period comparisons of
its operating results are not necessarily meaningful and should not be relied
upon as indications of future performance.
STAR's revenues, costs and expenses have fluctuated significantly in the
past and are likely to continue to fluctuate significantly in the future as a
result of numerous factors. STAR's revenues in any given period can vary due to
factors such as call volume fluctuations, particularly in regions with
relatively high per-minute rates; the addition or loss of major customers,
whether through competition, merger, consolidation or otherwise; the loss of
economically beneficial routing options for the termination of STAR's traffic;
financial difficulties of major customers; pricing pressure resulting from
increased competition; and technical difficulties with or failures of portions
of STAR's network that impact STAR's ability to provide service to or bill its
customers. STAR's cost of services and operating expenses in any given period
can vary due to factors such as fluctuations in rates charged by carriers to
terminate STAR's traffic; increases in bad debt expense and reserves; the timing
of capital expenditures, and other costs associated with acquiring or obtaining
other rights to switching and other transmission facilities; changes in STAR's
sales incentive plans; and costs associated with changes in staffing levels of
sales, marketing, technical support and administrative personnel. In addition,
STAR's operating results can vary due to factors such as changes in routing due
to variations in the quality of vendor transmission capability; loss of
favorable routing options; the amount of, and the accounting policy for, return
traffic under operating agreements; actions by domestic or foreign regulatory
entities; the level, timing and pace of STAR's expansion in international and
commercial markets; and general domestic and international economic and
political conditions. Further, a substantial portion of transmission capacity
used by STAR is obtained on a variable, per minute and short term basis,
subjecting STAR to the possibility of unanticipated price increases and service
cancellations. Since STAR does not generally have long term arrangements for the
purchase or resale of long distance services, and since rates fluctuate
significantly over short periods of time, STAR's gross margins are subject to
significant fluctuations over short periods of time. STAR's gross margins also
may be negatively impacted in the longer term by competitive pricing pressures.
PT-1
PT-1 was organized in April 1995 and has only a limited operating history
upon which to evaluate its performance. PT-1's operating results may vary
significantly in the future due to numerous factors, including (i) the timing of
the introduction of new products and services, (ii) changes in U.S. and foreign
legislation and regulation which affect the competitive environment for PT-1's
products and services, (iii) market acceptance of new products and services and
(iv) other competitive conditions. Accordingly, PT-1's prospects must be
considered in light of the risks, expenses, problems and delays inherent in
establishing a new business in a rapidly changing industry, and prior results of
operations should not be relied upon as an indication of PT-1's future
performance. See "--Ability to Continue and Manage Growth; Commercial
Market--PT-1;" "Management's Discussion and Analysis of Financial Condition and
Results of Operations of PT-1;" "Business of PT-1--Telecommunications Products
and Services" and "--Competition."
ABILITY TO CONTINUE AND MANAGE GROWTH; COMMERCIAL MARKET
STAR
STAR has increased revenues from $58.9 million in 1995 to $404.6 million in
1997. Such growth should not be considered indicative of future revenue growth
or operating results. If revenue levels fall below expectations, net income is
likely to be disproportionately adversely affected because a proportionately
smaller amount of STAR's operating expenses varies with its revenues. This
effect is likely to increase
23
<PAGE>
as a greater percentage of STAR's cost of services are associated with owned and
leased facilities. There can be no assurance that STAR will be able to achieve
or maintain profitability on a quarterly or annual basis in the future. It is
likely that in some future quarter STAR's operating results will be below the
expectations of public market analysts and investors. In such event, the price
of STAR Common Stock would likely be materially adversely affected. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations of STAR."
As part of STAR's significant revenue growth, it has expanded, and plans to
continue to expand, the number of its employees and the geographic scope of its
operations. Additionally, an important component of STAR's strategy is to grow
and expand through acquisitions, such as the Merger. These factors have
resulted, and will continue to result, in increased responsibilities for
management personnel and have placed, and will continue to place, increased
demands upon STAR's operating and financial systems, as well as its systems for
ensuring regulatory compliance, all of which may lead to unanticipated costs and
divert management's attention from day-to-day operations. STAR may also be
required to attract, train and retain additional highly qualified management,
technical, regulatory, sales and marketing and customer support personnel. The
process of locating such personnel with the combination of skills and attributes
required to implement STAR's strategy is often lengthy. The inability to attract
and retain additional qualified personnel could materially and adversely affect
STAR. STAR expects that its expansion into foreign countries will lead to
increased financial and administrative demands, such as increased operational
complexity associated with expanded network facilities, administrative burdens
associated with managing an increasing number of foreign subsidiaries and
relationships with foreign partners and expanded treasury functions to manage
foreign currency risks. STAR's accounting systems and policies have been
developed as STAR has experienced significant growth. There can be no assurance
that STAR's personnel, systems, procedures and controls will be adequate to
support STAR's future operations. See "--Dependence on Key Personnel" and
"Business of STAR--Employees."
With the acquisition of LDS, STAR began providing service to the commercial
market, which is more labor intensive than the wholesale market, and as a result
has higher overhead costs. STAR also may be required to update and improve its
billing systems and procedures and/or hire new management personnel to handle
the demands of the commercial market. There can be no assurance that STAR will
be able to effectively manage the costs of and risks associated with its
expansion into the commercial market.
PT-1
Although PT-1 has experienced substantial growth in revenues since inception
and expects to continue to grow, there can be no assurance that the growth
experienced by PT-1 will continue or that PT-1 will be able to expand its
telecommunications infrastructure, add services, expand its customer bases and
markets, install additional POPs or implement the other features of its business
strategy at the rate or to the extent presently planned. The Prepaid Card
segment of the telecommunications industry is an emerging business with an
increasing and substantial number of new market entrants. These entrants are
seeking to market, advertise and position their products and services as the
preferred method for accessing long distance telephone services. Because the
Prepaid Card segment is an emerging market, demand for and market acceptance of
newly introduced products and services is uncertain. There can be no assurance
that substantial markets will continue to develop for Prepaid Cards or that PT-1
will be able to meet its current marketing objectives, succeed in positioning
its products and services as a preferred method for accessing long distance
telephone services, increase market acceptance of its existing products and
services or achieve significant market acceptance of its new products and
services.
PT-1's recent growth has placed, and is expected to continue to place,
significant demands on all aspects of PT-1's business, including its management,
financial, technical and administrative personnel and its systems. There can be
no assurance that PT-1's systems, procedures and controls and existing office
space will be adequate to support expansion of PT-1's operations. PT-1's future
operating results will substantially depend upon the ability of its executive
officers to manage its growth and to attract and retain
24
<PAGE>
additional highly qualified personnel. In addition, as PT-1 increases its
service offerings and expands its target markets, there will be additional
demands on its customer service support and sales and marketing resources. There
can be no assurance that PT-1 will successfully manage its expanding operations
and continued growth or attract additional personnel, and any failure to do so
could have a material adverse effect on PT-1's business, financial condition or
results of operations. See "Business of PT-1--Strategy" and "--Employees."
RISKS ASSOCIATED WITH GROWTH OF STAR'S TELECOMMUNICATIONS NETWORK AND CUSTOMER
BASE
Historically, STAR has relied primarily on leased transmission capacity for
the delivery of its telecommunications services. STAR's telecommunications
expenses have in the past primarily been variable, based upon minutes of use,
consisting largely of payments to other long distance carriers, customer/carrier
interconnect charges, leased fiber circuit charges and switch facility costs.
During 1997, however, STAR made considerable capital expenditures in order to
expand its network, and intends to continue to do so in the future. See
"Business of STAR--Network." Although STAR's strategy is to seek to establish
significant traffic volumes prior to investing in fixed-cost facilities, the
development of such facilities entails significant costs and prior planning,
which are based in part on STAR's expectations concerning future revenue growth
and market developments. As STAR expands its network and the volume of its
network traffic, its cost of revenues will increasingly consist of fixed costs
arising from the ownership and maintenance of its switches and undersea fiber
optic cables. While STAR believes that in the long-term these investments will
allow it to reduce its cost of service and to enhance its service offerings, in
the short-term, cost increases and a decrease in STAR's operating margins may
occur. If STAR's traffic volume were to decrease, or fail to increase to the
extent expected or necessary to make efficient use of its network, STAR's costs
as a percentage of revenues could increase significantly, which could have a
material adverse effect on STAR's business, financial condition or results of
operations.
In addition, STAR's business depends in part on its ability to obtain
transmission facilities on a cost-effective basis. Because undersea fiber optic
cables typically take several years to plan and construct, carriers generally
make investments well in advance, based on a forecast of anticipated traffic.
Therefore, STAR's operations are subject to the risk that it will not adequately
anticipate the amount of traffic over its network, and may not procure
sufficient cable capacity or network equipment in order to ensure the cost-
effective transmission of customer traffic. Although STAR participates in the
planning of undersea fiber optic transmission facilities, it does not control
the construction of such facilities and must seek access to such facilities
through partial ownership positions. If ownership positions are not available,
STAR must seek access to such facilities through lease arrangements on
negotiated terms that may vary with industry and market conditions. There can be
no assurance that STAR will be able to continue to obtain sufficient
transmission facilities or access to undersea fiber optic cables on economically
viable terms. The failure of STAR to obtain telecommunications facilities that
are sufficient to support its network traffic in a manner that ensures the
reliability and quality of its telecommunications services may have a material
adverse effect on its business, financial condition or results of operations.
PT-1'S DEPENDENCE ON AND CONCENTRATION OF INDEPENDENT DISTRIBUTORS
PT-1 distributes substantially all of its Prepaid Cards through wholesale
distributors and does not have an internal retail sales department. Accordingly,
its success is significantly dependent upon its ability to recruit, maintain and
motivate a network of independent distributors. A significant element of PT-1's
growth strategy is to increase retail distribution of PT-1's products and
services by expanding its distribution network in existing markets and by
extending this network into new markets. PT-1 recruits a variety of types of
distributors, including: (a) members of targeted ethnic communities in those
metropolitan areas with high ethnic concentrations, (b) persons who are
currently distributing other types of products to retail outlets, and (c)
individuals who PT-1 believes have the requisite sales and marketing skills to
effectively promote PT-1's products. These types of distributors are typically
identified and recruited through relationships with existing distributors and
retail outlets, telemarketing and related promotional activities
25
<PAGE>
and direct inquiries from potential distributors. There can be no assurance that
PT-1 will be able to continue to effectively recruit, maintain and motivate
independent distributors or to prevent its distributors from marketing other
Prepaid Cards, and, if PT-1 is unable to do so it could have a material adverse
effect on PT-1's business, financial condition and results of operations. See
"Business of PT-1--Strategy."
As of September 30, 1998, PT-1 had approximately 200 distributors purchasing
PT-1's Prepaid Cards, of which approximately 20% (or approximately 40
distributors) were individuals. PT-1 believes that most of its distributors
(both distributors that are individuals and distributors that are corporations
or other business entities) sell PT-1 Prepaid Cards to sub-distributors who, in
turn, sell the cards to retailers. To date, PT-1 has not experienced any
reliability problems with individual distributors. PT-1's accounts receivable
were concentrated among distributors primarily in the Northeast, with one
distributor, Worldwide Telecom, Inc., representing approximately 28% of the net
accounts receivable balance at September 30, 1998. While PT-1 believes that it
could replace this distributor, a loss of this or other distributors could have
a material adverse effect on PT-1's business, financial condition and results of
operations.
PT-1 believes that a majority of Prepaid Cards directly sold to its
distributors are resold to sub-distributors (sometimes called route salespeople)
who resell the cards to retail outlets. The remainder of the cards are resold by
distributors directly to retail outlets. Sub-distributors and route salespeople
typically market other products to retail outlets in addition to Prepaid Cards.
PT-1's relationship with its distributors is based upon past relationships and
buying patterns rather than formalized written agreements. Additionally, PT-1
believes that the distributor relationships between PT-1 and its distributors
and among PT-1's distributors and their sub-distributors, route salespeople and
retail outlet customers are based on past relationships and buying patterns and
do not rely on written contracts. Thus, as a matter of practice, formal written
agreements are virtually non-existent in the PT-1 Prepaid Card chain of supply.
Distributors located in the New York metropolitan area generally pickup
Prepaid Cards directly from PT-1's distribution sites, while PT-1 delivers
Prepaid Cards by common carrier to those distributors located outside of the New
York metropolitan area. A substantial portion of PT-1 Prepaid Card sales are to
distributors who regularly maintain one or more places of business, with
sub-distributors typically picking-up Prepaid Cards directly from the
distributors' places of business. Because PT-1's relationship with distributors
is so informal, PT-1 could lose one or more significant distributors on very
short notice. Such loss could have a material adverse effect on PT-1's results
of operations.
FRAUD; THEFT OF SERVICES; UNCOLLECTIBLE ACCOUNTS
From time to time, callers have obtained services without rendering payment
to PT-1 by unlawfully using PT-1's access numbers and PINs. PT-1 attempts to
manage these theft and fraud risks through its internal controls and its
monitoring and blocking systems. There can be no assurance that PT-1's risk
management practices will be sufficient to protect PT-1 in the future from
unauthorized transactions or thefts of services which could have a material
adverse effect on PT-1's business, financial condition or results of operations.
PT-1 sells Prepaid Cards on terms ranging from cash on delivery to net
thirty days. Prepaid Cards that are shipped via common carrier or sold over the
counter in smaller quantities are generally sold on a cash on delivery basis.
Distributors who exclusively market PT-1's Prepaid Cards and undertake market
penetration efforts in new territories on behalf of PT-1 are generally accorded
terms of net 7-to-30 days. PT-1's extension of credit to distributors is a
standard business practice within the Prepaid Card industry. PT-1 also sells its
Prepaid Cards on a wholesale basis to distributors on 7-to-30 day terms and
sells dial around and presubscribed long distance services for which customers
are billed after services are rendered.
PT-1's accounts receivable balance at September 30, 1998 was approximately
$37.4 million as compared to approximately $18 million at September 30, 1997,
largely as a result of increasing sales to distributors who have entered
emerging markets in geographic areas other than the eastern seaboard.
Participants in the Prepaid Card industry, other than PT-1, have experienced
significant accounts receivable and credit losses. As PT-1 expands its
commercial business following the Merger, including its dial
26
<PAGE>
around and its presubscribed long distance services, accounts receivable
balances will continue to rise materially.
While PT-1 has not experienced material difficulty in collecting its
accounts receivable through September 30, 1998, and, to date, has not suffered
material credit losses, there can be no assurance that, following the Merger, as
accounts receivable balances grow and credit is extended to new retail
customers, PT-1 will be able to adequately monitor and evaluate its accounts
receivable and its credit risks or that it will be able to collect all amounts
due for services rendered. Any material difficulty in collecting rising accounts
receivable and any material credit losses could have a material adverse effect
on PT-1's business, financial condition or results of operations. See "Business
of PT-1--Information Systems; Debit Card Platforms" and "--Prepaid Card
Productions and Inventory Control."
RISKS OF INTERNATIONAL TELECOMMUNICATIONS BUSINESS
STAR has to date generated a substantial majority of its revenues by
providing international telecommunications services to its customers on a
wholesale basis. STAR sends traffic to numerous countries throughout the world,
including India, Mexico and China. Likewise, a substantial majority of PT-1's
revenues to date have been derived from providing international
telecommunications services to its customers, with a significant amount of phone
traffic directed to Mexico, the Dominican Republic and Colombia. For the six
months ended September 30, 1998, Mexico, as a calling destination, generated
approximately 12% of PT-1's revenues. The international nature of STAR and
PT-1's operations involves certain risks, such as changes in U.S. and foreign
government regulations and telecommunications standards, dependence on foreign
partners, tariffs, taxes and other trade barriers, the potential for
nationalization and economic downturns and political instability in foreign
countries. In addition, STAR and PT-1's businesses could be adversely affected
by a reversal in the current trend toward deregulation of telecommunications
carriers. STAR and PT-1 will be increasingly subject to these risks to the
extent that STAR and PT-1 proceed with the planned expansion of their
international operations.
RISK OF DEPENDENCE ON FOREIGN PARTNERS. STAR and, in some cases, PT-1 will
increasingly rely on foreign partners to terminate its traffic in foreign
countries and to assist in installing transmission facilities and network
switches, complying with local regulations, obtaining required licenses, and
assisting with customer and vendor relationships. STAR and PT-1 may have limited
recourse if their foreign partners do not perform under their contractual
arrangements. STAR and PT-1's arrangements with foreign partners may expose STAR
or PT-1 to significant legal, regulatory or economic risks.
RISKS ASSOCIATED WITH FOREIGN GOVERNMENT CONTROL AND HIGHLY REGULATED
MARKETS. Governments of many countries exercise substantial influence over
various aspects of the telecommunications market. In some cases, the government
owns or controls companies that are or may become competitors of STAR or PT-1 or
companies (such as national telephone companies) upon which STAR and PT-1 and
their foreign partners may depend for required interconnections to local
telephone networks and other services. Accordingly, government actions in the
future could have a material adverse effect on STAR and PT-1's operations. In
highly regulated countries in which either STAR or PT-1 is not dealing directly
with the dominant local exchange carrier, the dominant carrier may have the
ability to terminate service to either company or its foreign partner and, if
this occurs, STAR or PT-1 may have limited or no recourse. In countries where
competition is not yet fully established and STAR or PT-1 is dealing with an
alternative operator, foreign laws may prohibit or impede new operators from
offering services in these markets.
RISKS ASSOCIATED WITH FOREIGN CURRENCY FLUCTUATIONS. Each of STAR and
PT-1's revenues and cost of long distance services are sensitive to foreign
currency fluctuations. STAR and PT-1 expect that an increasing portion of their
net revenue and expenses will be denominated in currencies other than U.S.
dollars, and changes in exchange rates may have a significant effect on their
results of operations. Although STAR utilizes hedging instruments to reduce the
risk of foreign currency fluctuations, STAR will
27
<PAGE>
not be fully protected from these risks and the instruments themselves involve a
degree of risk. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations of STAR."
FOREIGN CORRUPT PRACTICES ACT. STAR and PT-1 are also subject to the
Foreign Corrupt Practices Act ("FCPA"), which generally prohibits U.S. companies
and their intermediaries from bribing foreign officials for the purpose of
obtaining or keeping business. STAR and PT-1 may be exposed to liability under
the FCPA as a result of past or future actions taken without STAR or PT-1's
knowledge by agents, strategic partners and other intermediaries. Such liability
could have a material adverse effect on STAR or PT-1's business, operating
results and financial condition.
POTENTIAL ADVERSE EFFECTS OF GOVERNMENT REGULATION
Each of STAR and PT-1's business is subject to various federal, state and
foreign laws, regulations, agency actions and court decisions. The U.S.
international telecommunications service offerings of STAR and PT-1 are subject
to regulation by the FCC. The FCC requires international carriers to obtain
authorizations under Section 214 of the Communications Act of 1934, as amended,
prior to acquiring international facilities by purchase or lease, or providing
international service to the public. Each of STAR and PT-1 must file reports,
contracts and tariffs covering interstate service offerings with the FCC and
must pay regulatory fees, which are subject to change. STAR and, in certain
cases PT-1, are also subject to the FCC policies and rules discussed below. The
FCC could determine, by its own actions or in response to a third party's
filing, that certain of STAR or PT-1's services, termination arrangements,
agreements with foreign carriers, transit or refile arrangements or reports do
not or did not comply with FCC policies and rules. If this occurred, the FCC
could order STAR or PT-1, as the case may be, to terminate noncompliant
arrangements, pay certain fines, or the FCC could revoke either company's
authorizations. Any of these actions could have a material adverse effect on
STAR or PT-1's respective business, operating results or financial condition.
FCC INTERNATIONAL PRIVATE LINE RESALE POLICY. The FCC's international
private line ("IPL") resale policy limits the conditions under which a carrier
may connect IPLs to the public switched telephone network ("PSTN") at one or
both ends to provide switched services, commonly known as International Simple
Resale ("ISR"). A carrier generally may only offer ISR services to a foreign
country if the FCC has found (a) the country is a member of the World Trade
Organization ("WTO") and at least 50% of the U.S. billed and settled traffic to
that country is settled at or below the FCC's benchmark settlement rate or (b)
the country is not a WTO member, but it offers U.S. carriers equivalent
opportunities to engage in ISR and at least 50% of the U.S. billed and settled
traffic is settled at or below the applicable benchmark. The FCC authority of
STAR and PT-1 currently permits the companies to provide ISR service to Canada,
the U.K., Sweden, New Zealand, Australia, the Netherlands, Germany, France,
Belgium, Denmark, Norway, Austria, Switzerland, Luxembourg, Italy, Ireland, Hong
Kong and Japan. The FCC is currently reviewing U.S. carrier applications to
provide ISR to Finland and Mexico, among other routes. Upon grant of any such
ISR application to a given country, the FCC's rules also would permit STAR and
PT-1 to provide ISR service to that country. If ISR is not permitted on a route,
absent prior FCC consent, U.S. facilities based international carriers must
terminate switched telephone traffic in accordance with the FCC's International
Settlements Policy ("ISP") which is primarily intended to deter foreign carriers
with market power from discriminating amongst competing U.S. carriers by, for
example, favoring the foreign carrier's U.S. affiliate. The ISP requires that
all U.S. carriers terminate traffic with a foreign carrier on the same terms
(i.e., that settlement rates be equivalent) and receive inbound traffic only in
proportion to the volume of U.S. outbound traffic which they generate.
On a few routes, STAR may use IPLs to terminate international switched
telephone services where ISR has not been authorized. On such routes, therefore,
STAR's termination arrangements may not be consistent with the FCC's ISP. On any
such route, however, to STAR's knowledge the foreign correspondent lacks market
power, no U.S. inbound traffic is involved, and the effective settlement rate is
lower than the prevailing rate. Thus, STAR believes its actions are not
inconsistent with the ISP's underlying purpose.
28
<PAGE>
FCC INTERNATIONAL SETTLEMENTS POLICY. The ISP limits the arrangements which
U.S. international carriers may enter into with foreign carriers for exchanging
public switched telecommunications traffic, which the FCC terms International
Message Telephone Service ("IMTS"). This policy does not apply to ISR services.
The ISP requires that U.S. carriers receive an equal share of the accounting
rate and receive inbound traffic in proportion to the volume of U.S. outbound
traffic which they generate. The ISP and other FCC policies also prohibit a U.S.
carrier and a foreign carrier which possesses sufficient market power on the
foreign end of the route to affect competition adversely in the U.S. market from
entering into exclusive arrangements involving services, facilities or functions
on the foreign end of a U.S. international route which are necessary for
providing basic telecommunications and which are not offered to similarly
situated U.S. carriers. It is possible that the FCC could find that certain of
STAR's arrangements with foreign operators are inconsistent with the ISP.
FCC POLICIES ON TRANSIT AND REFILE. STAR and, in certain cases, PT-1, use
both transit and refile arrangements to terminate their international traffic.
The FCC routinely approves transit arrangements by U.S. international carriers.
The FCC's rules also permit carriers in many cases to use ISR facilities to
route traffic via a third country for refile through the PSTN. The extent to
which U.S. carriers may enter into refile arrangements consistent with the ISP
is currently under review by the FCC. Certain of STAR's transit or refile
arrangements may violate the ISP or other FCC policies.
FCC POLICIES ON USE OF PAY PHONES. A small portion of PT-1's customers use
pay phones to access PT-1's services. The Communications Act requires long
distance carriers such as PT-1 to compensate pay phone owners when a pay phone
is used to originate a telephone call through a toll-free number. Recent
regulations adopted under the Communications Act mandate compensation in the
amount of $0.284 per call, although the basis for this compensation is currently
being reconsidered by the FCC pursuant to a court order. In February 1998, PT-1
began passing these costs on to its customers who use pay phones. However, there
can be no assurance that PT-1 will be able to successfully pass these costs on
to its customers or that these charges will not have a material adverse effect
on PT-1's business, financial condition or results of operations. See "Business
of PT-1--Government Regulation."
RECENT AND POTENTIAL FCC ACTIONS. Regulatory action that may be taken in
the future by the FCC may intensify the competition which STAR and PT-1 face,
impose additional operating costs upon them, disrupt certain of their
transmission arrangements or otherwise require either company to modify its
operations. Future FCC action may also provide STAR and PT-1 additional
competitive flexibility by, for example, eliminating or substantially reducing
the tariff requirements applicable to each of the companies' interstate and
international telecommunications services. The FCC is encouraging new market
entrants by implementing the WTO Basic Telecommunications Agreement (the "WTO
Agreement") and through other actions. The FCC may approve pending mergers which
could produce more effective competitors in STAR and PT-1's markets. The FCC may
increase regulatory fees charged to STAR and PT-1 and their competitors by
eliminating the exemption for carrier revenues obtained from other carriers for
certain fees or through other actions, which could raise STAR and PT-1's costs
of service without assurance that STAR and PT-1 could pass such fee increases
through to their customers. See "Business of STAR--Government Regulation" and
"Business of PT-1--Government Regulation."
STATE. The intrastate long distance telecommunications operations of STAR
and its subsidiaries and PT-1 are subject to various state laws and regulations,
including prior certification, notification, registration and/or tariff
requirements. The vast majority of states require that STAR and its subsidiaries
and PT-1 apply for certification to provide intrastate telecommunications
services. In most jurisdictions, STAR and PT-1 also must file and obtain prior
regulatory approval of tariffs for intrastate services. Certificates of
authority can generally be conditioned, modified or revoked by state regulatory
authorities for failure to comply with state laws and regulations. Fines and
other penalties, including revocation of a certificate of authority, may be
imposed.
29
<PAGE>
In 1997, prior to STAR's acquisition of LDS, LDS settled disputes with the
California Public Utilities Commission (the "California PUC") and with the
District Attorney of Monterey, California regarding LDS' alleged unauthorized
switching of long distance customers (the "Settlements"). As part of the
Settlements, LDS was subject to fines and restrictions on its business
operations in California. In addition, the FCC has received numerous informal
complaints against LDS regarding the alleged unauthorized switching of long
distance customers, which complaints currently remain under review.
Following STAR's acquisition of LDS and in order to comply with the
Settlements, STAR has imposed strict restrictions on certain former LDS
employees, restricting these employees with respect to California intrastate
telecommunications operations. Additionally, STAR has taken a number of steps to
reduce the risk of a repeat occurrence regarding the alleged unauthorized
switching of commercial customers in California. If STAR inadvertently fails to
comply with such guidelines or if such guidelines are determined to be
inadequate to comply with the Settlements, STAR may be subject to penalties or
revocation of its certificate of authority. See "Business of STAR--Government
Regulation--Actions Against LDS."
FOREIGN REGULATIONS. STAR is also subject to regulation in foreign
countries, such as the U.K. and Germany, in connection with certain of its
business activities. For example, STAR's use of transit, ISR or other routing
arrangements may be affected by laws or regulations in either the transited or
terminating foreign jurisdiction. Foreign countries, either independently or
jointly as members of the International Telecommunication Union ("ITU"), or
other supra-national organizations such as the European Union or the WTO, may
have adopted or may adopt laws or regulatory requirements regarding such
services for which compliance would be difficult or expensive, that could force
STAR to choose less cost-effective routing alternatives and that could adversely
affect STAR's business, operating results and financial condition. PT-1 is also
subject to regulation in the U.K. and certain other countries in connection with
certain of its business activities.
To the extent that they seek to provide telecommunications services in other
non-U.S. markets, STAR and PT-1 will be subject to the developing laws and
regulations governing the competitive provision of telecommunications services
in those markets. STAR currently plans to provide a limited range of services in
Mexico, Belgium and France, as permitted by regulatory conditions in those
markets, and to expand its operations as these markets implement scheduled
liberalization to permit competition in the full range of telecommunications
services. The nature, extent and timing of the opportunity for STAR to compete
in these markets will be determined, in part, by the actions taken by the
governments in these countries to implement competition and the response of
incumbent carriers to these efforts. There can be no assurance that the
regulatory regime in these countries will provide STAR or PT-1 with practical
opportunities to compete in the near future, or at all, or that STAR or PT-1
will be able to take advantage of any such liberalization in a timely manner.
See "Business of STAR--Government Regulation."
REGULATION OF CUSTOMERS. STAR's customers are also subject to actions taken
by domestic or foreign regulatory authorities that may affect the ability of
customers to deliver traffic to STAR. Regulatory sanctions have been imposed on
certain of STAR's customers in the past. While such sanctions have not adversely
impacted the volume of traffic received by STAR from such customers to date,
future regulatory actions could materially adversely affect the volume of
traffic received from a major customer, which could have a material adverse
effect on STAR's business, financial condition and results of operations.
RISKS OF NETWORK FAILURE; DEPENDENCE ON FACILITIES AND THIRD PARTIES
Any system or network failure that causes interruptions in STAR or PT-1's
operations could have a material adverse effect on their business, financial
condition or results of operations. STAR and PT-1's operations are dependent on
their ability to successfully expand their network and integrate new and
emerging technologies and equipment into their network, which are likely to
increase the risk of system failure and to cause strain upon the networks. STAR
and PT-1's operations also are dependent on each company's ability to protect
its hardware and other equipment from damage from natural disasters such as
fires, floods, hurricanes and earthquakes, other catastrophic events such as
civil unrest, terrorism and war
30
<PAGE>
and other sources of power loss and telecommunications failures. Although STAR
and PT-1 have taken a number of steps to prevent their network from being
affected by natural disasters, fire and the like, such as building redundant
systems for power supply to the switching equipment, there can be no assurance
that any such systems will prevent STAR's switches and PT-1's switches and Debit
Card Platforms from becoming disabled in the event of an earthquake, power
outage or otherwise. The failure of STAR or PT-1's network, or a significant
decrease in telephone traffic resulting from effects of a natural or man-made
disaster, could have a material adverse effect on STAR and PT-1's relationships
with their customers and their business, operating results and financial
condition. See "Business of STAR--Network" and "Business of PT-1--The
Telecommunications Network."
SOFTWARE AND INFORMATION SYSTEMS. PT-1 uses information systems and
software (including software licensed to PT-1 by GodotSoft, L.L.C.) to provide
information to management, deliver services to its customers, track inventory,
control fraud and monitor system usage. Although PT-1 engages in extensive
testing of its software prior to introduction, there can be no assurance that
errors will not be found in such information systems or software. Any such error
may result in an interruption in telecommunications services or a partial or
total failure of PT-1's network or information systems which could have a
material adverse effect on PT-1's business, financial condition and results of
operations. See "Business of PT-1-- Information Systems; Debit Card Platforms."
DEPENDENCE ON KEY PERSONNEL
STAR and PT-1's success depends to a significant degree upon the efforts of
senior management personnel and a group of employees with longstanding industry
relationships and technical knowledge of STAR and PT-1's operations, in
particular for STAR, Christopher E. Edgecomb, STAR's Chief Executive Officer and
for PT-1, Samer Tawfik, PT-1's Chief Executive Officer. STAR maintains and is
the beneficiary under a key person life insurance policy in the amount of $10.0
million with respect to Mr. Edgecomb. PT-1 does not maintain key man life
insurance with respect to any of its executive officers. STAR and PT-1 believe
that their future success will depend in large part upon their continuing
ability to attract and retain highly skilled personnel. Competition for
qualified, high-level telecommunications personnel is intense and there can be
no assurance that STAR or PT-1 will be successful in attracting and retaining
such personnel. The loss of the services of one or more of STAR or PT-1's key
individuals, or the failure to attract and retain other key personnel, could
materially adversely affect STAR or PT-1's respective business, operating
results and financial condition.
SIGNIFICANT COMPETITION
The international telecommunications industry is intensely competitive and
subject to rapid change. STAR and PT-1's competitors in the international
wholesale switched long distance market include large, facilities-based
multinational corporations and smaller facilities-based providers in the U.S.
and overseas that have emerged as a result of deregulation, switch-based
resellers of international long distance services and international joint
ventures and alliances among such companies. STAR also competes abroad with a
number of dominant telecommunications operators that previously held various
monopolies established by law over the telecommunications traffic in their
countries. International wholesale switched service providers compete on the
basis of price, customer service, transmission quality, breadth of service
offerings and value-added services. Additionally, the telecommunications
industry is in a period of rapid technological evolution, marked by the
introduction of competitive product and service offerings, such as the
utilization of the Internet for international voice and data communications.
STAR and PT-1 are unable to predict which technological development will
challenge their competitive positions or the amount of expenditures that will be
required to respond to a rapidly changing technological environment. Further,
the number of competitors is likely to increase as a result of the competitive
opportunities created by a new Basic Telecommunications Agreement concluded by
members of the WTO in February 1997. Under the terms of the WTO Agreement,
starting February 5, 1998, the United States and over 65 countries have
committed to open their telecommunications markets to competition and foreign
ownership and to adopt
31
<PAGE>
measures to protect against anticompetitive behavior. As a result, STAR and PT-1
believe that competition will continue to increase, placing downward pressure on
prices. Such pressure could adversely affect STAR and PT-1's gross margins if
they are not able to reduce their costs commensurate with such price reductions.
COMPETITION FROM DOMESTIC AND INTERNATIONAL COMPANIES. A majority of the
U.S.-based international telecommunications services revenue is currently
generated by AT&T Corp. ("AT&T"), MCI WorldCom Corp. ("MCI WorldCom") and Sprint
Corporation ("Sprint"). STAR and PT-1 also compete with other U.S.-based and
foreign long distance providers, including the Regional Bell Operating Companies
("RBOCs"), which presently have FCC authority to resell and terminate
international telecommunication services. Many of these competitors have
considerably greater financial and other resources and more extensive domestic
and international communications networks than STAR and PT-1. STAR and PT-1's
business would be materially adversely affected to the extent that a significant
number of such customers limit or cease doing business with either STAR or PT-1
for competitive or other reasons. Consolidation in the telecommunications
industry could not only create even larger competitors with greater financial
and other resources, but could also adversely affect STAR and PT-1 by reducing
the number of potential customers for such companies' services.
EXPANSION INTO COMMERCIAL MARKET. With the acquisition of LDS, STAR began
providing long distance service to the commercial market, a market that is
subject to intense competition from a number of well capitalized companies and
in which PT-1 currently competes. The commercial market is also characterized by
the lack of customer loyalty, with commercial customers regularly changing
service providers. There can be no assurance that STAR will be able to compete
successfully or that PT-1 will be able to continue to compete successfully in
the commercial market. See "Business of STAR--Strategy-- Expand into Commercial
Market."
COMPETITION IN THE PREPAID CARD MARKET. PT-1 competes with other providers
of Prepaid Cards, including many of the largest telecommunications providers,
such as AT&T, MCI WorldCom and Sprint. These companies are substantially larger
and have greater financial, technical, engineering, personnel and marketing
resources, longer operating histories, greater name recognition and larger
customer bases than PT-1. PT-1 also competes with smaller, emerging carriers in
both the Prepaid Card retail market and in the wholesale market, including IDT
Corporation, RSL Communications, SmarTalk Teleservices, Inc., Pacific Gateway
Exchange, Inc., FaciliCom International, Inc. and Telegroup, Inc. To the extent
PT-1 begins providing services to customers outside the U.S. market, it may
compete with the large operators such as British Telecommunications plc ("BT")
in the U.K. PT-1 believes that additional competitors will be attracted to the
Prepaid Card market (including Internet-based service providers and other
telecommunications companies). There can be no assurance that competition from
existing or new competitors or a decrease in the rates charged for
telecommunications services by the major long distance carriers or other
competitors will not have a material adverse effect on PT-1's business,
financial condition and results of operations. See "--Rapid Technological Change
in the Prepaid Card Market."
FTC INVESTIGATION OF PT-1
In July 1997, PT-1 was notified by the Federal Trade Commission (the "FTC")
and the New York Attorney General's Office (the "NYAG") that it was the subject
of an investigation alleging deceptive advertising practices in connection with
the sale of its Prepaid Cards. Primarily, the FTC alleged that PT-1's point of
sale posters for its Prepaid Cards, which did disclose the existence of
additional first minute connection charges for certain calls, did not
sufficiently disclose the specific amount of connection charges for such calls.
PT-1 modified these point of sale materials more than one year ago, and all
point of sale materials now routinely set forth the exact amount of all call
connection charges. Subsequently, the FTC and the NYAG indicated that they were
also reviewing whether PT-1 properly decremented minutes from its Prepaid Cards.
PT-1 has been informed that the NYAG has ended its investigation without taking
any action. The FTC has also completed its investigation and has determined not
to take any formal action
32
<PAGE>
regarding PT-1's Prepaid Card decrementation practices. With regard to prior
advertising of Prepaid Cards by PT-1, PT-1 and representatives of the FTC have
entered into an agreement in principle, which is subject to final approval by
the FTC, pursuant to which, in complete resolution of all allegations regarding
deceptive advertising: (1) PT-1 will pay to the FTC the sum of $300,000; (2)
PT-1 does not admit any of the allegations; and (3) on a going forward basis,
PT-1 has agreed to comply with certain standards regarding advertising (which
are consistent with PT-1's current advertising practices) and certain record
keeping requirements. The agreement with the FTC was entered into on July 17,
1998, but remains subject to full FTC approval. PT-1 expects such approval of
the settlement agreement within the next thirty (30) days. See "Business of
PT-1--Legal Proceedings."
RAPID TECHNOLOGICAL CHANGE IN THE PREPAID CARD MARKET
The Prepaid Card market is characterized by rapid technological change, new
product and service introduction, new sales channels and evolving industry
standards. PT-1's success will depend, in significant part, upon its ability to
make timely and cost-effective enhancements and additions to its technology and
to introduce new products and services that meet customer demands. PT-1 expects
new products and services to be developed and introduced by other companies that
compete with its products and services. The proliferation of new
telecommunications technology, including personal and voice communication
services over the Internet, may reduce demand for long distance services,
including Prepaid Cards. There can be no assurance that PT-1 will be successful
in responding to these or other technological changes, evolving industry
standards or to new products and services offered by PT-1's current and future
competitors. The inability of PT-1 to respond to these changes could have a
material adverse effect on PT-1's business, financial condition or results of
operations. See "Business of PT-1--Competition" and "--Telecommunications
Products and Services."
CUSTOMER CONCENTRATION
While the list of STAR's most significant customers varies from quarter to
quarter, STAR's five largest customers accounted for approximately 29% of its
revenues in 1997, although no one customer accounted for 10% or more of revenues
in such period. STAR could lose a significant customer for many reasons,
including the entrance into the market of significant new competitors with lower
rates than STAR, downward pressure on the overall costs of transmitting
international calls, transmission quality problems, changes in U.S. or foreign
regulations or unexpected increases in STAR's cost structure as a result of
expenses related to installing a global network or otherwise.
TAXATION OF SALE AND USE OF PREPAID CARDS
Taxable income realized by PT-1 from Prepaid Card revenue is subject to
federal corporate income tax at standard rates. In addition, since November 1,
1997, PT-1 has been required to and has collected a three percent (3%) federal
excise tax on sales of Prepaid Cards to its distributors. The taxation of the
sale and use of Prepaid Cards is evolving and is not specifically addressed by
the laws of many of the states in which PT-1 does business. In states that do
impose taxes on Prepaid Cards, the most common method of calculation and payment
is predicated on usage of the Prepaid Card and the revenue generated from the
underlying long distance service that is provided. Other states impose taxes on
the face value of the Prepaid Card when sold to consumers, with collection and
remittance made by the retailer at the point of sale. In the states where PT-1
does the majority of its business, and taxes on Prepaid Cards are based on their
usage, PT-1 collects and remits taxes to state authorities. PT-1 believes that
it has made adequate reserves to cover any state taxes it may ultimately be
required to pay, though there can be no assurance in that regard.
LIMITED PROTECTION OF PT-1'S PROPRIETARY RIGHTS; RISKS OF INFRINGEMENT
PT-1 believes that PT-1 and its Prepaid Card products have achieved
significant brand awareness among distributors, retail outlets and many ethnic
communities and other consumer groups. PT-1 has filed
33
<PAGE>
for federal trademark protection of the PT-1 Communications and PT-1 service
marks and for other names PT-1 uses or intends to use to market its Prepaid
Cards, including The PT-1 Card and The New York Card. In addition, PT-1 recently
changed its name from Phonetime, Inc. and the name of one of its Prepaid Cards
from The PTI Card to The PT-1 Card in response to letters challenging PT-1's use
of these names. There can be no assurance that PT-1's efforts to protect its
proprietary rights will be successful or that other companies will not challenge
PT-1's use of its trademarks and service marks. PT-1 also intends to expand the
marketing of Prepaid Cards in foreign countries. This expansion may result in
usage of PT-1's Prepaid Cards in countries where intellectual property
protections are more limited than the protections available in the United
States. PT-1's inability to protect its proprietary rights or continue to use
such marks in the U.S. and abroad could result in a material adverse effect on
PT-1's business, financial condition or results of operations. See "Business of
PT-1--Trademarks and Service Marks."
NEED FOR ADDITIONAL CAPITAL TO FINANCE GROWTH AND CAPITAL REQUIREMENTS
STAR believes that it must continue to enhance and expand its network and
build out its telecommunications network infrastructure in order to maintain its
competitive position and continue to meet the increasing demands for service
quality, capacity and competitive pricing. STAR's ability to grow depends, in
part, on its ability to expand its operations through the ownership and leasing
of network capacity, which requires significant capital expenditures, that are
often incurred prior to STAR's receipt of the related revenue.
STAR believes that, based upon its present business plan and its existing
cash resources and expected cash flow from operating activities, STAR will have
sufficient cash to meet its currently anticipated working capital and capital
expenditure requirements for at least twelve months. If STAR's growth exceeds
current expectations, if STAR obtains one or more attractive opportunities to
purchase the business or assets of another company, or if STAR's cash flow from
operations after the end of such period is insufficient to meet its working
capital and capital expenditure requirements, STAR will need to raise additional
capital from equity or debt sources. There can be no assurance that STAR will be
able to raise such capital on favorable terms or at all. If STAR is unable to
obtain such additional capital, STAR may be required to reduce the scope of its
anticipated expansion, which could have a material adverse effect on STAR's
business, financial condition or results of operations.
CONTROL OF STAR BY NAMED OFFICERS AND DIRECTORS
As a result of the Merger on a fully-diluted basis, executive officers and
directors of STAR, including certain officers of PT-1, in the aggregate will
beneficially own more than 50% of the outstanding shares of STAR Common Stock
and STAR's Chief Executive Officer will beneficially own approximately 22.1% of
the outstanding shares. Samer Tawfik, the Chief Executive Officer of PT-1, will
also own approximately 22% of STAR Common Stock following the Merger. These
stockholders may be able to exercise control over all matters requiring
stockholder approval, including the election of directors and approval of
significant corporate transactions. Such concentration of ownership may have the
effect of delaying or preventing a change in control of STAR. See "Security
Ownership of Certain Beneficial Owners and Management."
YEAR 2000 COMPUTER PROGRAM FAILURE
A significant percentage of the software that runs most of the computers in
the United States relies on two-digit date codes to perform computations and
decision-making functions. Commencing on January 1, 2000, these computer
programs may fail from an inability to interpret date codes properly,
misinterpreting "00" as the year 1900 rather than 2000. STAR and PT-1 have
implemented Year 2000 compliance programs to ensure that each of their software,
systems and equipment are Year 2000 compliant and to ensure that the software
and technology of their third party vendors and customers are also Year 2000
compliant. Each of STAR and PT-1 currently anticipates that its information
technology and non-information technology systems will be Year 2000 compliant
before January 1, 2000, though no assurances
34
<PAGE>
can be given that its compliance testing will not detect unanticipated Year 2000
compliance problems. While STAR and PT-1 intend to develop contingency plans to
prepare for a Year 2000 failure, there can be no assurance that such contingency
plans will be adequate. If either STAR or PT-1 and/or third parties are not Year
2000 compliant as of such date and if such contingency plans are inadequate or
fail to address a particular Year 2000 risk, STAR and PT-1 may be required to
incur unanticipated costs, change relationships with third parties, forego
revenues or be subjected to other material adverse effects. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations of
STAR" and "Management's Discussion and Analysis of Financial Condition and
Results of Operations of PT-1."
DILUTION OF VOTING POWER
Consummation of the Merger will result in an approximate 36.2% increase in
the number of shares of STAR Common Stock outstanding. Holders of PT-1 Options
and PT-1 Warrants, PT-1 stockholders and selected independent distributors of
PT-1 will receive approximately 26.6% of the outstanding voting stock of STAR,
on a fully-diluted basis, as a result of the Merger. See "The Merger--The Merger
Agreement." Thus, the stockholders of STAR will experience a 9.6% dilution of
their relative voting authority after the Merger.
35
<PAGE>
THE SPECIAL MEETING
PURPOSE; TIME AND PLACE. At the Special Meeting, holders of STAR Common
Stock on the Record Date will be asked to vote to approve and adopt the Merger
Agreement and the transactions contemplated thereby, including the Share
Issuance, and such other matters as may properly come before the Special
Meeting. The Special Meeting will be held on Wednesday, February 3, 1999 at 801
Garden Street, Room 203, Santa Barbara, California, starting at 9:00 a.m., local
time.
The Board has determined that the Merger is fair and in the best interests
of STAR and its stockholders and has unanimously approved the Merger Agreement.
THE BOARD UNANIMOUSLY RECOMMENDS THAT THE STOCKHOLDERS VOTE "FOR" THE APPROVAL
AND ADOPTION OF THE MERGER AGREEMENT AND THE TRANSACTIONS CONTEMPLATED THEREBY
AT THE SPECIAL MEETING, INCLUDING THE SHARE ISSUANCE. See "The Merger--STAR's
Reasons for the Merger;" "--Related Agreements" and "--Vote Required and
Recommendation of the Board."
VOTING RIGHTS; VOTES REQUIRED FOR APPROVAL. The Board has fixed the close
of business on December 29, 1998 as the Record Date. Only holders of record of
shares of STAR Common Stock on the Record Date are entitled to notice of and to
vote at the Special Meeting. On the Record Date, there were 42,234,659 shares of
STAR Common Stock outstanding and entitled to vote at the Special Meeting, held
by approximately 156 stockholders of record. Each holder of record, as of the
Record Date, of STAR Common Stock is entitled to cast one vote per share. The
presence, in person or by proxy, of the holders of a majority of the outstanding
shares of STAR Common Stock entitled to vote is necessary to constitute a quorum
at the Special Meeting. The affirmative vote, in person or by proxy, of the
holders of a majority of the shares of STAR Common Stock outstanding on the
Record Date is required to approve and adopt the Proposal.
SHARE OWNERSHIP OF MANAGEMENT; PT-1 BOARD APPROVAL. At the close of
business on December 29, 1998, directors and executive officers of STAR, as a
group, were the beneficial owners of an aggregate of 15,778,045 shares
(approximately 37.4%) of the STAR Common Stock then outstanding. As of December
29, 1998, directors and executive officers of PT-1, as a group, were beneficial
owners of an aggregate of approximately 45,665,200 shares (approximately 93.2%)
of the PT-1 Common Stock then outstanding. The Board of Directors of PT-1 has
already approved the Merger Agreement and the transactions contemplated thereby.
PROXIES. All shares of STAR Common Stock represented by properly executed
proxies received prior to or at the Special Meeting and not revoked will be
voted in accordance with the instructions indicated in such proxies. IF NO
INSTRUCTIONS ARE INDICATED ON A PROPERLY EXECUTED RETURNED PROXY, HOWEVER, SUCH
PROXIES WILL BE VOTED FOR THE APPROVAL OF THE PROPOSAL. A properly executed
proxy marked "ABSTAIN", although counted for purposes of determining whether
there is a quorum and for purposes of determining the aggregate voting power and
number of shares represented and entitled to vote at the Special Meeting, will
not be voted and will have the effect of a vote against the Proposal. Broker
non-votes will not be counted for the purpose of determining the presence or
absence of a quorum and will have the effect of a vote against the Proposal.
The STAR Board is not currently aware of any business to be acted upon at
the Special Meeting other than the proposed Merger. If, however, other matters
are properly brought before the Special Meeting, or any adjournments or
postponements thereof, the persons appointed as proxies will have discretion to
vote or act thereon according to their judgment. Such adjournments may be for
the purpose of soliciting additional proxies. Shares represented by proxies
voting against the approval and adoption of the Proposal will be voted against a
proposal to adjourn the Special Meeting for the purpose of soliciting additional
proxies. STAR does not currently intend to seek an adjournment of its Special
Meeting.
36
<PAGE>
Any proxy given by a stockholder may be revoked at any time before it is
exercised by filing with Ms. Casey, the Secretary of the Company, an instrument
revoking it, by delivering a duly executed proxy bearing a later date or by the
stockholder attending the Special Meeting and voting his or her shares in
person.
It is the policy of STAR to keep confidential proxy cards, ballots and
voting tabulations that identify individual stockholders, except where
disclosure is mandated by law and in other limited circumstances.
Stockholders do not need to take any action with respect to their stock
certificates, which will continue to evidence the same number of shares of STAR
Common Stock following the Merger.
37
<PAGE>
THE MERGER
GENERAL DESCRIPTION
The Merger Agreement provides for a business combination between STAR and
PT-1 in which Newco, a wholly-owned subsidiary of STAR, will be merged with and
into PT-1 and the holders of PT-1 Common Stock, options to acquire PT-1 Common
Stock and warrants exercisable for PT-1 Common Stock will be entitled to receive
shares of STAR Common Stock and cash in a transaction intended to qualify as a
tax-free reorganization for federal income tax purposes and as a purchase for
accounting purposes. As a result of the Merger, PT-1 will become a wholly-owned
subsidiary of STAR and holders of shares of PT-1 Common Stock will become
holders of shares of STAR Common Stock.
EFFECTIVE TIME OF THE MERGER
The Merger will become effective upon the filing of the Certificate of
Merger with the Department of State of the State of New York in accordance with
New York Business Corporation Law (the "Business Corporation Law"). The
Certificate of Merger will be filed as promptly as practicable after the
approval by the stockholders of STAR has been obtained and all other conditions
to the Merger have been satisfied or waived. It is currently expected that the
Merger will be consummated on or about February 3, 1999 or as soon thereafter as
such conditions are satisfied.
BACKGROUND OF THE MERGER
The terms of the Merger Agreement and the related agreements are the result
of arm's-length negotiations between representatives, legal advisors and
financial advisors of STAR and PT-1. The following is a brief discussion of the
background of these negotiations, which resulted in the Merger Agreement and
related transactions.
STAR actively pursues opportunities to enhance its business through
strategic and synergistic acquisitions. These acquisitions may focus on entering
new territories, enlarging STAR's presence in an existing territory, adding
capacity or expanding into new market segments, such as the commercial market.
In furtherance of this objective, STAR acquired LDS on November 30, 1997, and
T-One on March 10, 1998. In addition, on November 19, 1997, STAR entered into an
agreement to acquire UDN.
One of STAR's strategic objectives has been to expand into the retail
segment of the telecommunications market. STAR believes that the acquisition of
an established Prepaid Card business is one of the least expensive means to
diversify its wholesale operations. STAR believes that the Prepaid Card market
is the fastest growing segment of the telecommunications business. As a means to
entering this market, STAR considered acquiring several different companies but
ultimately decided upon PT-1 because STAR believes that PT-1 is the leading
competitor in the Prepaid Card market and that PT-1 enjoys valuable brand
recognition.
PT-1 has been evaluating a number of strategic options to provide it with
the necessary resources to fuel PT-1's continued growth and to remain
competitive in an industry undergoing rapid consolidation and change. At the
time PT-1 was approached by STAR, it was in the process of attempting to effect
an initial public offering of shares of PT-1 Common Stock.
On April 16, 1998, Mr. Edgecomb, Chief Executive Officer and Chairman of the
Board of STAR, and Ms. Casey, President and Secretary of STAR, had a dinner
meeting with Mr. Tawfik, Chief Executive Officer of PT-1, along with
representatives from each company's financial advisors, to discuss in very
general terms the possibility of a business combination between STAR and PT-1.
On May 7, 1998, Mr. Edgecomb and representatives of Hambrecht & Quist met
with Mr. Tawfik and other executive officers of PT-1, as well as representatives
from BT Alex. Brown Incorporated ("BT Alex. Brown"), financial advisor to PT-1,
to initiate discussions regarding a possible acquisition of PT-1 by STAR.
38
<PAGE>
On May 18, 1998, the parties met again and began to discuss the material
terms and conditions of a possible business combination between STAR and PT-1.
Given that PT-1 had been engaged in informal merger discussions with several
other companies in the retail and wholesale telecommunications industry, the
parties executed a nonsolicitation agreement on May 24, 1998, providing STAR
with exclusive negotiation rights to a potential merger with PT-1 through June
8, 1998.
During the week of May 25, 1998, Mr. Edgecomb and Ms. Enos, along with other
representatives from STAR, Hambrecht & Quist, CSFB and Riordan & McKinzie,
STAR's outside legal counsel, met in New York with Mr. Tawfik and John J.
Klusaritz, Executive Vice President and General Counsel of PT-1, along with
other representatives from PT-1 and BT Alex. Brown to discuss the respective
business strengths, operational strategies and financial results of each of STAR
and PT-1, and potential costs savings and synergies which might result from a
combination of the two companies. Also at this time, representatives from STAR
and its legal and financial advisors began to conduct a detailed review of
PT-1's business, examining operational, financial and legal information.
During the week of June 1, 1998, the representatives of STAR and PT-1
actively negotiated various terms of a merger agreement (the "Original Merger
Agreement"), including those related to an exchange ratio, a termination fee,
representations and warranties, conditions to closing, indemnification by the
PT-1 Stockholders and the operation of PT-1 during the pendency of the
transaction. The negotiations were principally conducted by Messrs. Tawfik and
Klusaritz on behalf of PT-1, and by Mr. Edgecomb and Ms. Enos, on behalf of
STAR. During this period, the management of STAR provided members of the Board
with drafts of the Original Merger Agreement and financial and other information
regarding PT-1 and informed the members of the Board of the status of the
ongoing discussions between STAR and PT-1, consulting with members of the Board
with respect to various aspects of the proposed transaction. On June 5, 1998,
the executive officers of PT-1 traveled to Santa Barbara to meet with Mr.
Edgecomb and other STAR executives and to tour STAR's executive offices. At that
time, negotiations of the Original Merger Agreement and related side agreements
continued.
On June 8, 1998, a lengthy special meeting of the Board was held. The Board
discussed with management and representatives of Hambrecht & Quist the principal
economic terms of the proposed transaction. Representatives from Hambrecht &
Quist presented to the Board a detailed report regarding the preparation of
their fairness opinion with respect to the exchange ratio, background
information regarding PT-1 and a pro forma overview of the two companies on a
combined basis. Riordan & McKinzie discussed with the Board the proposed terms
of the Original Merger Agreement and related side agreements. Mr. Edgecomb
discussed operational synergies, Ms. Enos presented to the Board the financials
of PT-1 and Mr. Edgecomb and Ms. Enos discussed anticipated operations of PT-1
following the Merger. The Board authorized the continued negotiation of the
final deal points of the Original Merger Agreement and the exchange ratio and
determined to adjourn the meeting to allow the members of the Board to continue
to analyze the transaction. The closing price of the STAR Common Stock on June
8, 1998, as reported on Nasdaq, was $26.25 per share.
On June 9, 1998, the Board reconvened to discuss the final terms of the
Merger. Mr. Edgecomb discussed with the Board the resolution of the negotiations
between STAR and PT-1, including the exchange ratio. The Board received the
fairness opinions of Hambrecht & Quist and CSFB, which fairness opinions
concluded that the exchange ratio was fair, from a financial point of view, to
the stockholders of STAR. Based on the foregoing, the Board unanimously resolved
that the Merger and the Original Merger Agreement were fair to and in the best
interests of STAR and its stockholders, approved the Merger, the Original Merger
Agreement and the related transactions and recommended that the stockholders of
STAR approve and adopt the Original Merger Agreement and the transactions
contemplated thereby, including the Share Issuance. On June 9, 1998, the closing
sale price of STAR Common Stock, as reported on Nasdaq, was $28.125 per share.
On June 9, 1998, a special meeting of the Board of Directors of PT-1 (the
"PT-1 Board") was held. The PT-1 Board meeting was attended by BT Alex. Brown.
At the meeting, the management of PT-1
39
<PAGE>
presented the principal economic terms of the proposed transaction, as well as
the principal reasons for pursuing the Merger. Management indicated that the
Merger would significantly accelerate PT-1's timetable for realizing significant
growth in revenue and increased profitability. Specifically, it was management's
view that the combination of the telecommunications networks, customer bases,
services offered, financial resources and management of STAR and PT-1 would
accelerate PT-1's growth, significantly lower PT-1's cost of providing service,
increase PT-1's profitability and competitive position and thereby enhance
revenue growth. Based on the foregoing, the PT-1 Board unanimously resolved that
the Original Merger Agreement and the transactions contemplated thereby were
fair to and in the best interests of PT-1 and its stockholders, approved the
Merger and the Original Merger Agreement and recommended that its stockholders
approve the transaction.
On August 12, 1998, the parties determined that "pooling of interests"
accounting treatment for the Merger would not be feasible on the timetable set
forth in the Original Merger Agreement, due primarily to a PT-1 treasury stock
transaction that was completed in March 1997. The parties acknowledged that, as
a result of the requirements of purchase accounting, among other things, STAR's
acquisition of PT-1 would have to be recorded from the date of acquisition,
resulting in STAR's reflection of net income (loss) of PT-1 for the year ended
December 31, 1998 from the Effective Time, rather than including PT-1's profit
or loss for current as well as prior periods. The change from pooling of
interests to purchase accounting resulted in the excess of the fair market value
of PT-1 (plus Merger-related accruals) over PT-1's net book value to be
amortized over a number of years equal to the estimated life of such assets.
Changing from pooling of interests to purchase accounting had the effect of
reducing pro forma net income of the combined companies for the year ended
December 31, 1997 from $16.3 million, or $0.31 per diluted share, to $11.7
million, or $0.24 per diluted share. Further, the market for emerging
telecommunications carriers became unstable and unpredictable. These factors,
and the fact that pooling of interests treatment was a condition to the Original
Merger Agreement, led the parties to discuss the renegotiation of several
material terms of the Merger. On August 12, 1998, the closing sale price of STAR
Common Stock, as reported on Nasdaq, was $15.625 per share.
During the week of August 17, 1998, Mr. Edgecomb, on behalf of STAR, and Mr.
Tawfik, on behalf of PT-1, along with their representatives, negotiated the
Merger Agreement, which modified certain terms in the Original Merger Agreement,
including the number of shares of STAR Common Stock to be issued in the Merger,
the exchange ratio and other terms of the consideration to be paid to the
stockholders of PT-1.
On August 20, 1998, a special meeting of the Board was held to consider the
terms of the Merger Agreement. The Board discussed with management and
representatives of Hambrecht & Quist the revised principal economic terms of the
Merger. The Board received a new fairness opinion from Hambrecht & Quist, which
opinion concluded that the consideration to be paid to the stockholders of PT-1
was fair, from a financial point of view, to the stockholders of STAR. Riordan &
McKinzie discussed with the Board the proposed changes to the terms of the
Original Merger Agreement and related side agreements. Mr. Edgecomb discussed
his continued belief in the synergies of the Merger. Based on the foregoing, the
Board unanimously resolved that the Merger and the Merger Agreement were fair to
and in the best interests of STAR and its stockholders and approved the Merger,
the Merger Agreement and the related transactions. The Board also recommended
that the stockholders of STAR approve and adopt the Merger Agreement and the
transactions contemplated thereby, including the Share Issuance. On August 20,
1998, the closing sale price of STAR Common Stock, as reported on Nasdaq, was
$14.813 per share. Effective as of September 1, 1998 the Merger Agreement was
amended by the parties to modify the consideration to be paid to the
stockholders of PT-1 and to provide STAR with managerial and operational
authority over PT-1 as of that date. On September 1, 1998, the closing sale
price of STAR Common Stock, as reported on Nasdaq, was $10.563 per share.
In the course of negotiations in the week of August 17, 1998 and immediately
prior to the September 1, 1998 amendment to the Merger Agreement, the parties
agreed to a number of changes to the Original Merger Agreement to serve the dual
purpose of providing adequate consideration to the
40
<PAGE>
stockholders of PT-1 while allowing STAR to retain the benefits of its
originally negotiated bargain. In addition to the reduction of shares of STAR
Common Stock to be issued in the Merger from 21 million shares to 15.3 million
shares, the Merger Agreement contemplates (a) the issuance of $19.5 million to
the PT-1 stockholders, (b) the removal of the pooling of interest treatment
condition, (c) the granting to STAR of certain managerial and operational rights
over PT-1, (d) the reservation for issuance by STAR of 250,000 shares of STAR
Common Stock to certain independent distributors of PT-1 following the Effective
Date and (e) the reservation for issuance by STAR of options to acquire 100,000
shares of STAR Common Stock to be granted to certain employees of PT-1 following
the Effective Date. In the course of negotiating modifications to the business
terms of the Original Merger Agreement, Mr. Tawfik proposed the issuance of
shares of STAR Common Stock to specific independent distributors of PT-1's
Prepaid Cards to incentivize such parties and to assist STAR in securing brand
loyalty regarding the distribution of PT-1 Prepaid Cards following the Merger.
Mr. Tawfik also suggested that, as a matter of employee retention and to provide
for a better transition to STAR's ownership of PT-1 following the Merger, STAR
should consider awarding select PT-1 employees options to acquire shares of STAR
Common Stock following the Merger. Mr. Edgecomb believed that both proposals
would positively contribute to the transition in the ownership of PT-1 by STAR
following the Merger. Ultimately, Messrs. Edgecomb and Tawfik agreed that,
immediately following the Merger, 250,000 shares of STAR Common Stock would be
issued to a select group of independent distributors, in the form of restricted
shares, and that options with respect to 100,000 shares of STAR Common Stock
would be granted to specific PT-1 employees.
On December 29, 1998 the STAR Board met to receive an update from Mr.
Edgecomb on the status of the Merger and to review information relating to the
pro forma financial statements set forth in this Proxy Statement. Following a
discussion of, among other things, the possible synergies of the Merger, the
Board unanimously affirmed its August 20, 1998 approval of the Merger and the
Merger Agreement.
On December 29, 1998 representatives from STAR contacted certain PT-1
stockholders to suggest that, given STAR's projected cash needs in the first
quarter of 1999, resulting primarily from anticipated and significant capital
expenditures targeted for such period, it may be appropriate for the PT-1
stockholders to defer receipt of the cash component of the Merger Consideration
for a short period of time after the Effective Time. The parties ultimately
agreed that STAR would have the option at the Effective Time of delivering to
the PT-1 stockholders cash or short term promissory notes in an aggregate amount
equal to the cash then due. See "The Merger--The Merger Agreement--Short Term
Notes."
Based on the closing price of a share of STAR Common Stock on June 9, 1998
of $28.125, the transactions contemplated by the Original Merger Agreement could
be valued at approximately $590 million. Based on the closing price of a share
of STAR Common Stock on September 1, 1998 of $10.563, the transactions
contemplated by the Merger Agreement could be valued at approximately $181
million.
STAR'S REASONS FOR THE MERGER
The Board has unanimously approved the Merger Agreement and the transactions
contemplated thereby, including the Merger. In reaching this determination, the
Board consulted with management, as well as its financial and legal advisors,
and considered a number of factors, including, without limitation: (i)
information with respect to the financial condition, business, operations and
prospects of both STAR and PT-1 on a historical and prospective basis, including
certain information reflecting the two companies on a pro forma combined basis;
(ii) the tax-free nature of the Merger; (iii) the financial presentation and
opinion of Hambrecht & Quist and (iv) the terms of the Merger Agreement and all
related agreements.
The Board also considered a number of strategic advantages that could be
created by the Merger including:
- CONTINUATION OF COMMERCIAL MARKET EXPANSION. Management believes that PT-1
is one of the leading providers in the U.S. of long distance service to
end users through the sale and distribution of Prepaid Cards. PT-1 has a
significant sales force of independent distributors with a large number of
retail customers. PT-1 also currently offers dial around and presubscribed
long distance service to
41
<PAGE>
residential and commercial end users with significant international long
distance calling needs. Accordingly, the Merger would accelerate a major
strategic objective of STAR--its expansion into the retail segment of the
commercial long distance market.
- ECONOMIES OF SCALE, RESOURCES OF COMBINED ENTITY. The combination of STAR
and PT-1 will create one of the largest facilities-based long distance
telecommunications companies in the U.S. and what STAR believes will be
the third largest provider of international long distance service in the
U.S. After giving effect to the Merger, for the fiscal year ended December
31, 1997, STAR and PT-1's pro forma combined revenues and operating income
would have been approximately $786.7 million and approximately $24.0
million, respectively. The Board believes that the Merger will provide
opportunities to achieve substantial benefits for the respective
stockholders and customers of each company through the more efficient
utilization of the combined assets, management and personnel of STAR and
PT-1. The Board further believes that the combined company, operating in
both the retail and wholesale telecommunications markets, with the
combined STAR and PT-1 assets, financials resources, management, personnel
and technical expertise will be better able to capitalize on growth
opportunities in the telecommunications industry, both domestically and
internationally, and will be better positioned to compete more effectively
with greater negotiating leverage, than either STAR or PT-1 on a
stand-alone basis.
- ACCELERATION OF STAR'S NETWORK STRATEGY. The Board believes that the
addition of PT-1's substantial retail minutes as well as the enhanced
financial strength of the combined entities will enable STAR to accelerate
its development of its international telecommunications network by
enabling STAR to deploy a domestic and international network on a demand
driven and cost efficient basis.
- USE OF STAR NETWORK BY PT-1 CUSTOMERS. The Board believes that the
existing telecommunications networks of STAR will serve as a cost
effective source for the transmission of long distance calls made by PT-1
customers. STAR's network will enable PT-1 to provide its retail customers
with low-cost access to additional foreign countries thereby facilitating
the development of additional retail international long distance business
and may enable both carriers to provide more competitively priced
wholesale services. PT-1's current relationships with third party carriers
do not involve significant minimum commitments or other restrictions that
would interfere with the immediate integration of PT-1's retail traffic
onto the STAR network.
When considering the Merger, the Board also considered a number of risks
relating to the potential acquisition of PT-1 and with respect to the Prepaid
Card industry in general, including:
- INTEGRATION OF PT-1. The Board believes that one of the most significant
risks of the Merger centers on the ability of STAR to integrate the
management, financial and accounting functions and the facilities of PT-1
with and into those of STAR without material disruption or expense. The
Board reviewed the members of PT-1 management and their experience and
discussed with STAR executives PT-1's financial systems and its controls
and network facilities. The Board ultimately determined that, if run on a
stand-alone basis with current PT-1 management left virtually intact, the
difficulties of integration would be greatly decreased.
- RETAIL RISKS. While STAR has operated quite successfully in the wholesale
telecommunications market, it has only recently entered the retail portion
of the long distance market. The Board recognized that PT-1's operations
were entirely retail, focused on, among other things, maintaining a
sizeable sales force, marketing its retail products to thousands of
end-users and continually developing new Prepaid Card offerings. While the
Board realized that the retail nature of PT-1 posed significant
operational challenges for a company with primarily wholesale operations
like STAR, the Board determined that the Merger offered STAR a unique
opportunity to pursue expand one of its major strategic objectives--the
expansion into the retail marketplace.
- GROWTH RATE OF PT-1. The Board acknowledged that PT-1 had experienced a
significant growth in revenue in 1997 from 1996 and discussed whether such
rate of growth would be sustainable in the
42
<PAGE>
foreseeable future. The Board also noted that PT-1's projected plan of
operations took into account significant national expansion of its Prepaid
Card business outside of the Northeastern United States. After discussing
these factors with STAR executive officers and financial advisors, the
Board determined that PT-1's expansion plan was reasonably feasible and
believes that PT-1 can continue to grow revenues, albeit at a rate that
will be lower than its historical rate of growth.
- THE PREPAID CARD INDUSTRY. The Board recognizes that the Prepaid Card
industry has seen tremendous growth over the last few years and that a
number of Prepaid Card operators have failed due to overexpansion and
undercapitalization. The Board also acknowledges that Prepaid Cards were
becoming a market commodity, with consumer demand focused primarily on
Prepaid Cards with the lowest per minute charges. At the same time, the
Board believes that consumers identify the PT-1 name and its Prepaid Cards
with quality phone service at competitive prices. Further, the Board
believes that PT-1 has established a solid base of independent
distributors for the distribution of its Prepaid Cards and that PT-1's
operations were sound and profitable.
The foregoing list of the information and factors considered by the Board is
not intended to be exhaustive. In view of the variety of factors considered in
connection with its evaluation of the Merger, the Board did not find it
practicable to and did not quantify or otherwise assign relative weights to the
specific factors considered in reaching its determination. In addition,
individual members of the Board may have given different weights to different
factors. The Board also consulted with its financial and legal advisors as it
deemed appropriate in the context of its review and approval of the Merger
Agreement and the Merger.
OPINIONS OF STAR'S FINANCIAL ADVISORS
OPINION OF HAMBRECHT & QUIST. STAR engaged Hambrecht & Quist to act as its
financial advisor in connection with the Merger of PT-1 and to render an opinion
as to the fairness from a financial point of view to STAR of the consideration
to be paid by the Company in the Merger. Hambrecht & Quist was selected by the
Board based on Hambrecht & Quist's qualifications, expertise and reputation, as
well as Hambrecht & Quist's historic investment banking relationship and
familiarity with STAR. Hambrecht & Quist rendered its oral opinion (subsequently
confirmed in writing) on August 20, 1998 to the Board that, as of such date, the
consideration to be paid by STAR in the Merger is fair from a financial point of
view. A COPY OF HAMBRECHT & QUIST'S OPINION DATED AUGUST 20, 1998, WHICH SETS
FORTH THE ASSUMPTIONS MADE, MATTERS CONSIDERED, THE SCOPE AND LIMITATIONS OF THE
REVIEW UNDERTAKEN AND THE PROCEDURES FOLLOWED BY HAMBRECHT & QUIST IS ATTACHED
AS ANNEX B TO THIS PROXY STATEMENT. STAR SHAREHOLDERS ARE ADVISED TO READ THE
OPINION IN ITS ENTIRETY. The assumptions made, matters considered and limits of
review contained in Hambrecht & Quist's written opinion delivered August 20,
1998 were substantially the same as those contained in the opinion attached
hereto. No limitations were placed on Hambrecht & Quist by the Board with
respect to the investigation made or the procedures followed in preparing and
rendering its opinion.
In its review of the Merger, and in arriving at its opinion, Hambrecht &
Quist, among other things: (i) reviewed the publicly available financial
statements of STAR for recent years and interim periods to date and certain
other relevant financial and operating data of STAR made available to Hambrecht
& Quist from published sources and from the internal records of STAR; (ii)
reviewed certain internal financial and operating information, including certain
projections, relating to STAR prepared by the management of STAR; (iii)
discussed the business, financial condition and prospects of STAR with certain
of its officers; (iv) reviewed the financial statements of PT-1 for recent years
and interim periods to date and certain other relevant financial and operating
data of PT-1 made available to Hambrecht & Quist from published sources and from
the internal records of PT-1; (v) reviewed certain internal financial and
operating information, including certain projections, relating to PT-1 based
upon information provided by the management of PT-1; (vi) discussed the
business, financial condition and prospects of PT-1 with certain of its
officers; (vii) reviewed the recent reported price and trading activity for the
STAR Common Stock
43
<PAGE>
and compared such information and certain financial information for STAR with
similar information for certain other companies engaged in businesses Hambrecht
& Quist considered comparable; (viii) reviewed the financial terms, to the
extent publicly available, of certain comparable merger and acquisition
transactions; (ix) reviewed the Merger Agreement and the Registration Rights and
Restricted Share Agreement; and (x) performed such other analyses and
examinations and considered such other information, financial studies, analyses
and investigations and financial, economic and market data as Hambrecht & Quist
deemed relevant.
Hambrecht & Quist did not independently verify any of the information
concerning STAR or PT-1 considered in connection with their review of the Merger
and, for purposes of its opinion, Hambrecht & Quist assumed and relied upon the
accuracy and completeness of all such information. In connection with its
opinion, Hambrecht & Quist did not prepare or obtain any independent valuation
or appraisal of any of the assets or liabilities of STAR or PT-1, nor did they
conduct a physical inspection of the properties and facilities of STAR or PT-1.
With respect to the financial forecasts and projections used in their analysis,
Hambrecht & Quist assumed that they reflected the best currently available
estimates and judgments of the expected future financial performance of PT-1 and
STAR. For the purposes of their opinion, Hambrecht & Quist also assumed that
neither STAR nor PT-1 was a party to any pending transactions, including
external financings, recapitalizations or merger discussions, other than the
Merger and those in the ordinary course of conducting their respective
businesses. For purposes of their opinion, Hambrecht & Quist assumed that the
Merger will qualify as a tax-free reorganization under the United States
Internal Revenue Code for the stockholders of PT-1 and that the Merger will be
accounted for as a purchase. Hambrecht & Quist's opinion is necessarily based
upon market, economic, financial and other conditions as they existed and can be
evaluated as of the date of the opinion and any subsequent change in such
conditions would require a reevaluation of such opinion.
The preparation of a fairness opinion is a complex process and is not
necessarily susceptible to partial analysis or summary description. The summary
of the Hambrecht & Quist analyses set forth below does not purport to be a
complete description of the presentation by Hambrecht & Quist to STAR's Board of
Directors. In arriving at its opinion, Hambrecht & Quist did not attribute any
particular weight to any analyses or factor considered by it, but rather made
qualitative judgments as to the significance and relevance of each analysis and
factor. Accordingly, Hambrecht & Quist believes that its analyses and the
summary set forth below must be considered as a whole and that selecting
portions of its analyses, without considering all analyses, or of the following
summary, without considering all factors and analyses, could create an
incomplete view of the processes underlying the analyses set forth in the
Hambrecht & Quist presentation to the STAR Board of Directors and its opinion.
In performing its analyses, Hambrecht & Quist made numerous assumptions with
respect to industry performance, general business and economic conditions and
other matters, many of which are beyond the control of STAR and PT-1. The
analyses performed by Hambrecht & Quist (and summarized below) are not
necessarily indicative of actual values or actual future results, which may be
significantly more or less favorable than suggested by such analyses.
Additionally, analyses relating to the values of businesses do not purport to be
appraisals or to reflect the prices at which businesses actually may be
acquired.
In performing its analyses, Hambrecht & Quist used stand-alone Wall Street
consensus estimates for projections of STAR's calendar year 1998 and 1999
financial performance. Hambrecht & Quist examined projections provided by PT-1's
management and derived its own financial projections based on conservative
growth assumptions for PT-1's calendar year 1998 and 1999 financial performance
(the "PT-1 Base Case"). For calendar year 1999, Hambrecht & Quist also developed
a second, more conservative case for PT-1 (the "PT-1 Conservative Case").
The following is a brief summary of certain financial analyses performed by
Hambrecht & Quist in connection with providing its written opinion to the Board
on August 20, 1998:
CONTRIBUTION ANALYSIS: Hambrecht & Quist analyzed the contribution of each
of STAR and PT-1 to certain calendar 1999 financial statement categories of the
pro forma combined company using both PT-1
44
<PAGE>
Base Case and PT-1 Conservative Case with no revenue or expense adjustments and
excluding the cash component and the resulting interest income effect. The
financial statement categories included revenue, operating income, and net
income. This contribution analysis was then compared to the pro forma ownership
percentage of STAR and PT-1 stockholders in the pro forma post-merger combined
company (the "Combined Company"). Hambrecht & Quist observed that, calculated on
a fully-diluted basis, STAR stockholders are expected to own approximately 74%
of the Combined Company equity at the close of the Merger and PT-1 stockholders
are expected to own approximately 26% of the Combined Company equity at the
close of the Merger. Hambrecht & Quist examined the expected contributions to
the Combined Company's revenues, operating income and net income by PT-1 for
calendar year 1999 using the PT-1 Base Case. It was estimated that STAR and PT-1
would contribute approximately 54% and 46%, respectively, of the combined
revenues and approximately 53% and 47%, respectively, of the combined operating
income in calendar year 1999. It was also estimated that in calendar year 1999,
using the PT-1 Base Case, STAR would contribute 55% of net income and that PT-1
would contribute approximately 45%. Using the PT-1 Conservative Case, it was
estimated that STAR and PT-1 would contribute approximately 55% and 45%,
respectively, of the combined revenues and approximately 63% and 37%,
respectively, of the combined operating income in calendar year 1999. It was
also estimated that in calendar year 1999, using the PT-1 Conservative Case,
STAR would contribute 64% of net income and that PT-1 would contribute
approximately 36%.
PRO FORMA MERGER ANALYSIS: Hambrecht & Quist analyzed the pro forma impact
of the Merger on the Combined Company's calendar 1999 earnings per share ("EPS")
using (i) stand-alone Wall Street consensus estimates of STAR's EPS in calendar
1998 and 1999 of $0.32 and $0.53, respectively, (ii) the PT-1 Base Case, and
(iii) the PT-1 Conservative Case. The analysis indicated that the EPS of the pro
forma Combined Company would be higher than for STAR as a stand-alone company
using both the PT-1 Base Case and the PT-1 Conservative Case. The actual results
and savings achieved by the Combined Company resulting from the Merger may vary
from the projected results and variations may be material.
ANALYSIS OF PUBLICLY TRADED COMPARABLE COMPANIES: Hambrecht & Quist
compared selected historical and projected financial information of PT-1 to
publicly traded companies Hambrecht & Quist deemed to be comparable to PT-1.
Such information included the ratio of market value to historical and projected
net income. Hambrecht & Quist also examined the ratio of the enterprise value
(market value plus debt less cash) to historical revenue, to historical earnings
before interest and taxes ("EBIT"), to historical earnings before interest,
taxes, depreciation and amortization ("EBITDA"), and to projected revenue.
Companies deemed comparable included selected telecommunication services
companies ("Comparable Public Companies") such as Excel Communications Inc.,
Frontier Corporations, SmarTalk TeleServices Inc., IDT Corporation, Pacific
Gateway Exchange Inc., PRIMUS Telecommunications Group, Inc., RSL Communications
Ltd., STAR, Telegroup Inc., Viatel Inc., and Worldcom Inc. The foregoing
multiples were applied to historical financial results of PT-1 for the
latest-twelve-month ("LTM") period ended June 30, 1998 and projected financial
results using PT-1 Base Case and PT-1 Conservative Case. Hambrecht & Quist
determined average multiples excluding the high and low values for the
Comparables Public Companies of 3.0 times LTM revenue, 23.1 times LTM EBITDA,
40.5 times LTM EBIT, 58.1 times LTM net income, 1.8 times projected calendar
year 1998 revenue, 1.2 times projected calendar 1999 revenue, 34.6 times
projected calendar 1998 net income, and 22.3 times projected calendar 1999 net
income. Based on the analysis of Comparable Public Companies, PT-1's implied
equity value applying multiples to historical results and the projections ranged
from $356 million to $1,442 million. This compared with an offer in the proposed
merger of approximately $261 million based on the closing price of STAR Common
Stock on August 18, 1998.
45
<PAGE>
ANALYSIS OF SELECTED MERGER AND ACQUISITION TRANSACTIONS: Hambrecht & Quist
compared the proposed merger with selected merger and acquisition transactions.
This analysis included 12 transactions with an aggregate consideration between
$100 million and $2 billion involving companies in the telecommunication
services industry ("Comparable M&A Transactions"). In examining these
transactions, Hambrecht & Quist analyzed certain income statement and balance
sheet parameters of the acquired company relative to the consideration offered.
The foregoing multiples were applied to historical financial results of PT-1 for
the twelve-month period ended June 30, 1998. Multiples analyzed included
consideration offered to LTM revenue, LTM EBITDA, LTM EBIT, and LTM net income.
The average multiples excluding high and low values offered in the selected
Comparable M&A Transactions was 2.0 times LTM revenues, 18.4 times LTM EBITDA,
29.2 times LTM EBIT, and 48.3 times LTM net income. Based on the analysis of
selected Comparable M&A Transactions, PT-1's implied equity value applying
multiples to historical results ranged from values between approximately $372
million and approximately $993 million. This result compared with an implied
value in the proposed merger of approximately $261 million based on the closing
price of STAR Common Stock on August 18, 1998.
No company or transaction used in the above analyses is identical to PT-1 or
the Merger. Accordingly, an analysis of the results of the foregoing is not
mathematical; rather it involves complex considerations and judgments concerning
differences in financial and operating characteristics of the companies and
other factors that could affect the public trading values of the companies or
company to which they are compared.
DISCOUNTED CASH FLOW ANALYSIS: Hambrecht & Quist performed discounted cash
flow analyses for PT-1 using projected financial performance through 2002. The
analysis aggregated (i) the present value of the projected free cash flow
(defined as EBIT), less increases in working capital, plus depreciation and
amortization, and less capital expenditures) through 2002 and (ii) the present
value of a range of terminal values for the year 2002. The terminal values for
PT-1 were determined by applying multiples ranging from 1.5 to 2.5 times PT-1's
estimated revenue for 2002. PT-1's free cash flow streams and terminal values
were discounted to present values using discount rates ranging from 18.5% to
20.5%. Such analyses indicated a range of equity values for PT-1 of between $641
million and $1,104 million. These results compared to an implied offer per share
of $261 million in the proposed merger, based on the closing price of STAR
Common Stock on August 18, 1998.
The foregoing description of Hambrecht & Quist's opinion is qualified in its
entirety by reference to the full text of such opinion which is attached as
Annex B to this Proxy Statement.
Hambrecht & Quist, as part of its investment banking services, is regularly
engaged in the valuation of businesses and their securities in connection with
mergers and acquisitions, strategic transactions, corporate restructurings,
negotiated underwriting, secondary distributions of listed and unlisted
securities, private placements and valuations for corporate and other purposes.
In the past, Hambrecht & Quist has provided investment banking and other
financial advisory services to STAR and has received fees for rendering these
services. In particular, Hambrecht & Quist acted as lead managing underwriter in
the Company's initial public offering in 1997 and as co-managing underwriter in
the Company's follow-on offering in 1998. In the ordinary course of business,
Hambrecht & Quist acts as a market maker and broker in the publicly traded
securities of STAR and receives customary compensation in connection therewith,
and also provides research coverage for STAR. In the ordinary course of
business, Hambrecht & Quist actively trades in the equity and derivative
securities of STAR for its own account and for the accounts of its customers
and, accordingly, may at any time hold a long or short position in such
securities. Hambrecht & Quist may in the future provide additional investment
banking or other financial advisory services to STAR. Hambrecht & Quist is also
familiar with PT-1, having participated in the preparation of a registration
statement on Form S-1 in connection with its potential public offering.
Pursuant to an engagement letter dated April 2, 1998, STAR has agreed to pay
Hambrecht & Quist a fee of $500,000 in connection with the delivery of a
fairness opinion rendered on June 9, 1998, and a fee of $500,000 in connection
with the delivery of the fairness opinion rendered on August 20, 1998 both of
which
46
<PAGE>
are credited against any further fees paid in the transaction. Upon consummation
of the Merger, STAR has agreed to pay Hambrecht & Quist a fee of 1.0% of the
aggregate consideration paid in the transaction, subject to adjustment in
certain circumstances. STAR also has agreed to reimburse Hambrecht & Quist for
its reasonable out-of-pocket expenses and to indemnify Hambrecht & Quist against
certain liabilities, including liabilities under the federal securities laws or
relating to or arising out of Hambrecht & Quist's engagement as financial
advisor.
OPINION OF CSFB. STAR also engaged CSFB to act as a financial advisor in
connection with the Merger. In connection with the engagement, STAR requested
that CSFB evaluate the fairness to STAR, from a financial point of view, of the
consideration to be paid by the Company in the Merger. CSFB delivered to STAR
and representatives of the Board on September 10, 1998 its opinion to the effect
that, as of August 20, 1998 and based upon and subject to certain matters stated
in the opinion, the consideration to be paid by the Company in the Merger was
fair to STAR from a financial point of view.
In arriving at its opinion, CSFB reviewed certain publicly available
business and financial information relating to STAR and PT-1, as well as the
Merger Agreement. CSFB also reviewed certain other information, including
financial forecasts provided by STAR and PT-1, and met with the respective
managements of STAR and PT-1 to discuss the business and prospects of STAR and
PT-1.
CSFB also considered certain financial and stock market data of STAR and
financial data of PT-1, and CSFB compared that data with similar data for other
publicly held companies in businesses similar to those of STAR and PT-1 and
considered, to the extent publicly available, the financial terms of certain
other business combinations and other transactions which have recently been
affected. CSFB also considered the results of certain discounted cash flow
projections and such other information, financial studies, analyses and
investigations and financial, economic and market criteria which CSFB deemed
relevant. CSFB also considered the views of the respective managements of STAR
and PT-1 concerning the business, operational and strategic benefits and
implications of the Merger, including financial forecasts provided to CSFB by
STAR and PT-1.
In connection with its review, CSFB did not assume any responsibility for
independent verification of any of the foregoing information and relied on such
information being complete and accurate in all material respects. With respect
to financial forecasts provided by STAR and PT-1, CSFB assumed that they were
reasonably prepared on bases reflecting the best currently available estimates
and judgments of the respective managements of STAR and PT-1 as to the future
financial performance of STAR and PT-1. In addition, CSFB was not requested to
make, and did not make, an independent evaluation or appraisal of the assets or
liabilities (contingent or otherwise) of STAR or PT-1. CSFB assumed, with the
consent of the Board, that the Merger would be accounted for under the
"purchase" method of accounting. CSFB's opinion is necessarily based upon
financial, economic, market and other conditions as they existed and could be
evaluated on the date of the opinion. CSFB did not express any opinion as to
what the value of the STAR Common Stock actually will be when issued to PT-1's
stockholders pursuant to the Merger or the prices at which the STAR Common Stock
will trade subsequent to the Merger. No limitations were imposed by STAR on CSFB
with respect to the investigations made or procedures followed by CSFB in
rendering its opinion.
THE FULL TEXT OF CSFB'S WRITTEN OPINION TO THE BOARD DATED SEPTEMBER 10,
1998, WHICH SETS FORTH THE ASSUMPTIONS MADE, MATTERS CONSIDERED AND LIMITATIONS
ON THE REVIEW UNDERTAKEN, IS ATTACHED AS ANNEX C TO THIS PROXY STATEMENT AND IS
INCORPORATED HEREIN BY REFERENCE. STAR'S STOCKHOLDERS ARE URGED TO READ THIS
OPINION CAREFULLY AND IN ITS ENTIRETY. CSFB'S OPINION IS DIRECTED ONLY TO THE
FAIRNESS OF THE CONSIDERATION TO BE PAID BY THE COMPANY IN THE MERGER FROM A
FINANCIAL POINT OF VIEW TO STAR, DOES NOT ADDRESS ANY OTHER ASPECT OF THE MERGER
OR ANY RELATED TRANSACTION AND DOES NOT CONSTITUTE A RECOMMENDATION TO ANY
STOCKHOLDER AS TO HOW SUCH STOCKHOLDER SHOULD VOTE AT THE SPECIAL MEETING. THE
SUMMARY OF THE
47
<PAGE>
OPINION OF CSFB SET FORTH IN THIS PROXY STATEMENT IS QUALIFIED IN ITS ENTIRETY
BY REFERENCE TO THE FULL TEXT OF SUCH OPINION.
In preparing its opinion for the Board, CSFB performed a variety of
financial and comparative analyses, including those described below. The summary
of CSFB's analyses set forth below does not purport to be a complete description
of the analyses underlying CSFB's opinion. The preparation of a fairness opinion
is a complex analytic process involving various determinations as to the most
appropriate and relevant methods of financial analyses and the application of
those methods to the particular circumstances and, therefore, such an opinion is
not readily susceptible to summary description. In arriving at its opinion, CSFB
made qualitative judgments as to the significance and relevance of each analysis
and factor considered by it. Accordingly, CSFB believes that its analyses must
be considered as a whole and that selecting portions of its analyses and
factors, without considering all analyses and factors, could create a misleading
or incomplete view of the processes underlying such analyses and its opinion. In
its analyses, CSFB made numerous assumptions with respect to STAR, PT-1,
industry performance, regulatory, general business, economic, market and
financial conditions and other matters, many of which are beyond the control of
STAR and PT-1. No company, transaction or business used in such analyses as a
comparison is identical to STAR, PT-1 or the Merger, nor is an evaluation of the
results of such analyses entirely mathematical; rather, it involves complex
considerations and judgments concerning financial and operating characteristics
and other factors that could affect the acquisition value, public trading value
or other values of the companies, their business segments or the transactions
being analyzed. The estimates contained in such analyses and the valuations
resulting from any particular analysis are not necessarily indicative of actual
values or predictive of future results or values, which may be significantly
more or less favorable than those suggested by such analyses. In addition,
analyses relating to the value of businesses or securities do not purport to be
appraisals or to reflect the prices at which businesses or securities actually
may be sold. Accordingly, such estimates are inherently subject to substantial
uncertainty.
The following is a summary of the material financial analyses performed by
CSFB in arriving at its written opinion delivered on September 10, 1998, but
does not purport to be a complete description of the analyses performed by CSFB
for such purposes.
DISCOUNTED CASH FLOW ANALYSIS. CSFB performed a discounted cash flow
analysis on PT-1's projected results for fiscal years 1998--2002. In general,
the discounted cash flow analysis aims to analyze the sum of (i) the present
value of projected "unlevered free cash flows" (defined, for the purposes of
this analysis as the projected after-tax operating earnings plus depreciation
and amortization and other non-cash items, less projected capital expenditures
and investment in working capital, if any) for a particular company and (ii) the
present value of the "terminal value" attributable to the particular company at
the end of the projection period. In conducting the discounted cash flow
analysis of PT-1, CSFB analyzed two projections: (i) forecasts prepared by
management of PT-1 (the "CSFB PT-1 Base Case"); and (ii) forecasts prepared by
CSFB for fiscal years 1998--2002 assuming more modest future performance of PT-1
resulting from lower revenue growth and lower profit margins (the "Amended PT-1
Case"). CSFB calculated terminal values applicable to PT-1 by applying a range
of estimated EBITDA multiples of 8.0x to 9.0x to the projected EBITDA of PT-1 in
fiscal year 2002. The unlevered free cash flows and terminal values were then
discounted to the present using a range of discount rates of 11% to 12%,
representing an estimated range of the weighted average cost of capital
applicable to PT-1. Based on this analysis, the CSFB PT-1 Base Case generated an
enterprise value reference range of approximately $2.0 billion to $2.3 billion,
and the Amended PT-1 Case generated an enterprise value reference range of
approximately $345 million to $400 million. The foregoing range of enterprise
values compares to the enterprise value for PT-1 inherent in the Merger of
approximately $226 million based on the closing price of the Company's Common
Stock as of September 2, 1998.
CSFB also performed a discounted cash flow analysis for STAR based on STAR's
projection of its operating results for the fiscal years 1998--2002 (the "STAR
Base Case"). CSFB calculated terminal values applicable to STAR by applying a
range of estimated EBITDA multiples of 8.0x to 9.0x to the
48
<PAGE>
projected EBITDA of STAR in fiscal year 2002. STAR's projected unlevered free
cash flows and terminal values were then discounted to the present using a range
of discount rates of 11% to 12%, representing an estimated range of the weighted
average cost of capital applicable to STAR. Based on this analysis, the STAR
Base Case generated an enterprise value reference range of approximately $1.1
billion to approximately $1.3 billion. The foregoing range of enterprise values
compares to STAR's enterprise value of approximately $640 million based on the
closing price of STAR Common Stock as of September 2, 1998.
COMPARABLE COMPANIES ANALYSIS. To provide contextual data and comparative
market information, CSFB analyzed the operating performance of PT-1 relative to
companies which offer telecommunication services through calling cards (prepaid
or otherwise) and/or provide international long distance services to ethnic
populations and whose securities are publicly traded and that are deemed by CSFB
to be comparable to PT-1. These companies are Premiere Technologies Corp.,
SmarTalk Teleservices Inc. and Startec Global Communications Corp. (the "CSFB
PT-1 Comparable Companies"). CSFB compared, among other things, enterprise
values based on current stock prices as multiples of estimated 1998 and 1999
revenues, EBITDA and EBIT, in each case based on equity research analysts'
estimates. CSFB determined that the relevant ranges of enterprise value
multiples for the PT-1 Comparable Companies were: (i) with respect to revenues,
0.6x to 0.9x for 1998 and 0.3x to 0.6x for 1999; (ii) with respect to EBITDA
3.0x to 4.0x for 1998 and 2.0x to 3.0x for 1999; and (iii) with respect to EBIT
4.0x to 5.0x for 1998 and 2.0x to 3.0x for 1999. CSFB then calculated imputed
enterprise values of PT-1 by applying projected revenues, EBITDA and EBIT for
1998 and 1999 based on both the PT-1 Base Case and the Amended PT-1 Case to the
multiples derived from its analysis of the CSFB PT-1 Comparable Companies. This
analysis, utilizing revenue and EBITDA multiples, generated an enterprise value
reference range of (i) approximately $132 million to approximately $550 million
based on the CSFB PT-1 Base Case and (ii) approximately $65 million to
approximately $525 million based on the Amended PT-1 Case. The foregoing range
of enterprise values compares to the enterprise value for PT-1 inherent in the
Merger of approximately $226 million based on the closing price of STAR Common
Stock as of September 2, 1998.
CSFB also analyzed the operating performance of STAR relative to certain
international and domestic long distance companies whose securities are publicly
traded and that are deemed by CSFB to be comparable to STAR. These companies are
Frontier Corp., Tel-Save Holdings Inc., RSL Communications Ltd., Pacific Gateway
Exchange Inc., Telegroup Inc. and Startec Global Communications Corp.
(collectively, the "STAR Comparable Companies"). CSFB compared, among other
things, enterprise values based on current stock prices as multiples of
estimated 1998 and 1999 revenues, EBITDA and EBIT, in each case based on equity
research analysts' estimates. CSFB determined that the relevant ranges of
enterprise value multiples for the STAR Comparable Companies were: (i) with
respect to revenues 0.6x to 1.3x for 1998 and 0.3x to 0.8x for 1999; (ii) with
respect to EBITDA 10.0x to 12.0x for 1998 and 7.0x to 9.0x for 1999; and (iii)
with respect to EBIT 19.0x to 20.0x for 1998 and 12.0 to 14.0x for 1999. CSFB
then calculated imputed enterprise values of STAR by applying projected
revenues, EBITDA and EBIT for 1998 and 1999 based on the STAR Base Case to the
multiples derived from its analysis of the STAR Comparable Companies. This
analysis, utilizing revenue and EBITDA multiples, generated an enterprise value
reference range of $400 million to $825 million. The foregoing range of
enterprise values compares to STAR's enterprise value of approximately $640
million based on the closing price of STAR Common Stock as of September 2, 1998.
COMPARABLE TRANSACTIONS ANALYSIS. In conducting its analysis of PT-1, CSFB
analyzed, among other things, the implied transaction multiples paid in selected
merger and acquisition transactions involving companies in the business of
offering telecommunication services through calling cards, pre-paid or
otherwise. These transactions included: the acquisition of each of Smartel
Communications, Inc., GTI Telecom, Inc., Conquest Telecommunications Service
Corp. and American Express Telcom, Inc. by SmarTalk Teleservices Inc., the
acquisitions of each of Global Link Telcom Corporation, Centerpiece
Communications, Inc. and Networks Around the World, Inc. by Global
Telecommunications Solutions Inc., the acquisition of BLT Technologies, Inc. by
WorldCom and the acquisition of MSN Communications, Inc.
49
<PAGE>
by Telscape International Inc. CSFB compared enterprise values inherent in these
transactions as multiples of revenues, EBITDA and EBIT of each acquired company
for the latest available twelve-month period immediately preceding the
announcement of the acquisition of such company. CSFB determined that the
relevant range of multiples for the acquired prepaid calling card companies was
2.0x--3.0x the revenues for the latest available twelve month period preceding
the acquisition announcement. CSFB then calculated imputed enterprise values of
PT-1 by applying actual PT-1 revenues for latest twelve months ended June 30,
1998, to the revenues multiples derived from its analyses of the acquired
companies. This analysis generated an enterprise value reference range of
approximately $1 billion to $1.5 billion. The foregoing range of enterprise
values compares to the enterprise value for PT-1 inherent in the Merger of
approximately $226 million based on the closing price of STAR Common Stock as of
September 2, 1998.
In conducting its analysis of STAR, CSFB also analyzed, among other things,
the implied enterprise value multiples paid in selected merger and acquisition
transactions involving companies in the international and domestic long distance
business. These transactions included: the acquisition of Trescom International,
Inc. by Primus Telecommunications Inc., the acquisition of IDB Communications
Group Inc. by LDDS Communications, Inc. (now WorldCom, Inc.), the acquisition of
LCI International, Inc. by Quest Communications International Inc. (now Qwest
Communications International Inc.), the acquisition of USLD Communications Corp.
by LCI International, Inc., the acquisition of Telco Communications Group Inc.
by Excel Communications Inc. (now Excelcom Inc.) and the acquisition of ALC
Communications Corporation by Frontier Corp. CSFB computed enterprise values
inherent in these transactions as multiples of revenues, EBITDA and EBIT of each
acquired company for the latest available twelve-month period immediately
preceding the announcement of the acquisition of such company. CSFB determined
that the relevant range of multiples for the acquired international and domestic
long distance companies were: (i) with respect to revenues, 2.0x to 2.5x; and
(ii) with respect to EBITDA, 16.0x to 21.0x and with respect to EBIT 18.0x to
25.0x. CSFB then calculated imputed enterprise values of STAR by applying actual
revenues, EBITDA and EBIT for the twelve months ended June 30, 1998 to the
multiples of revenues, EBITDA and EBIT, respectively, derived from its analyses
of the acquired companies. This analysis generated an enterprise value reference
range of approximately $300 million to approximately $1.1 billion. The foregoing
range of enterprise values compares to STAR's enterprise value of approximately
$640 million based on the closing price of STAR Common Stock as of September 2,
1998.
PRO FORMA MERGER ANALYSIS. CSFB analyzed the potential pro forma effect of
the Merger on STAR's projected earnings per share for fiscal years 1998; 1999
and 2000. This analysis indicated that the Merger would be accretive to STAR's
earnings per share in 1998 and 1999, taking into account certain intermediate
and long-term cost synergies which STAR's management believes can be reliably
achieved. The actual results achieved by the combined company may vary from
projected results, and the variations may be material. The analysis also
indicated that without the successful partial achievement of such synergies the
Merger could be dilutive to STAR's earnings per share in 1998 and 1999.
CONTRIBUTION ANALYSIS. CSFB also analyzed (i) the contribution each of STAR
and PT-1 has made or is projected to make to the 1997 and 1998 combined
revenues, EBITDA and EBIT and (ii) the exchange ratio inherent in the valuation
ranges imputed from the Discounted Cash Flow Analysis, Comparable Companies
Analysis and Comparable Transactions Analysis (each of which analysis has been
discussed above). CSFB noted that STAR's stockholders, in aggregate, will have a
disproportionately favorable percentage ownership in the combined companies'
equity value (the "Company Ownership Percentage") when compared with the
percentage ownership inherent in the contribution ratios referenced in (i) above
and the imputed exchange ratios referenced in (ii) above. The Company Ownership
Percentage inherent in the Merger is approximately 75% whereas the range of
contribution percentages and exchange ratios in (i) and (ii) preceding indicate
a Company Ownership Percentage ranging from approximately 39% to approximately
65%.
CSFB has advised STAR that, in the ordinary course of business, it and its
affiliates may actively trade the securities of STAR for its and such
affiliates' own account or for the account of customers and,
50
<PAGE>
accordingly, may at any time hold a long or short position in such securities.
In addition, CSFB previously rendered its opinion dated June 9, 1998 to the
Board that the consideration proposed to be paid pursuant to the terms of the
Original Merger Agreement were fair from a financial point of view to the
stockholders of the Company.
CSFB was selected by STAR as its financial advisor based on its reputation,
experience and expertise. CSFB is an internationally recognized investment
banking firm that is continually engaged in the valuation of businesses and
their securities in connection with mergers and acquisitions, negotiated
underwriting, competitive bids, secondary distributions of listed and unlisted
securities, private placements and valuations for estate, corporate and other
purposes. Neither STAR nor PT-1 has previously been a client of CSFB.
Pursuant to the terms of CSFB's engagement, STAR has agreed to pay CSFB,
upon the Closing, a transaction fee equal to 0.3% of the aggregate consideration
paid in the Merger, which fee shall in no event be less than $1.5 million nor
more than $1.8 million. STAR has also agreed to reimburse CSFB for its
reasonable out-of-pocket expenses, including the fees and expenses of legal
counsel retained by CSFB, and to indemnify CSFB and certain related persons and
entities for certain losses, claims, damages or liabilities (including actions
or proceedings in respect thereof) related to or arising out of, among other
things, its engagement as financial advisor. In connection with its engagement,
CSFB has expressly consented to the use of its fairness opinion in this Proxy
Statement.
IMPACT OF SEPTEMBER 1, 1998 AMENDMENT. As noted above, the fairness
opinions of each of Hambrecht & Quist and CSFB are dated or effective as of
August 20, 1998, the date on which the Merger Agreement, as amended and restated
from its original June 9, 1998 version, was approved by the Boards of Directors
of STAR and PT-1. As of August 20, 1998, the consideration to be delivered to
the stockholders of PT-1 included 15.0 million shares of STAR Common Stock and
$20.0 million in cash, as properly noted in the fairness opinion of each of
Hambrecht & Quist and CSFB. The Merger Agreement was amended as of September 1,
1998 and, among other things, the parties agreed to increase the number of
shares of STAR Common Stock to be issued to the stockholders of PT-1 in the
Merger by 50,000 and to reduce the cash consideration by $500,000, given that,
on such date, STAR Common Stock was trading at $10.563 per share. The STAR Board
determined that this minor change to the form of consideration to be received in
the Merger was not material to its support of the terms and conditions of that
transaction. After discussing this matter with STAR's investment bankers and
confirming that the September 1, 1998 amendment to the Merger Agreement would
not affect any of the analyses made or the conclusions drawn in support of
either fairness opinion, the Board determined that it was unnecessary for the
August 20, 1998 fairness opinions to be revised to reflect the September 1, 1998
changes to the Merger Agreement.
PT-1'S REASONS FOR THE MERGER
The PT-1 Board of Directors has unanimously approved the Merger Agreement
and the transactions contemplated thereby, including the Merger. In reaching
this determination, the PT-1 Board consulted with the management of PT-1, as
well as its financial and legal advisors, and considered a number of factors,
including, without limitation, the following:
(i) the potential economies of scale and efficiencies expected to result
from the combination of the internal operations, systems and departments
of PT-1 and STAR;
(ii) that the combination of the networks of STAR and PT-1 could be expected
to lower the cost to countries where PT-1 currently terminates a
substantial volume of minutes as well as provide PT-1 with low-cost
access to additional foreign countries;
(iii) the potential efficiencies and cost savings expected to result form the
combined traffic volumes of STAR and PT-1, which could result in
negotiating leverage for PT-1 and STAR;
(iv) that the Merger would permit the acceleration of development of the
combined international telecommunications network of STAR and PT-1,
including acquiring additional switches, leased
51
<PAGE>
lines, interests in international cables and direct termination
agreements with foreign carriers; and
(v) that the financial resources of the combined entity would expedite
PT-1's expansion of its retail dial around and presubscribed services
and improve PT-1's ability to introduce additional retail
telecommunications products and services.
In evaluating the Merger, the PT-1 Board of Directors also considered a
number of risks relating to the transaction including: (i) that the Merger would
result in the loss of independent control of PT-1; (ii) that STAR did not have
prior significant experience in the Prepaid Card industry; and (iii) that the
Merger would entail significant integration of the management, financial and
accounting functions and the facilities of PT-1 and STAR.
The foregoing list of the information and factors considered by the PT-1
Board is not intended to be exhaustive. In view of the variety of factors
considered in connection with its evaluation of the Merger, the PT-1 Board did
not find it practicable to and did not quantify or otherwise assign relative
weights to the specific factors considered in reaching its determination. In
addition, individual members of the PT-1 Board may have given different weights
to different factors. The Board also consulted with its financial and legal
advisors as it deemed appropriate in the context of its review and approval of
the Merger.
In accordance with the relevant provisions of the New York Business
Corporation Law, prior to the consummation of the Merger, the eight stockholders
of PT-1 will vote on the Merger Agreement and the transactions contemplated
thereby.
THE MERGER AGREEMENT
The following is a brief description of certain terms and provisions set
forth in the Merger Agreement. This description does not purport to be complete
and is qualified in its entirety by reference to the Merger Agreement, which is
attached hereto as Annex A and is incorporated herein by reference. Capitalized
terms used herein without definition shall have the respective meanings ascribed
thereto in the Merger Agreement. Holders of STAR Common Stock are strongly
encouraged to read the Merger Agreement in its entirety.
Pursuant to the terms of the Merger Agreement, at the Effective Time, (i)
Newco will be merged with and into PT-1 and (ii) the separate existence of Newco
will cease and PT-1 will succeed to all the rights, privileges, powers and
franchises and be subject to all the restrictions, disabilities and duties of
the Constituent Corporations. PT-1 will remain as the Surviving Corporation in
the Merger and will continue to exist as a wholly-owned subsidiary of STAR.
At the Effective Time, the holders of PT-1 Common Stock, PT-1 Options and
PT-1 Warrants will be entitled to receive the Merger Consideration, provided
that, at the Effective Time, STAR will have the option of delivering to the PT-1
stockholders cash or short term promissory notes in an aggregate amount equal to
the cash component of the Merger Consideration. The final exchange ratio for the
PT-1 Common Stock, PT-1 Options and PT-1 Warrants to be exchanged for shares of
STAR Common Stock will be determined immediately prior to the consummation of
the Merger based on a number of variable factors, including the market price of
STAR Common Stock at the Effective Time, the relative exercise price of the PT-1
Options and the expiration or termination of outstanding PT-1 options and PT-1
warrants. Based on 48.4 million shares of PT-1 Common Stock outstanding at
September 30, 1998, the issuance of 15.3 million shares of STAR Common Stock in
the Merger will result in an estimated exchange ratio of 0.31607, which does not
take into account the cash component of the Merger Consideration. No fractional
shares of STAR Common Stock will be issued in the Merger. Rather, holders of
PT-1 Common Stock whose shares are converted in the Merger will be entitled to a
cash payment in lieu of fractional shares, as described under "--Exchange of
Certificates" and "--Fractional Shares." The Merger Agreement also requires STAR
to issue 250,000 shares of STAR Common Stock to certain independent distributors
of PT-1 to be selected immediately prior to the consummation of the Merger. As
of September 1, 1998, based on a per
52
<PAGE>
share closing price of $10.563, the aggregate value of the 15.3 million shares
of STAR Common Stock issuable in connection with the Merger was approximately
$162 million.
EFFECTIVE TIME. The "Effective Time" shall mean the day on which the Merger
will become effective upon the filing, in accordance with Section 904 of the New
York Business Corporation Law, of the Certificate of Merger with the Department
of State of the State of New York, which will occur upon satisfaction or waiver
of all conditions set forth in the Merger Agreement.
DIRECTORS AND OFFICERS OF THE SURVIVING CORPORATION. The Merger Agreement
provides that the directors of Newco at the Effective Time will be the initial
directors of the Surviving Corporation and the officers of PT-1 at the Effective
Time will be the initial officers of the Surviving Corporation. Each of these
directors will hold office from the Effective Time until their respective
successors have been duly elected and qualified in accordance with the
Certificate of Incorporation and Bylaws of the Surviving Corporation.
DIRECTORS AND OFFICERS OF STAR. Following the Effective Time, the current
directors and officers of STAR will remain in their current positions as
directors or officers of STAR, as the case may be, and Mr. Klusaritz will serve
as General Counsel of STAR. Pursuant to the Merger Agreement, STAR has agreed to
take all necessary steps so that Mr. Tawfik will become a member of the Board of
Directors of STAR immediately following the Effective Time.
EXCHANGE OF CERTIFICATES. As soon as practicable after the Effective Time,
the Exchange Agent shall send a notice and a letter of transmittal to each
holder of record of PT-1 Common Stock immediately prior to the Effective Time
advising such holder of the effectiveness of the Merger and the procedure for
surrendering to the Exchange Agent the certificate or certificates to be
exchanged pursuant to the Merger. Holders of PT-1 Common Stock, upon surrender
of their certificates together with a duly completed letter of transmittal, will
receive the Merger Consideration without interest thereon.
FRACTIONAL SHARES. No certificates or scrip representing a fractional share
interest in STAR Common Stock will be issued. In lieu of any such fractional
share interest, each holder of PT-1 Common Stock who otherwise would be entitled
to receive a fractional share interest in STAR Common Stock in the Merger will
be paid cash upon surrender of PT-1 Common Stock in an amount (rounded to the
nearest whole $0.01) equal to the product of such fraction of a share multiplied
by the average closing price of STAR Common Stock on Nasdaq for the five (5)
trading days prior to the Effective Time.
REPRESENTATIONS AND WARRANTIES. The Merger Agreement contains various
customary representations and warranties of PT-1 relating to, among other
things: (a) PT-1's and its subsidiaries' organization and similar corporate
matters; (b) PT-1's capital structure; (c) the authorization, execution,
delivery and enforceability of the Merger Agreement and related matters; (d) the
absence of (i) conflicts under charter documents or bylaws, (ii) the need
(except as specified) for governmental or other filings, permits,
authorizations, consents or approvals with respect to the Merger Agreement and
the transactions contemplated thereby, (iii) violations of, conflicts with,
breaches of, or defaults under any agreement, lien, instrument, order or decree
and (iv) violations of laws; (e) subject to certain exceptions, the absence of
certain specified material changes or events; (f) litigation; (g) labor matters;
(h) employee benefit matters and matters relating to the Employee Retirement
Income Security Act of 1974, as amended ("ERISA"); (i) owned and leased real
property; (j) environmental matters; (k) tax matters; (l) the accuracy of
information to be supplied in connection with the Proxy Statement and any other
documents to be filed with the SEC or any other regulatory agency; (m) financial
statements and reports; material liabilities; and projections; (n) governmental
authorizations and regulations; (o) proprietary property; (p) material
agreements; (q) insurance; (r) accounts receivable; (s) the hiring of brokers or
finders; (t) transactions with affiliated parties; (u) labor matters; (v)
continuity of interests in PT-1 by affiliates; (w) distributors; and (x)
inventory.
The Merger Agreement also contained several representations and warranties
of the PT-1 Stockholders, relating to, among other things: (a) the PT-1
Stockholders' ownership and title to PT-1 Common Stock;
53
<PAGE>
(b) the authorization, execution, delivery and enforceability of the Merger
Agreement and related matters; (c) the absence of (i) violations of, conflicts
with, breaches of, or defaults under any agreement, lien, order, judgment or
decree and (ii) violations of law; (d) the PT-1 Stockholders' accredited
investor status under Rule 501 of the Securities Act; and (e) the shares of STAR
Common Stock to be issued in the Merger.
The Merger Agreement also contains various customary representations and
warranties of STAR and Newco relating to, among other things: (a) STAR and
Newco's organization; (b) STAR and Newco's capital structure; (c) authorization,
execution, delivery and enforceability of the Merger Agreement and related
matters; (d) the absence of (i) conflicts under charter documents or bylaws,
(ii) the need (except as specified) for governmental filings, permits,
authorizations, consents or approvals with respect to the Merger Agreement and
in the transactions contemplated thereby, (iii) violations of, conflicts with,
breaches of, or defaults under any agreement, lien, instrument, order or decree
and (iv) violations of laws; (e) documents filed by STAR with the SEC and the
accuracy of the information contained therein; (f) litigation; (g) the accuracy
of information to be supplied in connection with the Proxy Statement and any
other documents to be filed with the SEC or any other regulatory agency; (h) the
shares of STAR Common Stock to be issued in the Merger; (i) financial statements
and reports; (j) the hiring of brokers or finders; (k) employee benefit matters
and matters relating to ERISA; (l) environmental matters; (m) the absence of
certain material changes or events; and (n) government authorizations.
BUSINESS OF PT-1 PENDING THE MERGER. PT-1 and the PT-1 Stockholders have
agreed that prior to the Effective Time all material managerial and operational
matters will be presented to and subject to the reasonable review and approval
of STAR. In that regard, except as otherwise consented to or approved in writing
by STAR or expressly permitted by the Merger Agreement: (a) the business of PT-1
and of its subsidiaries will be conducted in the ordinary course and consistent
with past practice; (b) neither PT-1 nor its subsidiaries will (i) amend its
Certificate of Incorporation or Bylaws; (ii) change the number of authorized,
issued or outstanding shares of its capital stock, except upon the exercise of
stock options or warrants outstanding on the date of the Merger Agreement (iii)
declare, set aside or pay any dividend; (iv) make any redemption, retirement or
purchase of its capital stock; (v) split, combine or reclassify its capital
stock; (c) neither PT-1 nor its subsidiaries shall directly or indirectly (i)
issue, grant, sell or pledge or agree or propose to issue, grant, sell or pledge
any shares of its capital stock, except upon exercise of outstanding stock
options and warrants; (ii) incur any material indebtedness for borrowed money,
except material indebtedness for borrowed money incurred under existing credit
facilities; (iii) waive, release, grant or transfer any rights of material
value; or (iv) transfer, lease, license, sell, mortgage, pledge, dispose of or
encumber any material assets other than in the ordinary course of business and
consistent with past practice; (d) neither PT-1 nor its subsidiaries shall fail
to preserve intact its business organization, to use its respective best efforts
to keep available the services of its operating personnel or to use its
respective best efforts to preserve the goodwill of those having business
relationships with either PT-1 or its subsidiaries; (e) neither PT-1 nor its
subsidiaries shall directly or indirectly (i) increase the compensation payable
to any of its employees, officers or directors, except in accordance with
existing employment agreements and benefit plans; (ii) adopt any new, or make
any payment not required by any existing plan or agreements, including
provisions and actions under existing stock option plans in connection with the
Merger, in the ordinary course of business consistent with prior practice, with
respect to any stock option, bonus, profit-sharing, pension, retirement,
deferred compensation, employment, or other payment or employee compensation
plan; (iii) grant any stock option or stock appreciation rights or issue any
warrants; (iv) enter into or amend any employment or severance agreement; or
(iv) make any loan or advance to, or enter into any written contract with any
officer, director or PT-1 Stockholder; (f) neither PT-1 nor its subsidiaries
shall directly or indirectly assume, guarantee, endorse or otherwise become
responsible for the obligations of any other individual, firm or corporation or
make any loans or advances to any individual, firm or corporation other than in
the ordinary course of business and consistent with past practice; (g) neither
PT-1 nor its subsidiaries shall make any investment of a capital nature other
than in the ordinary course of business under certain material contracts in
place on the date of the Merger Agreement; (h) neither PT-1 nor its subsidiaries
shall enter into, modify, amend or terminate any material contract; (i) neither
PT-1 nor
54
<PAGE>
its subsidiaries shall take any action, other than reasonable and usual actions
in the ordinary course of business and consistent with past practice, with
respect to accounting policies or procedures, except for changes required by
GAAP; (j) neither PT-1 nor its subsidiaries shall settle or compromise any
material federal, state, local or foreign income tax proceeding or audit; (k)
neither PT-1 nor its subsidiaries shall fail to advise STAR in writing of
anything that would have a material adverse effect on the financial condition,
results of operations, business or properties of PT-1 or its subsidiaries or any
breach of PT-1's representations or warranties or any known breach of any
covenant in the Merger Agreement; or (l) neither PT-1 nor its subsidiaries shall
enter into an agreement to do any of the things described above.
ACQUISITION PROPOSALS. PT-1 and the PT-1 Stockholders have each agreed that
neither PT-1 nor any of its subsidiaries, nor the PT-1 Stockholders, directors,
officers, partners, employees, or other authorized persons of any of them, will,
directly or indirectly, solicit, initiate, encourage or participate in
discussions or negotiations with or the submission of any offer or proposal by
or provide any information or access to, any corporation, partnership, person,
or other entity or group (other than Newco or STAR or any officer or other
authorized representative of Newco or STAR) concerning an offer or proposal for
a merger or other business combination involving PT-1 or any of its
subsidiaries, or the acquisition of any equity interest in, or a substantial
portion of the assets of, PT-1 or any subsidiary, other than the transactions
contemplated by the Merger Agreement (each, an "Acquisition Proposal"). PT-1
will promptly, in no event later than 24 hours after receipt of the relevant
Acquisition Proposal, notify STAR after (i) PT-1 has received any acquisition
Proposal, (ii) PT-1 has actual knowledge that any person is considering making
an Acquisition Proposal, or (iii) PT-1 has received any request for information
relating to PT-1 or any subsidiary, or for access to the properties, books or
records of PT-1 or any subsidiary, by any person that PT-1 has actual knowledge
is considering making, or has made, an Acquisition Proposal.
TREATMENT OF PT-1 STOCK OPTIONS AND WARRANTS. On the Effective Time, STAR
shall assume the duties and obligations of PT-1, and STAR shall be vested with
the powers, rights and privileges of PT-1, under the PT-1 Warrants and the PT-1
Options. As of the Effective Time, STAR shall have reserved for issuance and
continue to maintain sufficient shares of registered STAR Common Stock to issue
the required shares of STAR Common Stock pursuant to the exercise of such
warrants and options after the Effective Time, subject to appropriate adjustment
in the exercise price thereof.
INDEMNIFICATION. The PT-1 Stockholders have agreed (a) with respect to the
representations and warranties of the PT-1 Stockholders, severally but not
jointly, and (b) with respect to the representations and warranties of PT-1,
jointly and severally, to indemnify STAR, and each of STAR's respective
officers, directors, employees, agents and representatives (collectively, the
"STAR Indemnities") against and hold such individuals harmless from any and all
claims, obligations, losses, damages, costs, expenses (including without
limitation, reasonable attorneys' fees and expenses) and other liabilities of
STAR (collectively, the "Losses") arising out of the breach of any
representation, warranty, covenant or agreement of PT-1 or the PT-1 Stockholders
in the Merger Agreement, as the case may be, whether or not such losses arise as
a result of third party claims asserted against PT-1. Notwithstanding the
foregoing, the PT-1 Stockholders shall not be liable pursuant to the
indemnification until the aggregate of all such Losses exceeds $1,000,000, in
which case, the PT-1 Stockholders will be required to indemnify the STAR
Indemnitees for the full amount of such Losses, including the $1,000,000
threshold amount, up to but not exceeding the value of the Escrow Shares (as
defined below). No claim for indemnification may be made after the Escrow
Period.
CONFIDENTIALITY. Subject to applicable law and to subpoena, STAR, Newco and
PT-1, its subsidiaries and the PT-1 Stockholders have agreed to hold, and to
cause each of their affiliates, employees, officers, directors and other
representatives to hold, in strict confidence, and to not use to the detriment
of the other party, any information or data concerning the other party furnished
to them in connection with the transactions contemplated by the Merger
Agreement, except for information or data generally known or available to the
public. If the transactions contemplated by the Merger Agreement are not
consummated, such confidence shall be maintained and all such information and
data as requested shall be returned.
55
<PAGE>
EXPENSES AND FEES. Each party to the Merger Agreement shall bear his or its
own fees and expenses incurred in connection with the transactions contemplated
by the Merger Agreement, provided that, in the context of the enforcement of the
terms and conditions of the Merger Agreement, the prevailing party will be
entitled to the payment of its reasonable legal fees and expenses incurred in
connection with the enforcement of such rights. In addition, in certain
circumstances, PT-1 shall pay to Newco a termination fee. See "--Termination
Fee."
CONDITIONS. The respective obligations of each of STAR, Newco, PT-1 and the
PT-1 Stockholders to effect the Merger are subject to the satisfaction of the
following conditions at or prior to the Effective Time: (a) the approval and
adoption of the Merger Agreement and the transactions contemplated thereby by
the requisite vote of STAR stockholders; (b) the absence of any statute, rule,
regulation, temporary, preliminary or permanent injunction or other order by any
United States or state governmental authority, agency, commission or United
States or state court of competent jurisdiction prohibiting consummation of the
Merger or having the effect of making the Merger illegal; (c) the expiration or
termination of any waiting period applicable to the consummation of the Merger
under the HSR Act; (d) the receipt by or on behalf of STAR of all necessary
regulatory approvals from the FCC, all PUCs and Foreign Agencies required for
the transfer of ownership or control over PT-1; (e) the authorization for
listing of the shares of STAR Common Stock to be issued in connection with the
Merger on the Nasdaq National Market upon official notice of issuance; and (f)
the absence of any action or proceeding by or before any court or governmental
authority or other regulatory or administrative agency or commission of
competent jurisdiction which would require either party to take any action which
would result in a material adverse effect to their respective businesses or
materially impair STAR's or the Surviving Corporation's ownership or operation
of all or a material portion of the business or assets of PT-1 and its
subsidiaries, taken as a whole, or compel STAR to dispose of all or a material
portion of the business or assets or PT-1 and its subsidiaries, taken as a
whole.
In addition, the obligations of PT-1 to effect the Merger are subject to the
satisfaction at or prior to the Effective Time of the following additional
conditions: (a) each of STAR and Newco shall have performed in all material
respects its obligations under the Merger Agreement required to be performed by
it on or prior to the Effective Time; (b) the representations and warranties of
STAR and Newco contained in the Merger Agreement shall be true and correct in
all material respects as if such representations and warranties were made as of
the Effective Time, except as contemplated by the Merger Agreement; (c) there
shall not have been any material adverse change in the financial condition,
results of operations, properties or business of STAR and its subsidiaries,
taken as a whole, excluding any such change caused by a general change in the
economy or in the telecommunications industry served by STAR and its
subsidiaries; (d) PT-1 shall have received a certificate of the President or
Vice President of STAR with respect to clauses (a), (b) and (c); (e) PT-1 shall
have received an opinion of counsel in form reasonably agreed to by the parties;
(f) STAR and each PT-1 Stockholder shall have entered into a registration rights
and restricted share agreement; (g) STAR shall have taken all necessary steps
such that Mr. Tawfik will become a member of the Board immediately following the
Effective Time; and (h) PT-1 shall have received reasonably satisfactory
evidence that, following the Effective Date, (i) the shares of STAR Common Stock
issuable on exercise of the PT-1 Options and Warrants shall be subject to an
effective Registration Statement on Form S-8 filed by STAR pursuant to the
Securities Act, (ii) 250,000 shares of STAR Common Stock have been reserved for
issuance to selected independent distributors of PT-1 in the form of restricted
shares pursuant to restricted stock purchase agreements to be entered into
between such distributors and STAR, at no consideration per share to such
distributors and with a pro rata vesting schedule of no more than four years,
such distributors to be designated by PT-1 and reasonably acceptable to STAR and
(iii) 100,000 shares of STAR Common Stock have been reserved for issuance to
selected employees in the form of stock options under STAR's presently
outstanding employee stock option plan, with such selected employees to be
designated by PT-1 and reasonably acceptable to STAR.
The obligations of STAR and Newco to effect the Merger are subject to the
satisfaction at or prior to the Effective Time of the following additional
conditions: (a) each of PT-1 and its subsidiaries shall have
56
<PAGE>
performed in all material respects its obligations under the Merger Agreement
required to be performed by it on or prior to the Effective Time; (b) the
representations and warranties of PT-1 contained in the Merger Agreement which
are qualified with respect to materiality shall be true and correct and all such
representations and warranties that are not so qualified shall be true and
correct in all material respects as if such representations and warranties were
made as of the Effective Time, except as contemplated by the Merger Agreement;
(c) there shall not have been any material adverse change in the financial
condition, results of operations, properties or business of PT-1 and its
subsidiaries taken as a whole, other than any change arising from any action
authorized, directed or otherwise approved by STAR pursuant to the Merger
Agreement or from STAR's express refusal to approve any action proposed by PT-1
and excluding any change caused by a general change in the economy or in the
telecommunications industry served by PT-1 and its subsidiaries, other than any
such change approved by STAR; (d) STAR and Newco shall have received a
certificate of the President or Vice President of PT-1 with respect to clauses
(a), (b) and (c); (e) Newco shall have received letters of resignation from the
members of PT-1's Board of Directors; and (f) STAR shall have received an
opinion of counsel from counsel to PT-1 in form reasonably agreed to by the
parties.
TERMINATION. The Merger Agreement may be terminated at any time prior to
the Effective Time and before approval by the STAR stockholders in a number of
circumstances which include, among others: (a) by mutual consent of STAR and
PT-1; (b) by STAR if (i) there has occurred a material adverse change in the
financial condition, results of operations, business or properties of PT-1 and
its subsidiaries taken as a whole, other than any change arising from any action
authorized, directed or otherwise approved by STAR pursuant to the terms of the
Merger Agreement or from STAR's express refusal to approve any action proposed
by PT-1 and except for any change caused by a general change in the economy of
the United States or in the telecommunications industry served by PT-1, (ii)
there is a breach of any of the representations and warranties of PT-1 which are
qualified with respect to materiality or if STAR shall have breached in any
material respect any of such representations or warranties which are not so
qualified, or (iii) if PT-1 or any of the PT-1 Stockholders fails to comply in
any material respect with any of its covenants or agreements, or otherwise
wilfully breaches or fails to perform pursuant to the terms of the Merger
Agreement which breaches or failures are, in the aggregate, material in the
context of the transactions contemplated by the Merger Agreement; (c) by PT-1
(i) if there has occurred a material adverse change in the financial condition,
results of operations, business or properties of STAR except for any change
caused by a general change in the economy of the United States or in the
telecommunications industry served by PT-1, and except as otherwise approved in
writing by STAR or (ii) there is a breach of any of the representations and
warranties of STAR or Newco which are qualified with respect to materiality or
if STAR shall have breached in any material respect any of such representations
or warranties which are not so qualified, or if STAR or Newco fails to comply in
any material respect with any of its covenants or agreements, or otherwise
wilfully breaches or fails to perform pursuant to the terms of the Merger
Agreement which breaches or failures are, in the aggregate, material in the
context of the transactions contemplated by the Merger Agreement; and (d) by
either STAR or PT-1, if on or before March 31, 1999 (such date being referred to
as the "Closing Date"), or on or before June 30, 1999, provided that if
immediately prior to December 31, 1998 the approvals with respect to all
material filings with the FCC, PUCs and Foreign Agencies shall not have been
received but all other conditions to the closing of the Merger shall have been
satisfied or waived, the Merger shall not have been consummated; provided that
such failure has not been caused by that party's material breach of the Merger
Agreement; provided further that if any condition to the Merger Agreement shall
fail to be satisfied by reason of the existence of an injunction or order of any
court or governmental or regulatory body resulting from an action or proceeding
commenced by any party which is not a government or governmental authority, then
at the request of either party the deadline date referred to above shall be
extended for a reasonable period of time, not in excess of 120 days, to permit
the parties to have such injunction vacated or order reversed.
In the event of such termination and abandonment, no party to the Merger
Agreement (or any of its directors or officers) shall have any liability or
further obligation to any other party to the Merger
57
<PAGE>
Agreement, except for the Termination Fee, if required, and except that nothing
in the Merger Agreement will relieve any party from liability for any wilful
breach of the Merger Agreement prior to such termination or abandonment.
TERMINATION FEE. If the Merger Agreement is terminated by STAR, pursuant to
clause (b)(iii) above, and, within six months following such termination, PT-1
and/or the PT-1 Stockholders enter into an agreement contemplating the
acquisition, by means of a tender or exchange offer, merger, consolidation,
business combination or otherwise, of all or a substantial portion of the
outstanding shares of PT-1 Common Stock or of the assets of PT-1 and its
subsidiaries and the value of the consideration to be received by the
stockholders of PT-1 with respect to such transaction equals or exceeds $500
million, then PT-1 shall, simultaneously with consummation of such transaction
or transactions, pay to STAR, by wire transfer of immediately available funds,
$20 million (the "Termination Fee").
AMENDMENT AND WAIVER. Subject to applicable law, the Merger Agreement may
be amended by the parties thereto solely by action of their respective Boards of
Directors. Any such amendment must be in writing and signed by both of the
parties. At any time prior to the Effective Time, the parties may (i) extend the
time for the performance of any of the obligations or other acts of the other
parties to the Merger Agreement, (ii) waive any inaccuracies in the
representations and warranties of the other party or in any documents delivered
pursuant to the Merger Agreement, and (iii) waive compliance by the other party
with any of the agreements or conditions to the Merger Agreement. Any agreement
on the part of such a party to any such extension or waiver shall be valid only
if set forth in an instrument in writing signed on behalf of such party.
RELATED AGREEMENTS
Certain additional agreements are attached as exhibits to the Merger
Agreement, consisting of: (a) the Shareholder Agreement among PT-1 and Messrs.
Edgecomb and Crumly and Ms. Casey, which was executed simultaneously with the
Merger Agreement; (b) the Registration Rights and Restricted Share Agreement
between STAR and the PT-1 Stockholders; and (c) the Escrow Agreement among STAR
and the PT-1 Stockholders. STAR and certain executives of PT-1 also entered into
amendments (the "Amendments") to such officers' current employment agreements
with PT-1 to provide, among other things, for the officers' employment with PT-1
or STAR following the Merger and certain non-competition provisions.
SHAREHOLDER AGREEMENT. Pursuant to the Shareholder Agreement, Messrs.
Edgecomb and Crumly and Ms. Casey have agreed to vote all shares of STAR Common
Stock held, beneficially or of record, by such individuals, and to express their
consent, in favor of approval of the Merger Agreement and any actions required
in furtherance thereof and against any action or agreement that would result in
a breach in any respect of any covenant, representation or warranty or any other
obligation or agreement of STAR or Newco under the Merger Agreement. The
obligations of such individuals under the Shareholder Agreement will terminate
on the earlier of the Effective Time or termination of the Merger Agreement for
any reason. As of October 13, 1998, Mr. Edgecomb held 12,702,807 shares, or
approximately 30.1% of the outstanding STAR Common Stock, Mr. Crumly held
737,666 shares, or approximately 1.7% of the outstanding STAR Common Stock, and
Ms. Casey held 1,596,613 shares, or approximately 3.8% of the outstanding STAR
Common Stock.
REGISTRATION RIGHTS AND RESTRICTED SHARE AGREEMENT. The Registration Rights
and Restricted Share Agreement between STAR and the PT-1 Stockholders, which
will be executed by the parties on the Closing Date, provides for certain
transfer restrictions on the shares received by the PT-1 Stockholders in the
Merger. The Agreement prohibits the PT-1 Stockholders from transferring
1,550,000 of such shares (the "One-Year Shares"), until after the passage of the
first anniversary of the Closing Date and the remaining 13.5 million of such
shares until after the passage of the second anniversary of the Closing Date
(the "Two-Year Shares"). The transfer restrictions imposed on the One-Year
Shares and the Two-Year Shares are very expansive and effectively prohibit
virtually all transfers of such shares by the PT-1 Stockholders during
58
<PAGE>
such periods. The restrictions on transfer of such shares are much more
prohibitive than would otherwise be the case under Rule 144 of the Securities
Act. The Registration Rights and Restricted Share Agreement also provides that,
with respect to the shares of STAR Common Stock received by each PT-1
Stockholder pursuant to the Merger (the "Registrable Securities"), the PT-1
Stockholders may, on not more than one occasion during each of the first
twelve-month periods following the second anniversary of the Closing Date,
request STAR to prepare and file with the Commission a registration statement
under the Securities Act covering the public offer and sale of the Registrable
Securities, provided that such request relates to the registration of at least
three million shares of Registrable Securities. The Agreement also provides for
customary "piggyback" registration rights commencing after the second
anniversary of the Closing Date, or, with respect to the One-Year Shares, at any
time after the first anniversary of the Closing Date, in the event STAR proposes
to register any of its stock or other securities, for its own account or for the
account of any other stockholder. The Agreement contains additional customary
terms and provisions, including reciprocal restrictions on the public sale or
distribution of shares of STAR Common Stock during certain underwritten
offerings and reciprocal indemnification and contribution provisions with
respect to information furnished or provided by STAR or the PT-1 Stockholders
for inclusion in any registration statement.
ESCROW AGREEMENT. The Escrow Agreement between STAR and the PT-1
Stockholders, which will be executed by the parties on the Closing Date,
provides that 1,505,000 of the shares of STAR Common Stock issued to the
stockholders of PT-1 in the Merger (the "Escrow Shares") will be deposited at
the Closing Date in an escrow established with Santa Barbara Bank and Trust, or
another mutually agreed upon escrow agent. The Escrow Shares will be subject to
offset pursuant to the indemnification provisions of the Merger Agreement. The
maximum liability of the PT-1 Stockholders pursuant to such indemnification is
limited to the Escrow Shares. Subject to the filing of any claims against any
portion of the Escrow Shares, the Escrow Agreement will be in place for a period
commencing at the Closing Date and ending on the first anniversary thereof,
provided that, at ninety day intervals during the escrow period, portions of the
Escrow Shares may be released to the PT-1 Stockholders, though such shares will
become First-Year Shares following the release of such shares from escrow.
EMPLOYMENT AGREEMENTS. Pursuant to the Amendments, after consummation of
the Merger, the officers of PT-1 will be Mr. Tawfik (President), Mr. Vita
(Executive Vice President), Douglas Barley (Chief Financial Officer) and Mr.
Klusaritz (General Counsel). Mr. Klusaritz will also serve as General Counsel of
STAR. Such officers also agreed to certain restrictions on competition during
their employment with PT-1 and/or STAR.
SHORT TERM NOTES. Pursuant to the December 29, 1998 amendment to the Merger
Agreement, at the Effective Time, STAR has the option of delivering to the PT-1
stockholders cash or short term promissory notes (the "Short Term Notes") in an
aggregate amount equal to the cash component of the Merger Consideration. If
issued by STAR at the Effective Time, the Short Term Notes will be non-interest
bearing demand promissory notes payable at the earliest to occur of (a) the date
of funding of STAR's 1999 senior credit facility and (b) March 31, 1999.
ACCOUNTING TREATMENT OF THE MERGER
The Merger will be accounted for by STAR under the purchase method of
accounting in accordance with APB No. 16. Under this method of accounting, the
purchase price will be allocated to assets acquired and liabilities assumed
based on their estimated fair values. A representative of Arthur Andersen,
STAR's independent public accountants will be available at the Special Meeting
to respond to appropriate questions.
FEDERAL INCOME TAX CONSEQUENCES OF THE MERGER
The Merger will not have any U.S. federal, state or local income tax effect
on STAR or any stockholder of STAR.
59
<PAGE>
REGULATORY APPROVALS
Under the HSR Act, and the rules promulgated thereunder by the FTC, the
Merger may not be consummated until notification and certain information has
been furnished to the FTC and the Antitrust Division of the Department of
Justice (the "Antitrust Division") and specified waiting period requirements
have been satisfied.
STAR and PT-1 have each filed notification and report forms with respect to
the Merger under the HSR Act with the FTC and the Antitrust Division. The
required waiting period with respect to the Merger expired on September 14,
1998. At any time before or after consummation of the Merger, the Antitrust
Division or the FTC could take such action under the antitrust laws as it deems
necessary or desirable in the public interest, including seeking to enjoin the
consummation of the Merger or seeking divestiture of substantial assets of STAR
or PT-1 or any of their respective subsidiaries. At any time before or after the
Effective Time, and notwithstanding that the HSR Act waiting period has expired,
any state could take such action under its antitrust laws as it deems necessary
or desirable. Such action could include seeking to enjoin the consummation of
the Merger or seeking divestiture of substantial assets of STAR or PT-1 or the
Surviving Corporation. Private parties also may seek to take legal action under
the antitrust laws under certain circumstances.
Prior to the change in ownership or management of PT-1 or the transfer of
control over PT-1's certificate of public convenience and necessity and daily
operations, STAR was required to obtain regulatory approvals for the transfer of
ownership or control over PT-1 from the FCC, all PUCs and certain Foreign
Agencies. STAR has received all such necessary regulatory approvals. See "Risk
Factors-- Potential Adverse Effect of Government Regulation--Change of Control."
STOCK EXCHANGE LISTING
It is a condition to the consummation of the Merger that the shares of STAR
Common Stock issuable to the stockholders of PT-1 pursuant to the terms of the
Merger Agreement be authorized for listing on Nasdaq.
LOAN TO PT-1
In contemplation of the Merger, on August 17, 1998, STAR entered into a
$10.0 million loan arrangement with PT-1 (the "PT-1 Loan"). The PT-1 Loan is due
and payable on August 17, 1999 and accrues interest monthly at a rate of 6 3/4%
per annum. STAR agreed to the PT-1 Loan to allow for an expansion of PT-1's
business in areas other than Prepaid Cards. PT-1 has used the proceeds from the
PT-1 Loan to finance the production and distribution of marketing materials and
advertisements relating to PT-1's dial around program, to finance receivables
generated from the program, to cover network-related operating expenses and for
other internal working capital purposes.
VOTE REQUIRED AND RECOMMENDATION OF THE BOARD
The Merger Agreement and the Share Issuance contemplated thereby requires
the affirmative vote of the holders of a majority of the outstanding shares of
STAR Common Stock entitled to vote at the Special Meeting.
THE BOARD UNANIMOUSLY RECOMMENDS THAT THE STOCKHOLDERS VOTE "FOR" THE
APPROVAL AND ADOPTION OF THE MERGER AGREEMENT AND THE TRANSACTIONS CONTEMPLATED
THEREBY, INCLUDING THE SHARE ISSUANCE.
60
<PAGE>
UNAUDITED PRO FORMA FINANCIAL DATA
The following unaudited pro forma financial data is presented assuming the
Merger will be accounted for as a purchase, whereby STAR will allocate the
purchase price to assets acquired and liabilities assumed based on their fair
values. STAR also entered into an agreement to acquire UDN on November 19, 1997,
and plans to account for this transaction as a pooling of interests. The
consummation of the UDN acquisition is subject to several conditions, including
the approval of the stockholders of UDN and certain regulatory agencies. Because
of the various contingencies relating to the consummation of the UDN
transaction, the pro forma financial statements of STAR have been presented
alternatively: (1) assuming that STAR will not complete the acquisition of UDN
and (2) assuming that STAR will complete the acquisition of UDN.
Thus the first set of unaudited pro forma condensed statement of operations
data for the twelve months ended December 31, 1997 and the nine months ended
September 30, 1997 and 1998 only gives effect to the Merger as if it had
occurred on January 1, 1997. The unaudited pro forma condensed combined balance
sheet as of September 30, 1998 gives effect to the Merger as if it had occurred
on September 30, 1998. None of the above referenced unaudited pro forma
condensed financial statements include UDN.
The Merger will be accounted for as a purchase transaction. The estimated
total purchase price will be allocated to the fair value of the assets and
liabilities acquired. The excess of the purchase price plus transaction costs
over the fair value of the net assets acquired will be allocated to goodwill and
as such amortized on a straight-line basis over a 20-year period. The
preliminary amount allocated to goodwill is estimated to be approximately $181
million. The table below sets forth the computation of the total purchase price
(in thousands), calculated in accordance with APB 16 and the preliminary
allocation of the purchase price to the acquired assets and assumed liabilities.
<TABLE>
<S> <C>
Shares of STAR Common Stock to be issued the Merger:
One-year shares (1)..................................................... $ 17,376
Two-year shares (2)..................................................... 136,202
---------
Fair value of shares issued........................................... 153,578
Cash consideration.................................................... 19,500
Merger related costs.................................................. 14,000
Cash payment to Godot................................................. 2,000
---------
Total purchase price...................................................... 189,078
Net assets of PT-1 acquired........................................... (3,820)
Adjustment for acquired service obligation............................ (4,247)
---------
Total goodwill............................................................ $ 181,011
---------
---------
</TABLE>
- ------------------------
(1) 1.55 million shares of STAR Common Stock at $11.21 per share
(2) 13.5 million shares of STAR Common Stock at $11.21 per share, less a 10%
discount
The second set of unaudited pro forma condensed financial statements assumes
completion of STAR's merger with UDN in a pooling of interests transaction. The
historical condensed statement of operations data for the years ended December
31, 1995, 1996 and 1997 and the nine months ended September 30, 1997 and 1998 is
combined with the historical operating results of UDN for the twelve months
ended January 31, 1996, 1997 and 1998, and the nine months ended September 30,
1997 and 1998. The resulting combined unaudited pro forma statements of
operations for the twelve months ended December 31, 1997 and the nine months
ended September 30, 1997 and 1998 are combined with the results of operations of
PT-1 for the year ended March 31, 1998 and the nine months ended September 30,
1997 and 1998 assuming the acquisition of PT-1 had occurred on January 1, 1997.
The historical condensed balance sheet
61
<PAGE>
of STAR at September 30, 1998 is combined with the historical condensed balance
sheet of UDN assuming they had always been one entity. The resulting pro forma
balance sheet at September 30, 1998 gives effect to the Merger as if it had
occurred on September 30, 1998.
THE UNAUDITED PRO FORMA FINANCIAL DATA DOES NOT PURPORT TO PRESENT THE
FINANCIAL POSITION OR RESULTS OF OPERATIONS OF STAR HAD THE TRANSACTIONS AND
EVENTS ASSUMED THEREIN OCCURRED ON THE DATES SPECIFIED, NOR ARE THEY NECESSARILY
INDICATIVE OF THE RESULTS OF OPERATIONS THAT MAY BE ACHIEVED BY STAR IN THE
FUTURE.
The unaudited pro forma financial data does not give effect to certain cost
savings that STAR believes may be realized as a result of the Merger. There can
be no assurances that such cost savings, if any, will be achieved. See
"Description of Forward-Looking Statements."
The unaudited pro forma financial data is based on certain assumptions and
adjustments described in the notes to the unaudited pro forma financial data
included in this Proxy Statement and should be read in conjunction therewith and
with "Management's Discussion and Analysis of Financial Condition and Results of
Operations of STAR," "Management's Discussion and Analysis of Financial
Condition and Results of Operations of PT-1" and the consolidated financial
statements of each of STAR, PT-1 and UDN and the related notes thereto, included
elsewhere in this Proxy Statement.
62
<PAGE>
UNAUDITED PRO FORMA CONDENSED COMBINED BALANCE SHEET
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
AT SEPTEMBER 30, 1998
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
STAR PT-1
SEPTEMBER SEPTEMBER
30, 30, MERGER PRO FORMA
1998 1998 ADJUSTMENTS COMBINED
-------- -------- ------------- ---------
<S> <C> <C> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents............. $11,808 $ 5,382 $ -- $ 17,190
Short-term investments................ 92,390 2,148 (19,500)(a) 73,038
(2,000)(s)
Accounts and notes receivable......... 80,721 46,940 (22,951)(b) 104,710
Receivable from related parties....... 330 -- -- 330
Other current assets.................. 27,580 5,390 (2,110)(c) 30,860
-------- -------- ------------- ---------
Total current assets.................. 212,829 59,860 (46,561) 226,128
Property and equipment, net........... 113,851 43,480 -- 157,331
Intangible assets, net................ -- 2,493 -- 2,493
Goodwill.............................. -- -- 181,011(d) 181,011
Deferred distributor costs............ -- -- 2,803(t) 2,803
Other long-term assets................ 7,340 1,119 -- 8,459
-------- -------- ------------- ---------
Total assets........................ $334,020 $106,952 $137,253 $578,225
-------- -------- ------------- ---------
-------- -------- ------------- ---------
CURRENT LIABILITIES:
Short-term debt....................... $ -- $15,000 $(10,000)(b) $ 5,000
Payable to stockholders............... 5 -- -- 5
Current portion of long-term 7,595 1,736 -- 9,331
obligations.........................
Note payable.......................... -- 5,000 -- 5,000
Accounts payable and accrued 36,200 21,470 14,000(c) 56,609
expenses............................ (12,951)(b)
(2,110)(c)
Due to carriers....................... -- 13,113 -- 13,113
Deferred revenue...................... -- 42,026 (42,026)(p) --
Acquired service obligation........... -- -- 37,779(v) 37,779
Accrued network cost.................. 52,464 -- -- 52,464
-------- -------- ------------- ---------
Total current liabilities........... 96,264 98,345 (15,308) 179,301
-------- -------- ------------- ---------
Long-term obligations................. 31,053 7,512 -- 38,565
Other long-term liabilities........... 1,638 700 -- 2,338
-------- -------- ------------- ---------
Total long-term liabilities......... 32,691 8,212 -- 40,903
STOCKHOLDERS' EQUITY (DEFICIT)
Common stock of STAR (100,000,000
shares authorized, 42,205,418 actual
shares and 57,505,418 pro forma
shares issued and outstanding)...... 42 -- 15(f) 57
Common stock of PT-1 (150,000,000
shares authorized, 73,459,180 actual
shares issued, 48,406,548 actual
shares outstanding and no pro forma
shares issued or outstanding)....... -- 735 (735)(g) --
Paid-in capital....................... 194,138 16,166 156,366(h) 350,504
(16,166)(j)
Accumulated other comprehensive 219 -- -- 219
income..............................
Retained earnings (deficit)........... 10,666 1,919 (1,919)(j) 10,666
Treasury stock........................ -- (15,000 ) 15,000(k) --
Note receivable from stockholder...... -- (3,425 ) -- (3,425)
-------- -------- ------------- ---------
205,065 395 152,561 358,021
-------- -------- ------------- ---------
Total liabilities and stockholder's $334,020 $106,952 $137,253 $578,225
equity............................
-------- -------- ------------- ---------
-------- -------- ------------- ---------
</TABLE>
63
<PAGE>
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
FOR THE YEAR ENDED DECEMBER 31, 1997
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
STAR YEAR
ENDED PT-1 YEAR
DECEMBER ENDED
31, MARCH 31, MERGER PRO FORMA
1997 1998 ADJUSTMENTS COMBINED
---------- ---------- ------------- ----------
<S> <C> <C> <C> <C>
REVENUES................................ $ 404,605 $ 431,520 $ (49,441)(l) $ 786,684
OPERATING EXPENSES:
Cost of services...................... 351,821 395,501 (49,441)(l) 697,881
Selling, general and administrative
expenses............................ 36,782 17,724 701(m) 55,207
Depreciation and amortization......... 4,637 1,535 9,051(n) 15,223
---------- ---------- ------------- ----------
393,240 414,760 (39,689) 768,311
---------- ---------- ------------- ----------
Income from operations................ 11,365 16,760 (9,752) 18,373
---------- ---------- ------------- ----------
OTHER INCOME (EXPENSE):
Interest income....................... 492 517 (1,009)(e) --
Interest expense...................... (1,738) (1,021) (174)(e) (2,933)
Legal settlement and expenses......... (1,653) -- -- (1,653)
Other income (expense)................ 208 474 -- 682
---------- ---------- ------------- ----------
(2,691) (30) (1,183) (3,904)
---------- ---------- ------------- ----------
Income before provision for income
taxes............................... 8,674 16,730 (10,935) 14,469
PRO FORMA PROVISION FOR INCOME TAXES.... 3,100 5,150 156(o) 8,406
---------- ---------- ------------- ----------
PRO FORMA NET INCOME.................... $ 5,574 $ 11,580 $ (11,091) $ 6,063
---------- ---------- ------------- ----------
---------- ---------- ------------- ----------
Pro forma net income per common share:
Basic................................. $ 0.18 $ 0.25 $ 0.13
Diluted............................... $ 0.17 $ 0.24 $ 0.13
Weighted average number of common shares
outstanding:
Basic................................. 30,221 46,922 45,521
Diluted............................... 32,978 47,720 48,278
</TABLE>
64
<PAGE>
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
STAR PT-1
NINE NINE
MONTHS MONTHS
ENDED ENDED
SEPTEMBER SEPTEMBER
30, 30, MERGER PRO FORMA
1997 1997 ADJUSTMENTS COMBINED
---------- ---------- ------------- ----------
<S> <C> <C> <C> <C>
REVENUES................................ $ 283,374 $ 250,906 $ (35,530)(l) $ 498,750
OPERATING EXPENSES:
Cost of services...................... 246,712 229,949 (35,530)(l) 441,131
Selling, general and administrative
expenses............................ 25,118 16,260 526(m) 41,904
Depreciation and amortization......... 3,040 439 6,788(n) 10,267
---------- ---------- ------------- ----------
274,870 246,648 (28,216) 493,302
---------- ---------- ------------- ----------
Income from operations................ 8,504 4,258 (7,314) 5,448
---------- ---------- ------------- ----------
OTHER INCOME (EXPENSE):
Interest income....................... 367 234 (601)(e) --
Interest expense...................... (1,289) (412) (286)(e) (1,987)
Other income (expense)................ (1,499) 243 -- (1,256)
---------- ---------- ------------- ----------
(2,421) 65 (887) (3,243)
---------- ---------- ------------- ----------
Income (loss) before provision for
income taxes........................ 6,083 4,323 (8,201) 2,205
PRO FORMA PROVISION INCOME TAXES
(BENEFIT)............................. 2,718 2,018 (718)(o) 4,018
---------- ---------- ------------- ----------
PRO FORMA NET INCOME (LOSS)............. $ 3,365 $ 2,305 $ (7,483) $ (1,813)
---------- ---------- ------------- ----------
---------- ---------- ------------- ----------
Pro forma net income (loss) per common
share:
Basic............................... $ 0.12 $ 0.05 $ (0.04)
Diluted............................. $ 0.11 $ 0.04 $ (0.04)
Weighted average number of common
shares outstanding:
Basic............................... 28,650 50,480 43,950
Diluted............................. 31,580 51,346 43,950
</TABLE>
65
<PAGE>
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
STAR PT-1
NINE NINE
MONTHS MONTHS
ENDED ENDED
SEPTEMBER SEPTEMBER
30, 30, MERGER PRO FORMA
1998 1998 ADJUSTMENTS COMBINED
---------- ---------- ------------- ----------
<S> <C> <C> <C> <C>
REVENUES................................ $ 425,531 $ 396,599 $ (63,922)(l) $ 758,208
OPERATING EXPENSES:
Cost of services...................... 363,794 364,942 (63,922)(l) 664,814
Selling, general and administrative
expenses............................ 39,167 23,016 526(m) 62,709
Depreciation and amortization......... 8,055 2,485 6,788(n) 17,328
---------- ---------- ------------- ----------
411,016 390,443 (56,608) 744,851
---------- ---------- ------------- ----------
Income from operations................ 14,515 6,156 (7,314) 13,357
---------- ---------- ------------- ----------
OTHER INCOME (EXPENSE):
Interest Income....................... 3,511 428 (887)(e) 3,052
Interest expense...................... (2,080) (1,201) -- (3,281)
Other income (expense)................ (171) 196 -- 25
---------- ---------- ------------- ----------
1,260 (577) (887) (204)
---------- ---------- ------------- ----------
Income before provision for income
taxes............................... 15,775 5,579 (8,201) 13,153
PROVISION FOR INCOME TAXES............ 6,643 1,915 (161)(o) 8,397
---------- ---------- ------------- ----------
NET INCOME............................ $ 9,132 $ 3,664 $ (8,040) $ 4,756
---------- ---------- ------------- ----------
---------- ---------- ------------- ----------
Net income per common share:
Basic............................... $ 0.23 $ 0.08 $ 0.09
Diluted............................. $ 0.22 $ 0.08 $ 0.08
Weighted average number of common
shares outstanding:
Basic............................... 39,147 48,405 54,447
Diluted............................. 40,921 48,587 56,221
</TABLE>
66
<PAGE>
UNAUDITED PRO FORMA CONDENSED COMBINED BALANCE SHEET
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
AT SEPTEMBER 30, 1998
(IN THOUSANDS)
<TABLE>
<CAPTION>
STAR UDN PT-1
SEPTEMBER SEPTEMBER MERGER PRO FORMA SEPTEMBER MERGER PRO FORMA
30, 1998 30, 1998 ADJUSTMENTS COMBINED 30, 1998 ADJUSTMENTS COMBINED
---------- ---------- -------------- ---------- ---------- -------------- ----------
<S> <C> <C> <C> <C> <C> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents..... $ 11,808 $ 1,060 $ -- $ 12,868 $ 5,382 $ -- $ 18,250
Short-term investments........ 92,390 -- -- 92,390 2,148 (19,500)(a) 73,038
(2,000)(s)
Accounts and notes
receivable.................. 80,721 5,068 (5,977)(b) 79,812 46,940 (22,951)(b) 103,801
Receivable from related
parties..................... 330 -- -- 330 -- -- 330
Other current assets.......... 27,580 251 (671)(u) 27,160 5,390 (2,110)(c) 30,440
---------- ---------- ------- ---------- ---------- -------------- ----------
Total current assets...... 212,829 6,379 (6,648) 212,560 59,860 (46,561) 225,859
Property and equipment, net... 113,851 1,875 -- 115,726 43,480 -- 159,206
Intangible assets, net........ -- 5,558 -- 5,558 2,493 -- 8,051
Goodwill...................... -- -- -- -- -- 181,011(d) 181,011
Deferred distributor costs.... -- -- -- -- -- 2,803(t) 2,803
Other long-term assets........ 7,340 72 -- 7,412 1,119 -- 8,531
---------- ---------- ------- ---------- ---------- -------------- ----------
Total assets.............. $ 334,020 $ 13,884 $ (6,648) $ 341,256 $ 106,952 $ 137,253 $ 585,461
---------- ---------- ------- ---------- ---------- -------------- ----------
---------- ---------- ------- ---------- ---------- -------------- ----------
CURRENT LIABILITIES:
Short-term debt............... $ -- $ -- $ -- $ -- 15,000 $ (10,000)(b) $ 5,000
Payable to stockholders....... 5 1,550 -- 1,555 -- -- 1,555
Current portion of long-term
obligations................. 7,595 1,042 -- 8,637 1,736 -- 10,373
Note payable.................. -- 4,500 (4,500)(b) -- 5,000 -- 5,000
Accounts payable and accrued
expenses.................... 36,200 10,658 (1,477)(b) 46,210 21,470 14,000(c) 66,619
1,500(u) (12,951)(b)
(671)(u) (2,110)(c)
Due to carriers............... -- -- -- -- 13,113 -- 13,113
Deferred revenue.............. -- 1,163 -- 1,163 42,026 (42,026)(p) 1,163
Acquired service obligation... -- -- -- -- -- 37,779(v) 37,779
Accrued network cost.......... 52,464 -- -- 52,464 -- -- 52,464
---------- ---------- ------- ---------- ---------- -------------- ----------
Total current
liabilities............. 96,264 18,913 (5,148) 110,029 98,345 (15,308) 193,066
---------- ---------- ------- ---------- ---------- -------------- ----------
Long-term obligations......... 31,053 233 -- 31,286 7,512 -- 38,798
Other long-term liabilities... 1,638 -- -- 1,638 700 -- 2,338
---------- ---------- ------- ---------- ---------- -------------- ----------
Total long-term
liabilities............. 32,691 233 -- 32,924 8,212 -- 41,136
---------- ---------- ------- ---------- ---------- -------------- ----------
STOCKHOLDER'S EQUITY (DEFICIT)
Common stock of STAR
(100,000,000 shares
authorized, 42,205,418
actual shares and
58,117,581 pro forma
shares issued and
outstanding).............. 42 -- -- 42 -- 15(f) 57
Common stock of UDN
(100,000,000 shares
authorized, 7,054,844
actual shares and no pro
forma shares issued and
outstanding).............. -- 71 (71)(q) -- -- -- --
Common stock of PT-1
(150,000,000 shares
authorized, 73,459,180
actual shares issued,
48,406,548 actual shares
outstanding and no pro
forma shares issued or
outstanding).............. -- -- -- -- 735 (735)(g) --
Paid-in capital............. 194,138 13,007 71(q) 207,216 16,166 156,366(h) 363,582
(16,166)(i)
Accumulated other
comprehensive income...... 219 -- -- 219 -- -- 219
Retained earnings
(deficit)................. 10,666 (18,340) (1,500)(u) (9,174) 1,919 (1,919) (j) (9,174)
Treasury stock.............. -- -- -- -- (15,000) 15,000(k) --
Note receivable from
stockholder............... -- -- -- -- (3,425) -- (3,425)
---------- ---------- ------- ---------- ---------- -------------- ----------
205,065 (5,262) (1,500) 198,303 395 152,561 351,259
---------- ---------- ------- ---------- ---------- -------------- ----------
Total liabilities and
stockholder's equity.... $ 334,020 $ 13,884 $ (6,648) $ 341,256 $ 106,952 $ 137,253 $ 585,461
---------- ---------- ------- ---------- ---------- -------------- ----------
---------- ---------- ------- ---------- ---------- -------------- ----------
</TABLE>
67
<PAGE>
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
FOR THE YEAR ENDED DECEMBER 31, 1995
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
UDN TWELVE
STAR MONTHS
YEAR ENDED ENDED PRO
DECEMBER 31, JANUARY 31, MERGER FORMA
1995 1996 ADJUSTMENTS COMBINED
------------ ----------- ------------ --------
<S> <C> <C> <C> <C>
REVENUES........................... $58,937 $ 5,711 $ (43)(l) $64,605
OPERATING EXPENSES:
Cost of services................... 44,270 4,342 (43)(l) 48,569
Selling, general and administrative
expenses......................... 10,452 2,494 -- 12,946
Depreciation and amortization...... 368 484 -- 852
------------ ----------- ----- --------
55,090 7,320 (43) 62,367
------------ ----------- ----- --------
Income (loss) from operations...... 3,847 (1,609) -- 2,238
------------ ----------- ----- --------
OTHER INCOME (EXPENSE):
Interest income.................... 22 (12) -- 10
Interest expense................... (64) (91) -- (155)
Other income (expense)............. (33) (183) -- (216)
------------ ----------- ----- --------
(75) (286) -- (361)
------------ ----------- ----- --------
Income (loss) before provision
for income taxes............... 3,772 (1,895) -- 1,877
PRO FORMA PROVISION FOR INCOME
TAXES............................ 1,632 -- (819)(o) 813
------------ ----------- ----- --------
PRO FORMA NET INCOME (LOSS)........ $ 2,140 $(1,895) $ 819 $ 1,064
------------ ----------- ----- --------
------------ ----------- ----- --------
Pro forma net income (loss) per
common share:
Basic.............................. $ 0.11 $ (0.57) $ 0.05
Diluted............................ $ 0.11 $ (0.57) $ 0.05
Weighted average number of common
shares outstanding:
Basic.............................. 19,373 3,331 19,662
Diluted............................ 19,373 3,331 19,662
</TABLE>
68
<PAGE>
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
FOR THE YEAR ENDED DECEMBER 31, 1996
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
UDN TWELVE
STAR MONTHS
YEAR ENDED ENDED
DECEMBER 31, JANUARY 31, MERGER PRO FORMA
1996 1997 ADJUSTMENTS COMBINED
------------ ----------- ------------ ---------
<S> <C> <C> <C> <C>
REVENUES........................... $259,697 $19,685 $(259)(l) $ 279,123
OPERATING EXPENSES:
Cost of services................. 225,957 15,051 (259)(l) 240,749
Selling, general and
administrative expenses........ 35,956 4,563 -- 40,519
Depreciation and amortization.... 1,442 818 -- 2,260
------------ ----------- ----- ---------
263,355 20,432 (259) 283,528
------------ ----------- ----- ---------
Income (loss) from operations.... (3,658) (747) -- (4,405)
------------ ----------- ----- ---------
OTHER INCOME (EXPENSE):
Interest income.................. 110 4 -- 114
Interest expense................. (609) (448) -- (1,057)
Legal settlement and expenses.... (100) -- -- (100)
Other income..................... 39 17 -- 56
------------ ----------- ----- ---------
(560) (427) -- (987)
------------ ----------- ----- ---------
Income (loss) before provision
for income taxes............... (4,218) (1,174) -- (5,392)
PRO FORMA PROVISION FOR INCOME
TAXES (BENEFIT).................. 1,520 (50) -- 1,470
------------ ----------- ----- ---------
PRO FORMA NET INCOME (LOSS)........ $ (5,738) $(1,124) $ -- $ (6,862)
------------ ----------- ----- ---------
------------ ----------- ----- ---------
Pro forma net income (loss) per
common share:
Basic............................ $ (0.25) $ (0.22) $ (0.29)
Diluted.......................... $ (0.25) $ (0.22) $ (0.29)
Weighted average number of common
shares outstanding:
Basic............................ 23,292 5,048 23,730
Diluted.......................... 23,292 5,048 23,730
</TABLE>
69
<PAGE>
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
FOR THE YEAR ENDED DECEMBER 31, 1997
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
UDN
STAR TWELVE PT-1
YEAR ENDED MONTHS YEAR ENDED
DECEMBER 31, JANUARY 31, MERGER PRO FORMA MARCH 31, MERGER PRO FORMA
1997 1998 ADJUSTMENTS COMBINED 1998 ADJUSTMENTS COMBINED
------------ ----------- ------------- --------- ---------- ------------- ---------
<S> <C> <C> <C> <C> <C> <C> <C>
REVENUES...................... $404,605 $31,179 $(1,153)(l) $434,631 $431,520 $(49,441)(l) $816,710
OPERATING EXPENSES:
Cost of services............ 351,821 24,633 (1,153)(l) 375,301 395,501 (49,441)(l) 721,361
Selling, general and
administrative expenses... 36,782 11,544 -- 48,326 17,724 701(m) 66,751
Depreciation and
amortization.............. 4,637 1,010 -- 5,647 1,535 9,051(n) 16,233
------------ ----------- ------------- --------- ---------- ------------- ---------
393,240 37,187 (1,153) 429,274 414,760 (39,689) 804,345
------------ ----------- ------------- --------- ---------- ------------- ---------
Income (loss) from
operations.................. 11,365 (6,008) -- 5,357 16,760 (9,752) 12,365
------------ ----------- ------------- --------- ---------- ------------- ---------
OTHER INCOME (EXPENSE):
Interest income............. 492 35 (28)(r) 499 517 (1,016)(e) --
Interest expense............ (1,738) (941) 28(r) (2,651) (1,021) (167)(e) (3,839)
Legal settlement and
expenses.................... (1,653) -- -- (1,653) -- -- (1,653)
Other income (expense)...... 208 (406) -- (198) 474 -- 276
------------ ----------- ------------- --------- ---------- ------------- ---------
(2,691) (1,312) -- (4,003) (30) (1,183) (5,216)
------------ ----------- ------------- --------- ---------- ------------- ---------
Income (loss) before
provision for income
taxes..................... 8,674 (7,320) -- 1,354 16,730 (10,935) 7,149
PRO FORMA PROVISION FOR INCOME
TAXES....................... 3,100 -- (2,617)(o) 483 5,150 157(o) 5,790
------------ ----------- ------------- --------- ---------- ------------- ---------
PRO FORMA NET INCOME (LOSS)... $ 5,574 $(7,320) $ 2,617 $ 871 $ 11,580 $(11,092) $ 1,359
------------ ----------- ------------- --------- ---------- ------------- ---------
------------ ----------- ------------- --------- ---------- ------------- ---------
Pro forma net income (loss)
per common share:
Basic....................... $ 0.18 $ (1.15) $ 0.03 $ 0.25 $ 0.03
Diluted..................... $ 0.17 $ (1.15) $ 0.03 $ 0.24 $ 0.03
Weighted average number of
common shares outstanding:
Basic....................... 30,221 6,339 30,771 46,922 46,071
Diluted..................... 32,978 6,339 33,528 47,720 48,828
</TABLE>
70
<PAGE>
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
STAR UDN PT-1
NINE NINE NINE
MONTHS MONTHS MONTHS
ENDED ENDED ENDED
SEPTEMBER SEPTEMBER MERGER PRO FORMA SEPTEMBER MERGER PRO FORMA
30, 1997 30, 1997 ADJUSTMENTS COMBINED 30, 1997 ADJUSTMENTS COMBINED
---------- ---------- ------------ --------- ---------- ------------- ---------
<S> <C> <C> <C> <C> <C> <C> <C>
REVENUES........................... $283,374 $22,249 $(505)(l) $305,118 $250,906 $(35,530)(l) $520,494
OPERATING EXPENSES:
Cost of services................. 246,712 16,986 (505)(l) 263,193 229,949 (35,530)(l) 457,612
Selling, general and
administrative expenses........ 25,118 6,319 -- 31,437 16,260 526(m) 48,223
Depreciation and amortization.... 3,040 720 -- 3,760 439 6,788(n) 10,987
---------- ---------- ------------ --------- ---------- ------------- ---------
274,870 24,025 (505) 298,390 246,648 (28,216) 516,822
---------- ---------- ------------ --------- ---------- ------------- ---------
Income (loss) from operations.... 8,504 (1,776) -- 6,728 4,258 (7,314) 3,672
---------- ---------- ------------ --------- ---------- ------------- ---------
OTHER INCOME (EXPENSE):
Interest income.................. 367 19 -- 386 234 (620)(e) --
Interest expense................. (1,289) (699) -- (1,988) (412) (267)(e) (2,667)
Other income (expense)........... (1,499) -- -- (1,499) 243 -- (1,256)
---------- ---------- ------------ --------- ---------- ------------- ---------
(2,421) (680) -- (3,101) 65 (887) (3,923)
Income (loss) before provision
for income taxes and
extraordinary gain............. 6,083 (2,456) -- 3,627 4,323 (8,201) (251)
PRO FORMA PROVISION FOR INCOME
TAXES (BENEFIT).................. 2,718 (27) (1,070)(o) 1,621 2,018 (718)(o) 2,921
---------- ---------- ------------ --------- ---------- ------------- ---------
PRO FORMA NET INCOME (LOSS) BEFORE
EXTRAORDINARY GAIN............... 3,365 (2,429) 1,070 2,006 2,305 (7,483) (3,172)
EXTRAORDINARY GAIN ON DEBT
RESTRUCTURING.................... -- 52 -- 52 -- -- 52
---------- ---------- ------------ --------- ---------- ------------- ---------
PRO FORMA NET INCOME (LOSS)........ $ 3,365 $(2,377) $1,070 $ 2,058 $ 2,305 $ (7,483) $ (3,120)
---------- ---------- ------------ --------- ---------- ------------- ---------
---------- ---------- ------------ --------- ---------- ------------- ---------
Pro forma net income (loss) per
common share:
Basic............................ $ 0.12 $ (0.39) $ 0.07 $ 0.05 $ (0.07)
Diluted.......................... $ 0.11 $ (0.39) $ 0.06 $ 0.04 $ (0.07)
Weighted average number of common
shares outstanding:
Basic............................ 28,650 6,022 29,173 50,480 44,473
Diluted.......................... 31,580 6,022 32,103 51,346 44,473
</TABLE>
71
<PAGE>
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
STAR UDN PT-1
NINE NINE NINE
MONTHS MONTHS MONTHS
ENDED ENDED ENDED
SEPTEMBER SEPTEMBER MERGER PRO FORMA SEPTEMBER MERGER PRO FORMA
30, 1998 30, 1998 ADJUSTMENTS COMBINED 30, 1998 ADJUSTMENTS COMBINED
---------- ---------- ------------- --------- ---------- ------------- ---------
<S> <C> <C> <C> <C> <C> <C> <C>
REVENUES...................... $425,531 $23,811 $(4,207)(l) $445,135 $396,599 $(63,922)(l) $777,812
OPERATING EXPENSES:
Cost of services............ 363,794 18,626 (4,207)(l) 378,213 364,942 (63,922)(l) 679,233
Selling, general and
administrative expenses... 39,167 6,402 -- 45,569 23,016 526(m) 69,111
Depreciation and
amortization.............. 8,055 836 -- 8,891 2,485 6,788(n) 18,164
---------- ---------- ------------- --------- ---------- ------------- ---------
411,016 25,864 (4,207) 432,673 390,443 (56,608) 766,508
---------- ---------- ------------- --------- ---------- ------------- ---------
Income (loss) from
operations.................. 14,515 (2,053) -- 12,462 6,156 (7,314) 11,304
OTHER INCOME (EXPENSE):
Interest income............. 3,511 34 (310)(r) 3,235 428 (887)(e) 2,776
Interest expense............ (2,080) (751) 310(r) (2,521) (1,201) -- (3,722)
Other income (expense)...... (171) (299) -- (470) 196 -- (274)
---------- ---------- ------------- --------- ---------- ------------- ---------
1,260 (1,016) -- 244 (577) (887) (1,220)
---------- ---------- ------------- --------- ---------- ------------- ---------
Income (loss) before
provision for income
taxes..................... 15,775 (3,069) -- 12,706 5,579 (8,201) 10,084
PROVISION FOR INCOME TAXES.... 6,643 -- (1,292)(o) 5,351 1,915 (161)(o) 7,105
---------- ---------- ------------- --------- ---------- ------------- ---------
NET INCOME (LOSS)............. $ 9,132 $(3,069) $ 1,292 $ 7,355 $ 3,664 $ (8,040) $ 2,979
---------- ---------- ------------- --------- ---------- ------------- ---------
---------- ---------- ------------- --------- ---------- ------------- ---------
Net income (loss) per common
share:
Basic....................... $ 0.23 $ (0.44) $ 0.19 $ 0.08 $ 0.05
Diluted..................... $ 0.22 $ (0.44) $ 0.18 $ 0.08 $ 0.05
Weighted average number of
common shares outstanding:
Basic....................... 39,147 6,989 39,752 48,405 55,052
Diluted..................... 40,921 6,989 41,526 48,587 56,826
</TABLE>
72
<PAGE>
NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL DATA
1. COMPANIES AND PERIODS COMBINED
Because of the various contingencies relating to the consummation of the UDN
transaction, the pro forma financial statements combining the operations of STAR
with PT-1 have been presented alternatively: (1) assuming that STAR will not
complete the merger with UDN, and (2) assuming that STAR will complete the
merger with UDN. Thus, the first set of pro forma statement of operations data
reflects the combination of the historical operating results of STAR for the
year ended December 31, 1997 and the nine months ended September 30, 1997 and
1998 with the historical operating results of PT-1 for the year ended March 31,
1998 and the nine months ended September 30, 1997 and 1998. The balance sheet
data included in the unaudited pro forma condensed financial statements reflects
the combination of the historical balance sheet data of STAR and of PT-1 as of
September 30, 1998. None of the above-referenced unaudited pro forma condensed
financial statements include UDN. The second set of pro forma statement of
operations data, which assumes completion of STAR's merger with UDN, reflects
the combination of the historical operating results of STAR for the years ended
December 31, 1995, 1996 and 1997 and the nine months ended September 30, 1997
and 1998 plus the historical operating results of UDN for the twelve months
ended January 31, 1996, 1997 and 1998 and the nine months ended September 30,
1997 and 1998, respectively, and the historical operating results of PT-1 for
the year ended March 31, 1998 and the nine months ended September 30, 1997 and
1998. The balance sheet data included in the unaudited pro forma condensed
financial statements reflects the combination of the historical balance sheets
of STAR and UDN with the historical balance sheet of PT-1 as of September 30,
1998.
2. GOODWILL
The number of shares of STAR Common Stock to be issued in the Merger for all
common shares and share equivalents of PT-1 is composed as follows:
<TABLE>
<CAPTION>
<S> <C>
Common stock, options and warrants--PT-1 shareholders........................... 15,050,000
Restricted common stock--PT-1 distributors...................................... 250,000
------------
Total........................................................................... 15,300,000
------------
------------
</TABLE>
The restricted shares of STAR Common Stock to be issued to PT-1 distributors
will vest over four years. The options and warrants to be issued will be in
satisfaction of the PT-1 Options and PT-1 Warrants. STAR will also issue 100,000
additional stock options to certain PT-1 employees under STAR's stock option
plan. To show the full dilutive effect of the transaction, 15.3 million
additional shares of STAR Common Stock were used for purposes of computing pro
forma basic and diluted earnings per share. The 15.3 million additional shares
are also reflected in pro forma shares of STAR Common Stock outstanding at
September 30, 1998.
The consideration for the Merger consists of 15.05 million shares of STAR
Common Stock and $19.5 million. In addition, STAR will be required to issue
250,000 restricted shares of STAR Common Stock to selected PT-1 distributors for
no consideration and to pay $2 million to a company owned by an executive of
PT-1 as a result of a change in control agreement. The value of the STAR Common
Stock to be issued is based on the average of the high and low market price from
August 31, 1998 through September 2, 1998, the dates surrounding the first
amendment to the Merger Agreement. This average market price computes to $11.21
per share (the "Average Price"), which will be discounted by 10% with respect to
the 13.5 million Two-Year Shares.
STAR followed the principles prescribed by APB No. 17 in identifying and
estimating the fair value of the identifiable tangible and intangible assets to
be acquired. The primary tangible assets of PT-1 consist of
73
<PAGE>
NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL DATA (CONTINUED)
2. GOODWILL (CONTINUED)
telecommunications and network equipment which, for the most part, has been
acquired during the past two years. STAR believes that the carrying value of
such equipment approximates its fair value. This equipment includes the digital
switches, debit card platform, information system, and PIN database software.
The primary intangible assets to be acquired consist of PT-1's distribution
network and name. The distribution network consists of a series of wholesale
distributors who sell to sub-distributors and directly to retail outlets such as
grocery and convenience stores. These stores sell the cards to the individual
ultimate end user. While no individual distributor is considered critical to the
long term future success of PT-1, certain distributors have been identified who
are important to the near term growth objectives of PT-1. In connection with the
Merger, STAR has agreed to issue to no more than 10 of PT-1's approximately 200
distributors for no consideration 250,000 shares of STAR Common Stock, which are
restricted and will vest over four years. STAR considers the fair value of such
shares to represent the near term value of these distributor relationships.
STAR considered other potential intangible assets for which it may be
appropriate to assign value such as franchise agreements and leases. All
contracts have been entered into during the past three years and the terms and
conditions of those contracts reflect the current economic and industry
environment.
After consideration of the above, STAR has determined that the excess of the
purchase price over the PT-1 equity represents residual goodwill in accordance
with APB No. 17.
The allocation of the purchase price is preliminary only with respect to the
assumed service obligation and certain intangible assets. STAR will have an
appraisal performed on the significant PT-1 intangible assets. Such intangible
assets include PT-1's distributor network, billing platform and software license
agreements. Such appraisal is expected to be completed within 90 days from the
date the Merger is consummated. Based upon STAR's review, it is anticipated that
the final allocation of the purchase price will not differ materially from
STAR's preliminary allocation. Additionally, STAR does not expect a significant
amount of the purchase price to be allocated to other identified intangible
assets.
The excess of the purchase price thus computed over the net assets acquired,
as adjusted, plus estimated acquisition costs of $14 million, results in
goodwill of approximately $181 million. Goodwill is amortized over a period of
20 years, which period represents STAR's estimate of future benefit to STAR.
3. UDN TRANSACTION
The ratio of STAR Common Stock to be exchanged for UDN Common Stock as
reflected in the unaudited pro forma condensed financial statements of 0.086772
is based on the closing price of STAR Common Stock of $23.625 per share as of
May 27, 1998. No share adjustment has been made for changes in the price of STAR
Common Stock since May 27, 1998 because the impact of such change would not be
material. Had the closing price of STAR Common Stock at September 30, 1998 of
$12.375 per share been used for purposes of the STAR/UDN exchange ratio, an
additional 556,515 shares would be reflected as outstanding in the pro forma
balance sheet as of September 30, 1998.
STAR and UDN estimate they will incur direct transaction costs of
approximately $1.5 million associated with their merger, consisting of fees for
investment banking, legal, accounting, financial printing and other related
charges, most of which will be charged to operations in the fiscal quarter in
which that merger is consummated. At September 30, 1998, STAR capitalized
$671,000 in UDN related merger costs.
74
<PAGE>
NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL DATA (CONTINUED)
4. INTERCOMPANY BALANCES
At September 30, 1998, STAR had amounts due from UDN as follows (amounts in
thousands):
<TABLE>
<CAPTION>
<S> <C>
Note receivable...................................................................... $ 4,500
Trade receivable..................................................................... 1,140
Interest receivable.................................................................. 337
---------
Total................................................................................ $ 5,977
---------
---------
</TABLE>
Intercompany balances between STAR and PT-1 represent trade receivables and
payables between STAR and PT-1 in the amount of $12,908,000 and $43,000,
respectively, and a short term loan to PT-1 in the amount of $10,000,000. There
are no intercompany balances between UDN and PT-1.
5. INTERCOMPANY TRANSACTIONS
For the years ended December 31, 1995, 1996 and 1997, intercompany sales and
related cost of sales between STAR and UDN amounted to $43,000, $259,000 and
$1,153,000, respectively. Intercompany sales for the nine months ended September
30, 1997 and 1998 amounted to $505,000 and $4,207,000, respectively.
Intercompany sales and cost of sales between STAR and PT-1 for the year ended
December 31, 1997 amounted to $49,441,000. Sales between STAR and PT-1 for the
nine months ended September 30, 1997 and 1998 amounted to $35,530,000 and
$63,922,000, respectively. There were no intercompany transactions between PT-1
and UDN for the periods presented.
6. PRO FORMA INCOME TAXES
The pro forma provision for income taxes, pro forma net income (loss) and
pro forma net income (loss) per share of STAR Common Stock for the years ended
December 31, 1995, 1996 and 1997 as well as for the nine months ended September
30, 1997 reflect a pro forma tax adjustment, which assumes that both STAR as
well as LDS, which was acquired by STAR in a pooling of interests transaction on
November 30, 1997, were C-corporations for all periods presented (see Note 9 of
Notes to Consolidated Financial Statements of STAR).
The Merger adjustments reflect STAR's effective tax rate (as adjusted for
non-deductible goodwill amortization) in the pro forma statements of operations
for the combined entity.
7. EXCHANGE OF STOCK
The UDN adjustment reflects the elimination of UDN Common Stock less the par
value of 612,162 shares of STAR Common Stock to be issued in STAR's merger with
UDN.
8. PRO FORMA EARNINGS PER SHARE
The unaudited pro forma combined earnings per share and diluted earnings per
share are based on the weighted average number of common and dilutive equivalent
shares, for each period: (1) at the exchange ratio of 0.086772 shares of STAR
Common Stock for each share of UDN Common Stock outstanding at the effective
time of STAR's merger with UDN and (2) 15.05 million shares of STAR Common Stock
for all of PT-1 Common Stock, stock options and warrants outstanding at the
Effective Time plus an additional 250,000 shares of STAR Common Stock to be
issued to selected PT-1 distributors.
75
<PAGE>
NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL DATA (CONTINUED)
9. RESULTS OF OPERATIONS INCLUDED IN MORE THAN ONE PERIOD
The PT-1 results of operations for the nine months ended September 30, 1997
and 1998 include PT-1 revenue of $62.7 million and $127.7 million and net income
of approximately $3.1 million and $2.3 million, which are also included in the
results of operations for the years ended December 31, 1996 and 1997,
respectively. The UDN results of operations for the nine months ended September
30, 1997 and 1998 include UDN revenue of $2.3 million and $2.9 million, and net
loss of $99,000 and $173,000, which are also included in the results of
operations for the twelve month periods ended January 31, 1997 and 1998,
respectively.
10. MERGER ADJUSTMENTS
Following is an explanation for merger adjustments reflected in the
unaudited pro forma condensed financial statements:
(a) Represents cash portion of consideration for the Merger
(b) Represents the elimination of intercompany balances
(c) Represents accrual for Merger-related expenses, net of $2,110,000
previously incurred
(d) Represents the excess of the purchase price for PT-1 plus acquisition
related expenses over the fair value of net assets acquired
(e) Represents foregone interest income on the $19.5 million cash portion of
consideration for the Merger, plus a $2 million payment to Godot due on
consummation of the Merger
(f) Represents the par value of STAR Common Stock to be issued in the Merger
(g) Eliminates par value of PT-1 Common Stock
(h) Represents additional paid in capital of STAR Common Stock to be issued in
the Merger
(i) Represents elimination of paid in capital of PT-1
(j) Represents elimination of retained deficit of PT-1
(k) Represents elimination of PT-1 treasury stock which will be retired
(l) Represents elimination of intercompany revenue and related cost of revenue
(m) Represents amortization expense relating to 250,000 restricted shares of
STAR Common Stock to be issued to certain PT-1 distributors which will vest
over their four year vesting period (see note 10t)
(n) Represents amortization of goodwill over 40 years
(o) Represents tax adjustment to reflect STAR's effective tax rate (as adjusted
for non-deductible goodwill amortization)
(p) Represents elimination of PT-1 deferred revenue
(q) Reclassifies UDN Common Stock to additional paid in capital
(r) Represents elimination of intercompany interest on UDN note
(s) Represents a $2 million payment to Godot due on consummation of the Merger
(t) Represents the fair market value of 250,000 shares of STAR Common Stock
issuable to certain PT-1 distributors. Such amount will be amortized over
the four year vesting period (see note 10m)
76
<PAGE>
NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL DATA (CONTINUED)
10. MERGER ADJUSTMENTS (CONTINUED)
(u) Reflects an estimate of non-recurring expenses relating to the UDN merger
of which $671,000 was capitalized at September 30, 1998
(v) Represents estimated amounts to be incurred to settle the obligations
relating to the PT-1 deferred revenue. Such amount has been computed based
upon the historical deferred revenue recorded by PT-1 at September 30,
1998, which represents an assumed service obligation to STAR. The
obligation has been adjusted for the historical percentage of revenue
received by PT-1, which ultimately expires unused (2.5%). The assumed
obligation has also been reduced by PT-1's historical gross margin
percentage for the year ended March 31, 1998 as adjusted for the effect of
their revenue resulting from expired Prepaid Cards ($2,500,000), to
properly reflect STAR's assumed service obligation. STAR will recognize as
revenue an amount equal to the expense ultimately required to satisfy the
obligation. Any adjustment to the original estimate of the assumed
obligation will be recorded as an adjustment to goodwill.
77
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS OF STAR
THE FOLLOWING DISCUSSION OF THE FINANCIAL CONDITION AND RESULTS OF
OPERATIONS OF STAR SHOULD BE READ IN CONJUNCTION WITH "SELECTED CONSOLIDATED
FINANCIAL DATA OF STAR" AND THE STAR CONSOLIDATED FINANCIAL STATEMENTS AND THE
NOTES THERETO, EACH OF WHICH IS INCLUDED ELSEWHERE IN THIS PROXY STATEMENT. THIS
DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS, AS DEFINED IN SECTION 27A OF THE
SECURITIES ACT, THAT INVOLVE RISKS AND UNCERTAINTIES. STAR'S ACTUAL RESULTS
COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THE FORWARD-LOOKING STATEMENTS
AS A RESULT OF CERTAIN FACTORS, INCLUDING, BUT NOT LIMITED TO THOSE DISCUSSED IN
"RISK FACTORS" AND ELSEWHERE IN THIS PROXY STATEMENT. SEE "DESCRIPTION OF
FORWARD-LOOKING STATEMENTS."
OVERVIEW
STAR is an emerging multinational carrier focused primarily on the
international long distance market. STAR offers highly reliable, low-cost
switched voice services on a wholesale basis, primarily to U.S.-based long
distance carriers. STAR provides international long distance service to
approximately 220 countries through its flexible network comprised of various
foreign termination relationships, international gateway switches, leased and
owned transmission facilities and resale arrangements with other long distance
providers.
STAR installed its first international gateway switch in Los Angeles in June
1995 and initially recognized wholesale revenues in August 1995. A significant
portion of STAR's revenues in 1994 and 1995 were generated by the commercial
operations of LDS.
REVENUES. Most of STAR's revenues are generated by the sale of
international long distance services on a wholesale basis to other, primarily
domestic, long distance providers. STAR records revenues from the sale of long
distance services at the time of customer usage. STAR's agreements with its
wholesale customers are short-term in duration and the rates charged to
customers are subject to change from time to time, generally with five days
notice to the customer.
Historically, STAR has increased revenues from quarter to quarter, often
times by a significant percentage. STAR's North American wholesale minutes of
use have also greatly increased from quarter to quarter, generally by amounts
that exceed the relative increases in revenues. For example, in the nine months
ended September 30, 1998, revenues increased by 50.2% over revenues for the nine
months ended September 30, 1997. Over the same period to period comparison,
North American minutes of wholesale use increased by 73.0%. There are a variety
of reasons for the growth in STAR's call volume, including the growth of STAR's
North American customer base, which increased by 27.7% from the nine months
ended September 30, 1997 compared to the same period in 1998, an increased usage
by existing North American customers, and increased capacity over STAR's
telecommunications network, with the addition of a number of switches and growth
in available fiber optic lines.
The growth in North American wholesale minutes has been accompanied by a
corresponding decline in North American rates per minute. For example, for the
nine months ended September 30, 1998, such rates declined by 24.3% from
wholesale rates per minute in the corresponding period in 1997. The decline in
wholesale rates can be attributed to a number of factors, including a changing
country mix that includes a growing number of minutes routed by STAR to lower
rates per minute countries such as Mexico, Germany and the United Kingdom and,
as the wholesale international long distance market continues to mature and
evolve, a general downward trend in rates on competitive routes. STAR's pricing
for wholesale minutes varies materially from customer to customer and is
generally based on the time of day, the day of the week and the destination of
the call. While STAR continues to route traffic to certain destinations at
attractive rates, market conditions have forced STAR to reduce its overall
wholesale rates per minute.
Accordingly, STAR believes that the growth in its revenues has been fueled
almost entirely by STAR's ability to increase the volume of North American
wholesale minutes of use, for the reasons noted above.
78
<PAGE>
At the same time, the general erosion in the rates per minute for such wholesale
traffic has partially offset the contribution to the increase of revenues made
by such increased volume of minutes.
STAR completed its acquisition of T-One in March 1998. Revenues from T-One's
operations for the periods set forth below were not material to the overall
result of operations of STAR during such periods.
COSTS OF SERVICES (EXCLUSIVE OF DEPRECIATION AND AMORTIZATION). STAR has
pursued a strategy of attracting customers and building calling volume and
revenue by offering favorable rates compared to other long distance providers.
STAR continues to lower its cost of services (exclusive of depreciation and
amortization) by (i) expanding STAR's owned network facilities, (ii) continuing
to utilize STAR's sophisticated information systems to route calls over the most
cost-effective routes and (iii) leveraging STAR's traffic volumes and
information systems to negotiate lower variable usage-based costs with domestic
and foreign providers of transmission capacity.
Costs of services (exclusive of depreciation and amortization) include those
costs associated with the transmission and termination of international long
distance services and does not include depreciation or amortization expenses.
Currently, a majority of transmission capacity used by STAR is obtained on a
variable, per minute basis. As a result, some of STAR's current costs of
services (exclusive of depreciation and amortization) is variable. STAR's
contracts with its vendors provide that rates may fluctuate, with rate change
notice periods varying from five days to one year, with certain of STAR's longer
term arrangements requiring STAR to meet minimum usage commitments in order to
avoid penalties. Such variability and the short-term nature of many of the
contracts subject STAR to the possibility of unanticipated cost increases and
the loss of cost-effective routing alternatives. Each quarter management reviews
the cost of services (exclusive of depreciation and amortization) accrual and
adjusts the balance for resolved items. Cost of services (exclusive of
depreciation and amortization) also include fixed costs associated with the
leasing of network facilities.
STAR recently began to provide international long distance services to
commercial customers in certain European countries including Germany. STAR began
providing long distance service to commercial markets in the U.S. with its
acquisition of LDS in November 1997. STAR believes that traffic from commercial
customers will be more profitable than wholesale traffic. STAR also expects,
however, that an expansion into this market will also increase the risk of bad
debt exposure and lead to higher overhead costs. Information related to
wholesale and commercial revenues and operations will be reported in future
Exchange Act filings made by STAR in accordance with Financial Accounting
Standards Board Statement No. 131.
Prices in the international long distance market have declined in recent
years and, as competition continues to increase, STAR believes that prices are
likely to continue to decline. Additionally, STAR believes that the increasing
trend of deregulation of international long distance telecommunications will
result in greater competition, which could adversely affect STAR's revenue per
minute. STAR believes, however, that the effect of such decreases in prices will
be offset by increased calling volumes and decreased costs.
OPERATING EXPENSES. Selling, general and administrative expenses consist
primarily of personnel costs, depreciation and amortization, tradeshow and
travel expenses and commissions and consulting fees, as well as an accrual for
bad debt expense. These expenses have been increasing over the past year, which
is consistent with STAR's recent growth, accelerated expansion into Europe, and
investment in systems and facilities. STAR expects this trend to continue, and
to include, among other things, a significant increase in depreciation and
amortization. Management believes that additional selling, general and
administrative expenses will be necessary to support the expansion of STAR's
network facilities, its sales and marketing efforts and STAR's expansion into
commercial markets.
FOREIGN EXCHANGE. STAR's revenues and cost of long distance services are
sensitive to foreign currency fluctuations. STAR expects that an increasing
portion of STAR's revenues and expenses will be
79
<PAGE>
denominated in currencies other than U.S. dollars, and changes in exchange rates
may have a significant effect on STAR's results of operations.
FACTORS AFFECTING FUTURE OPERATING RESULTS. STAR's quarterly operating
results are difficult to forecast with any degree of accuracy because a number
of factors subject these results to significant fluctuations. As a result, STAR
believes that period-to-period comparisons of its operating results are not
necessarily meaningful and should not be relied upon as indications of future
performance.
STAR's revenues, costs and expenses have fluctuated significantly in the
past and are likely to continue to fluctuate significantly in the future as a
result of numerous factors. STAR's revenues in any given period can vary due to
factors such as call volume fluctuations, particularly in regions with
relatively high per-minute rates; the addition or loss of major customers,
whether through competition, merger, consolidation or otherwise; the loss of
economically beneficial routing options for the termination of STAR's traffic;
financial difficulties of major customers; pricing pressure resulting from
increased competition; and technical difficulties with or failures of portions
of STAR's network that impact STAR's ability to provide service to or bill its
customers. STAR's cost of services (exclusive of depreciation and amortization)
and operating expenses in any given period can vary due to factors such as
fluctuations in rates charged by carriers to terminate STAR's traffic; increases
in bad debt expense and reserves; the timing of capital expenditures, and other
costs associated with acquiring or obtaining other rights to switching and other
transmission facilities; changes in STAR's sales incentive plans; and costs
associated with changes in staffing levels of sales, marketing, technical
support and administrative personnel. In addition, STAR's operating results can
vary due to factors such as changes in routing due to variations in the quality
of vendor transmission capability; loss of favorable routing options; the amount
of, and the accounting policy for, return traffic under operating agreements;
actions by domestic or foreign regulatory entities; the level, timing and pace
of STAR's expansion in international and commercial markets; and general
domestic and international economic and political conditions. Further, a
substantial portion of transmission capacity used by STAR is obtained on a
variable, per minute and short-term basis, subjecting STAR to the possibility of
unanticipated price increases and service cancellations. Since STAR does not
generally have long term arrangements for the purchase or resale of long
distance services, and since rates fluctuate significantly over short periods of
time, STAR's operating results are subject to significant fluctuations over
short periods of time. STAR's operating results also may be negatively impacted
in the longer term by competitive pricing pressures.
RECENT ACQUISITIONS AND DEVELOPMENTS
STAR has recently acquired or entered into agreements to acquire the
following companies and has taken the following actions:
- UNITED DIGITAL NETWORK, INC. On November 19, 1997, STAR entered into an
agreement to acquire UDN for approximately 650,000 shares of STAR Common
Stock. The acquisition of UDN is subject to the approval of UDN's
stockholders and to various regulatory approvals, and STAR may not
complete this acquisition.
- L.D. SERVICES, INC. On November 30, 1997, STAR acquired LDS, certain
non-operating entities and majority ownership in another entity for
approximately 849,000 shares of STAR Common Stock in a transaction
accounted for as a pooling of interests. STAR's audited financial
statements have been restated to include LDS' historical performance for
all periods presented. The commercial business of LDS has historically had
higher revenue per minute and higher selling, general and administrative
expenses and operating costs than STAR's wholesale operations. As STAR
integrates and expands the commercial accounts of LDS, such increase in
operations may affect STAR's future operating margins. In 1997, LDS
settled disputes with the California PUC and with the District Attorney of
Monterey, California. The resulting payments and restrictions on LDS'
activities adversely affected its 1997 operating results. See "Business of
STAR--Government Regulation-- Actions Against LDS."
80
<PAGE>
- T-ONE CORP. On March 10, 1998, STAR acquired T-One for 1,353,000 shares of
STAR Common Stock in a transaction accounted for as a pooling of
interests. All financial data presented has been restated to include the
results of operations, financial position and cash flows of T-One.
- STOCK SPLIT. On March 31, 1998, STAR effected a 2.05-for-1 stock split
with payment to the holders of the shares of STAR Common Stock outstanding
on February 20, 1998 of a stock dividend equal to 1.05 shares of STAR
Common Stock for each such outstanding share.
- PUBLIC OFFERING. On May 4, 1998, STAR consummated a firmly underwritten
public offering of 6,000,000 shares of STAR Common Stock, of which
5,685,000 shares were sold by STAR and 315,000 shares were sold by a
certain stockholder of STAR. On June 4, 1998, an additional 30,900 shares
of STAR Common Stock were sold by a certain stockholder of STAR to cover
an over-allotment option for the offering.
RESULTS OF OPERATIONS
The following table sets forth certain selected items in STAR's statements
of operations as a percentage of total revenues for the periods indicated:
<TABLE>
<CAPTION>
THREE MONTHS NINE MONTHS
ENDED ENDED SEPTEMBER
YEARS ENDED DECEMBER 31, SEPTEMBER 30, 30,
----------------------------- ----------------- ---------------
1995 1996 1997 1997 1998 1997 1998
------ ------- ------ ------ ------ ------ ------
(UNAUDITED)
<S> <C> <C> <C> <C> <C> <C> <C>
Revenues................................ 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Operating Expenses:
Cost of services...................... 75.1 87.0 87.0 87.2 84.8 87.1 85.5
Selling, general and administrative... 17.8 13.8 9.1 8.6 9.7 8.9 9.2
Depreciation and amortization......... 0.6 0.6 1.1 1.2 2.1 1.1 1.9
------ ------- ------ ------ ------ ------ ------
Total operating expenses.......... 93.5 101.4 97.2 97.0 96.6 97.0 96.6
Income (loss) from operations........... 6.5 (1.4) 2.8 3.0 3.4 3.0 3.4
------ ------- ------ ------ ------ ------ ------
Income (loss) before provision for
income taxes.......................... 6.4 (1.6) 2.1 2.1 4.2 2.1 3.7
Provision for income taxes.............. 0.1 0.2 0.7 1.2 1.7 0.8 1.6
------ ------- ------ ------ ------ ------ ------
Net income (loss)....................... 6.3% (1.8)% 1.4% 0.8% 2.4% 1.3% 2.1%
------ ------- ------ ------ ------ ------ ------
------ ------- ------ ------ ------ ------ ------
Pro forma net income (loss)............. 3.6% (2.2)% 1.4% 0.9% 1.2%
------ ------- ------ ------ ------
------ ------- ------ ------ ------
</TABLE>
THREE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO THREE MONTHS ENDED
SEPTEMBER 30, 1997
REVENUES: Total revenues increased 59.1% to $164.3 million in the third
quarter of 1998 from $103.3 million in the third quarter of 1997. Total revenues
for the third quarter of 1998 increased 24.6% from $131.9 million in the second
quarter ended June 30, 1998.
Revenues from North American wholesale customers increased 54.2% to $149.4
million from $96.9 million in the prior year quarter. Minutes of use generated
by North American wholesale customers increased 97.2% to 475.1 million minutes
of use in the third quarter of 1998, as compared to 240.9 million minutes of use
in the comparable quarter of the year prior. This increase in revenues and
minutes reflects growth in the number of North American wholesale customers to
175 at September 30, 1998, up from 137 customers at September 30, 1997, as well
as an increase in usage by existing customers, primarily resulting from STAR's
expanding transmission capacity. The increase in revenues was partially offset
by a decline in rates per minute, as the average North American wholesale rate
per minute of use declined to $0.30 for the current quarter as compared to $0.40
for the quarter ended September 30, 1997, as well as the quarter ended June 30,
1998 of $0.34, reflecting continued lower prices on competitive routes. The
decline in rates
81
<PAGE>
per minute is also attributable to the change in country mix to include a larger
proportion of lower rate per minute countries such as Mexico, Germany and the
United Kingdom. The period to period decline in rates per minute was not a
significant factor in the relative increase in minutes of use.
North American commercial revenues increased 28.1% to $8.2 million in the
third quarter of 1998 from $6.4 million in the third quarter of 1997 reflecting
the continued success of new international rate plans that target ethnic markets
for Latin America and the Pacific Rim. Traditionally, the telemarketing
operation experiences declining minutes of use during the third quarter summer
months due to the usage trends of its international users. On a quarter to
quarter basis, the growth in North American commercial minutes and the average
North American commercial rate per minute at $0.24 remained flat due to these
trends.
The third quarter also includes revenues of $6.7 million generated from
STAR's European operations, representing the initial realization of benefits
from STAR's investment in the German telecommunication marketplace. Management
believes that the prospects for growth in Germany remain strong as Star
Telecommunications Deutscheland, GmbH is fully utilizing its interconnect with
Deutsche Telekom, AG to lower STAR's cost of services and to grow its European
commercial customer base.
COST OF SERVICES (EXCLUSIVE OF DEPRECIATION AND AMORTIZATION): Cost of
services (exclusive of depreciation and amortization) increased 54.6% to $139.3
million in the third quarter of 1998 from $90.1 million in the third quarter of
1997 and decreased as a percentage of revenues for the same periods to 84.8%
from 87.2%. The growth in cost of services (exclusive of depreciation and
amortization) reflects the increase in minutes of use offset by an overall
declining average cost per minute as well as an increase in leased private line
cost. The average cost per minute declined as a result of changes in country mix
to include a larger proportion of lower cost per minute countries, competitive
pricing pressures as well as an increasing proportion on traffic routed over the
STAR's proprietary network. STAR currently routes to 43 countries on its global
network, up from 40 countries in the quarter ended June 30, 1998. Management
believes that countries will continue to be added to STAR's global network,
thereby contributing to an overall decline in cost per minute.
SELLING, GENERAL AND ADMINISTRATIVE: For the third quarter of 1998,
selling, general and administrative expenses increased 78.9% to $15.9 million
from $8.9 million in the third quarter of 1997 and increased as a percentage of
revenues to 9.7% from 8.6% over the comparable periods. North American wholesale
selling, general and administrative expenses increased to $10.1 million in the
third quarter of 1998 from $6.4 million in the comparable period of 1997 and
increased as a percentage of North American wholesale revenue from 6.6% to 6.8%.
North American commercial selling, general and administrative expenses
increased to $3.0 million during the period from $2.2 million in the third
quarter of 1997. North American commercial selling, general and administrative
expenses increased as a percentage of North American commercial revenues to
36.6% during the period from 34.4% in the third quarter of 1997, reflecting the
expansion of the telemarketing sales force to focus on new ethnic markets.
Selling, general and administrative expenses related to the European
operations amounted to $2.8 million in the third quarter of 1998, an increase
from $348,000 in the third quarter of 1997 reflecting the start up of new
business efforts in Europe. STAR expects overall selling, general and
administrative expenses to continue to grow as a percentage of revenues as STAR
adds personnel to become a carrier in additional European countries and
continues to hire a sales force to expand its North American commercial customer
base.
DEPRECIATION AND AMORTIZATION: Depreciation expense increased to $3.4
million for the third quarter of 1998 from $1.2 million for the third quarter of
1997, and increased as a percentage of revenues to 2.1% from 1.2% over the
comparable period in the prior year. Depreciation expense increased with the
operation of new switch sites, the purchase of additional fiber capacity to
connect STAR's expanding network and leasehold improvements. Depreciation
attributable to North American assets amounted to
82
<PAGE>
$2.4 million. European operations realized total depreciation of $1.1 million.
STAR expects depreciation expense to continue to increase as a percentage of
revenues as it continues to expand its global telecommunications network. As of
July 1, 1998, STAR revised the remaining lives of certain operating equipment
from five to ten years. This change increased income before income taxes by
approximately $1.0 million.
INCOME FROM OPERATIONS: Income from operations increased to $5.6 million
during the third quarter of 1998 from $3.1 million in the third quarter of 1997
and operating margin increased to 3.4% from 3.0%, respectively. Operating margin
is expanding overall as STAR continues to increasingly route traffic over its
proprietary network. Offsetting the declining cost of services on a per minute
basis were the startup costs of launching operations in new European countries
and the expansion of the North American based commercial operations.
OTHER INCOME (EXPENSE): STAR reported other income of $1.2 million in the
third quarter of 1998 as compared to other expense of approximately $1.0 million
for the third quarter of 1997. Interest income earned on short-term investments
increased to $1.8 million in the third quarter of 1998 from $293,000 in the
third quarter of 1997 as a result of interest earned on investing the proceeds
from STAR's secondary equity offering in May 1998. Interest expense increased to
$740,000 during the quarter from $453,000 in the third quarter of 1997 in
response to the additional capital leases for the financing of new switches.
Included in other expense for the third quarter ended September 30, 1997 is
approximately $700,000 for a legal settlement which relates to the dispute
settled by LDS with the District Attorney of Monterey County.
PROVISION FOR INCOME TAXES: STAR's provision for income taxes increased to
$2.8 million in the third quarter of 1998 from $1.3 million in the third quarter
of 1997. The effective tax rate decreased to 41.1% in the third quarter of 1998
from 59.3% in the third quarter of 1997. The effective tax rate in the third
quarter of 1997 includes the impact of the valuation reserve on the deferred tax
asset created by foreign operating losses and other book/tax timing differences.
NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO NINE MONTHS ENDED SEPTEMBER
30, 1997
REVENUES: Total revenues increased 50.2% to $425.5 million in the nine
months ended September 30, 1998 up from $283.4 million in the nine months ended
September 30, 1997. The increase in total revenues can be attributed to the
growth of the North American wholesale operations.
North American wholesale minutes of use increased to 1.1 billion with an
average rate per minute of $0.33 for the period ended September 30, 1998 as
compared to minutes of use of 635.9 million at an average rate per minute of
$0.41 in the comparable period of 1997. The volume growth was driven by an
increase in sales to existing North American wholesale customers taking
advantage of STAR's expanding transmission capacity and an increase in the
number of North American wholesale carrier customers, which growth was partially
offset by a decline in rates per minute from period to period. The relative
decline in rates per minute was not a significant factor in the period to period
increase in minutes of use.
COST OF SERVICES (EXCLUSIVE OF DEPRECIATION AND AMORTIZATION): Cost of
services (exclusive of depreciation and amortization) increased 47.5% to $363.8
million during the nine months ended September 30, 1998, up from $246.7 million
for the comparable period of 1997, but decreased as a percentage of revenues to
85.5% from 87.1%, respectively. The decrease in cost of services (exclusive of
depreciation and amortization) relative to revenues reflects the increasing
amount of traffic terminated over STAR's owned network. Management believes that
countries will continue to be added to STAR's global network thereby
contributing to an overall decline in cost per minute.
SELLING, GENERAL AND ADMINISTRATIVE: Selling, general and administrative
expenses increased 54.7% to $38.9 million during the first nine months of 1998
from $25.1 million in the comparable period of 1997 and increased as a
percentage of revenues to 9.1% from 8.9%, respectively. The increase in these
expenses
83
<PAGE>
both in absolute terms and as a percentage of revenues reflects the continued
expansion of the STAR network in its North American and European operations.
DEPRECIATION AND AMORTIZATION: Depreciation expense increased to $8.1
million for the nine months ended September 30, 1998 from $3.0 million for the
comparable period of 1997. Depreciation expense increased as a result of STAR's
continued expansion of its global transmission network which involved the
expansion and start-up of new switch sites, the purchase of fiber capacity and
the build out of direct termination arrangements around the world. As of July 1,
1998, STAR revised the remaining lives of certain operating equipment from five
to ten years. This change increased income before income taxes by approximately
$1.0 million.
INCOME FROM OPERATIONS: Income from operations increased 70.7% to $14.5
million during the nine months ended September 30, 1998 from $8.5 million during
the same period of 1997. Operating margin increased to 3.4% from 3.0%,
respectively. Operating margin will continue to expand as STAR continues to
diversify its revenue base and as traffic is migrated from leased facilities
onto STAR's owned network.
OTHER INCOME (EXPENSE): Other income, net increased to $1.3 million in the
nine months ended September 30, 1998 from a net expense of $2.4 million in the
comparable period of 1997. This increase can be attributed to interest income of
$3.5 million earned on the proceeds from the secondary offering offset by
interest expense of $2.1 million incurred on capital leases for the nine months
ended September 30, 1998. Other expense for the nine months ended September 30,
1997 included $1.6 million in legal settlements which relate to the disputes
settled by LDS with the California PUC and the District Attorney of Monterey
County.
PROVISION FOR INCOME TAXES: STAR's provision for income taxes increased to
$6.6 million for the nine months ended September 30, 1998 from $2.4 million for
the comparable period in 1997. The effective tax rate increased to 42.1% during
the nine months ended September 30, 1998 from 39.6% during the comparable period
in 1997. The lower effective tax rate for the period ended September 30, 1997
includes the write-off of a customer accounts receivable in the first quarter of
1997.
YEARS ENDED DECEMBER 31, 1997 AND 1996.
REVENUES: Revenues increased 55.8% to $404.6 million in 1997 from $259.7
million in 1996. Wholesale revenues increased to $377.1 million from $229.8
million, with wholesale minutes of use increasing to 863.3 million minutes in
1997, as compared to 479.7 million minutes of use in the prior year. This
increase reflects an increase in the number of wholesale customers from 84 in
1996 to 105 at the end of 1997, as well as an increase in usage by existing
customers, primarily resulting from STAR's expanding transmission capacity and
improving transmission quality. The average rate per minute of usage for
wholesale customers declined from $0.43 cents per minute in 1996 to $0.40 cents
per minute in 1997, reflecting the change in country mix to include a larger
proportion of lower rate per minute countries as well as lower prices on
competitive routes. The decline in rates per wholesale minute partially offset
the increase in wholesale minutes of use. The period to period decline in rates
per minute was not a significant factor in the relative increase in minute of
use. Wholesale minutes or average rate per minute computations do not include
the revenue or minutes of T-One.
Commercial revenues decreased to $27.5 million in 1997 from $29.9 million in
1996 reflecting the termination of the LDS customer base in California due to
the 1997 settlement entered into by LDS with each of the California PUC and the
District Attorney of Monterey, California. In 1997, commercial revenues
generated in the State of California was $10.4 million, as compared to
California-generated commercial revenues of $14.5 million in 1996. See "Business
of STAR--Governmental Regulation-- Actions Against LDS."
COST OF SERVICES (EXCLUSIVE OF DEPRECIATION AND AMORTIZATION): Cost of
services (exclusive of depreciation and amortization) increased 55.7% to $351.8
million in 1997 from $226.0 million in 1996. Wholesale cost of services
(exclusive of depreciation and amortization) increased to $335.5 million in 1997
from
84
<PAGE>
$208.8 million for 1996 and as a percentage of wholesale revenues decreased to
88.0% from 90.9%, respectively. Wholesale cost of services (exclusive of
depreciation and amortization) declined during 1997 as traffic was increasingly
routed over STAR's proprietary international network. Commercial cost of
services (exclusive of depreciation and amortization) decreased 5.2% to $16.3
million in 1997 from $17.2 million in 1996 and as a percentage of commercial
revenue increased to 59.3% from 57.4% over such periods, reflecting declining
prices in the competitive long distance market. As STAR migrates the LDS
commercial customer base onto STAR's network, LDS's cost of commercial long
distance services (exclusive of depreciation and amortization) is expected to
decline.
SELLING, GENERAL AND ADMINISTRATIVE: In 1997, selling, general and
administrative expenses (exclusive of merger related costs of $286,000)
increased 1.5% to $36.5 million, from $36.0 million in 1996. Wholesale selling,
general and administrative expenses increased to $27.1 million in 1997 from
$25.4 million in 1996, but decreased as a percentage of wholesale revenues to
7.2% from 11.1% over the comparable periods. Total expenses increased year to
year in absolute dollars as STAR expanded its proprietary international network
and employee base. Included in the 1996 selling, general and administrative
expense was $11.6 million in reserves and write-offs against deposits and
accounts receivable related to bad debts from two customers. Commercial selling,
general and administrative expenses decreased to $9.4 million in 1997 from $10.2
million in 1996 and remained flat as a percentage of commercial revenues at
approximately 34.1%. STAR expects selling, general and administrative expenses
to expand in absolute dollars and as a percentage of revenues in fiscal year
1998, as STAR expands its network and employee base and in connection with
STAR's entry into the commercial market.
DEPRECIATION AND AMORTIZATION: Depreciation increased to $4.6 million for
1997 from $1.4 million for 1996, and increased as a percentage of revenues to
1.1% from 0.6% in the prior period. Depreciation increased as a result of STAR's
continuing expansion of its proprietary international network which includes
purchases of switches, submarine cable and leasehold improvements associated
with switch sites. STAR expects depreciation expense to increase as STAR
continues to expand its global telecommunications network.
OTHER INCOME (EXPENSE): Other expense, net, increased to $2.7 million in
1997 from $560,000 in 1996. This increase is primarily due to interest expense
of $1.7 million incurred under various capital leases and bank lines of credit
and a legal settlement and associated expenses of $1.7 million. The legal
settlement relates to the dispute settled by LDS with the California PUC and the
District Attorney of Monterey County. See "Business of STAR--Governmental
Regulation--Actions Against LDS." Interest income earned on short-term
investments increased to $492,000 in 1997 from $110,000 in 1996 due to interest
earned on the proceeds of STAR's June 1997 initial public offering.
PROVISION FOR INCOME TAXES: The historical provision for income taxes
increased to $2.9 million in 1997 from $577,000 in 1996 primarily due to the
increase in profitability of STAR.
YEARS ENDED DECEMBER 31, 1996 AND 1995.
REVENUES: Revenues increased 340.6% to $259.7 million in 1996 from $58.9
million 1995. Wholesale revenues increased to $229.8 million in 1996 from $28.7
million in 1995, with minutes of use increasing to 479.7 million in 1996, as
compared to 38.1 million minutes of use in the prior year. These wholesale
minutes do not include any minutes from T-One. The increase in wholesale revenue
resulted from STAR's commencement of operations as an international long
distance carrier, an increase in the number of customers as compared to the
prior year and an increase in minutes of wholesale traffic from new and existing
customers. The increase in traffic is also attributable to an increase in the
number of routes with favorable rates that STAR was able to offer to customers.
Commercial revenues decreased to $29.9 million in 1996 from $30.2 million in
1995 due to a decrease in the rate per minute charged, which was partially
offset by an increase in the number of minutes sold. In 1996, commercial revenue
generated in the State of California was $14.5 million, as compared to
California-generated commercial revenues of $15.4 million in 1995.
85
<PAGE>
COST OF SERVICES (EXCLUSIVE OF DEPRECIATION AND AMORTIZATION): Cost of
services (exclusive of depreciation and amortization) increased 410.4% to $226.0
million for 1996 from $44.3 million in 1995. Wholesale cost of services
(exclusive of depreciation and amortization) increased to $208.8 million in 1996
from $26.6 million for 1995. Wholesale cost of services (exclusive of
depreciation and amortization) as a percentage of wholesale revenues decreased
to 90.9% in 1996 from 92.7% in 1995, reflecting the change from STAR's prior
consulting business to operating as an international long distance carrier. Cost
of services (exclusive of depreciation and amortization) was positively impacted
during 1996 by the negotiation of lower rates on routes with significant
traffic, and negatively impacted by increases in traffic on routes with lower
margins. Commercial cost of services (exclusive of depreciation and
amortization) decreased to $17.2 million in 1996 from $17.6 million in 1995
representing 57.4% and 58.2% of commercial revenues, respectively. Cost of
services (exclusive of depreciation and amortization) from commercial services
declined as costs associated with the local exchange carriers declined.
SELLING, GENERAL AND ADMINISTRATIVE: Selling, general and administrative
expenses increased 244.0% to $36.0 million in 1996 from $10.5 million in 1995.
Wholesale selling, general and administrative expenses increased to $25.8
million in 1996 from $2.5 million in 1995, and increased as a percentage of
revenues to 11.2% from 8.5% in the prior period. Selling, general and
administrative expenses increased between periods as STAR increased its employee
base and incurred payroll, employee benefits, commission and related expenses.
STAR also established a reserve for doubtful accounts to reflect its
significantly higher revenue levels and invested in sales and marketing
activities, including tradeshows and travel. Hi-Rim and CCI, two of STAR's major
customers in 1996, informed STAR that they were experiencing financial
difficulties and would be unable to pay in full outstanding accounts receivable.
As a result, the full amount of the approximately $10.8 million owed to STAR by
Hi-Rim and CCI as of December 31, 1996 which was not subsequently collected or
for which no offsetting value was received, was written off or reserved in 1996.
In addition, STAR wrote-off $820,000 of intangible assets relating to CCI.
Commercial selling, general and administrative expenses increased to $10.2
million in 1996 from $8.0 million in 1995 reflecting higher operating costs.
DEPRECIATION: Depreciation increased to $1.4 million for 1996 from $368,000
for 1995, but remained at 0.6% of revenues. Depreciation increased as a result
of STAR's purchase of switches and of the operating equipment and leasehold
improvements associated with its Los Angeles and New York switching facilities.
Depreciation expense will increase as STAR expands its ownership of switching
and transmission facilities through purchase or use of capital leases.
OTHER INCOME (EXPENSE): Other expense, net, increased to $560,000 in 1996
from $75,000 in 1995. This increase is primarily due to a $100,000 legal
settlement in the second quarter of 1996 as well as $609,000 in interest expense
incurred under various bank and stockholder lines of credit. This increase was
offset by $110,000 in interest income on short-term investments and cash
equivalents primarily from funds raised in private placements of equity
securities during the first three quarters of 1996.
PROVISION FOR INCOME TAXES: Through December 31, 1995 STAR had elected to
be taxed as an S-Corporation for both federal and state income tax purposes and
thus was only subject to 1.5% tax on taxable income for state purposes. LDS was
an S-Corporation through the date of the merger on November 30, 1997. The pro
forma provision for income taxes, assumes that both STAR and LDS were
C-Corporations for all periods presented. During 1996, the historical provision
for income taxes increased to $577,000 as a result of the reserve of $3.4
million of the net deferred tax asset.
LIQUIDITY AND CAPITAL RESOURCES.
As of September 30, 1998, STAR had cash and cash equivalents of
approximately $11.8 million, short-term investments of $92.4 million (as a
result of STAR's secondary stock offering), and a working capital surplus of
$116.6 million. In June 1997, STAR completed an initial public offering of 9.4
million shares of
86
<PAGE>
STAR Common Stock of which approximately 8.1 million shares were sold by STAR
and approximately 1.3 million shares were sold by certain selling stockholders.
The net proceeds to STAR (after deducting, underwriting, discounts and offering
expenses) from the sale of such shares of STAR Common Stock were approximately
$30.9 million. As of December 31, 1997, STAR had used the proceeds from the
offering to repay indebtedness of $14.2 million, to purchase switching and
transmission related equipment and to finance STAR's operations in the U.K.
On May 4, 1998, STAR completed a secondary offering of 6,000,000 shares of
STAR Common Stock of which 5,685,000 shares were sold by STAR and 315,000 shares
were sold by a selling stockholder. The net proceeds to STAR (after deducting
underwriting discounts and offering expenses) from the sale of such shares of
STAR Common Stock were approximately $145.0 million.
As of September 30, 1998, STAR had no funds outstanding on its $25 million
revolving line of credit, which bears interest at the bank's cost of funds plus
137.5 basis points and expires on July 1, 1999. However, available borrowing
under the line of credit is reduced by outstanding letters of credit in the
amount of $4.9 million.
STAR generated net cash from operating activities of $11.1 million in 1997,
primarily from net income plus depreciation and amortization, while using $2.8
million in 1996. STAR's investing activities used cash of approximately $30.0
million during 1997 primarily resulting from capital expenditures and the
investment of the proceeds from the initial public offering in marketable
securities, while using $10.4 million in 1996. STAR's financing activities
provided cash of approximately $18.9 million during 1997 primarily from the sale
of STAR Common Stock and borrowings under lines of credit, offset by repayments
under various lines of credit, while providing $14.7 million in 1996.
STAR generated net cash from operating activities of $4.3 million for the
nine months ended September 30, 1998, primarily from net income plus
depreciation and amortization, as well as increases in accounts payable and
accrued expenses offset by increases in accounts and notes receivable. The
increase in accounts and notes receivable was due to general increases in volume
and extended payment terms for certain customers. The Company's investing
activities used cash of $136.7 million during the nine months ended September
30, 1998, primarily from capital expenditures and the purchase of short-term
investments. The Company's financing activities generated cash of approximately
$142.0 million primarily from $144.7 million net proceeds raised in the
secondary stock offering as well as stock options exercised, offset by payments
under capital lease obligations.
At September 30, 1998, STAR had capital lease obligations of $37.7 million,
and $0.9 million in term loans, relating to its switching facilities and
operating equipment. STAR believes that the proceeds from its secondary stock
offering and cash generated from operations, as well as funding under its bank
line of credit, will satisfy STAR's current liquidity needs. Nevertheless, as
STAR continues to expand its network facilities and pursues its strategy of
growth through acquisition, STAR's liquidity needs may increase, perhaps
significantly, which could require STAR to seek such additional financing or the
expansion of its borrowing capacity under current or new lines of credit.
The Company also entered into a 20 year commitment to purchase IRUs from IXC
Communications, Inc. for approximately $31 million and a 20 year, $70 million
agreement to purchase capacity on the Qwest nationwide Macro Capacity (SM) Fiber
network.
As appropriate, STAR will use capital lease financing or raise additional
debt or equity capital to finance new projects or acquisitions. STAR had foreign
currency contracts outstanding at December 31, 1997 in the notional amount of
$6.3 million. STAR had no foreign currency contracts outstanding at September
30, 1998.
While the termination of the LDS customer base in California will result in
a loss of commercial revenues from that state during 1998, management does not
believe that the loss of such revenues will have a material impact on STAR's
liquidity in the future.
87
<PAGE>
YEAR 2000 COMPLIANCE.
A significant percentage of the software that runs most of the computers in
the United States relies on two-digit date codes to perform a number of
computation and decision making functions. Commencing on January 1, 2000, these
computer programs may fail from an inability to interpret date codes properly,
misreading "00" for the year 1900 instead of the year 2000.
STAR has initiated a comprehensive program to identify, evaluate and address
issues associated with the ability of its information technology and
non-information technology systems to properly recognize the Year 2000 in order
to avoid interruption of the operation of these systems and a material adverse
effect on STAR's operations as a result of the century change. Each of the
information technology software programs that STAR currently uses has either
been certified by its respective vendor as Year 2000 compliant or will be
replaced with software that is so certified prior to January 1, 1999. STAR
intends to conduct comprehensive tests of all of its software programs for Year
2000 compliance as part of its Year 2000 readiness program. An integral part of
STAR's non-information technology systems, its telecommunications switches, is
not currently Year 2000 compliant. The respective vendors of STAR's twelve
switches are in the process of upgrading the switches and have informed STAR
that the switches will be compliant on or before February 28, 1999. STAR does
not believe that its other non-information technology systems will be affected
by the Year 2000, but will not know definitively until STAR tests and evaluates
such equipment during January 1999.
STAR's computer systems interface with the computers and technology of many
different telecommunications companies, including those of foreign companies, on
a daily basis. STAR considers the Year 2000 readiness of its foreign customers
and vendors of particular importance given the general concern that the computer
systems abroad may not be as prepared as those in domestic operations to handle
the century change. As part of its Year 2000 compliance program, STAR intends to
contact its significant vendors and customers to ascertain whether the systems
used by such third parties are Year 2000 compliant. STAR plans to have all Year
2000 compliance initial testing and any necessary conversions completed by July
1999.
Historically, STAR has not incurred any costs to date to reprogram, replace
and test its information and non-information technology systems for Year 2000
compliance. The costs associated with STAR's Year 2000 compliance efforts will
be incurred during the remainder of 1998 and throughout 1999. STAR estimates the
costs of such efforts will be between $70,000 and $150,000 over the life of the
project; though such expenditures may increase materially following testing of
non-information technology systems and the evaluation of the Year 2000
compliance status of integral third party vendors and customers. Costs incurred
in connection with STAR's Year 2000 compliance efforts will be expensed as
incurred.
STAR currently anticipates that its information technology and
non-information technology systems will be Year 2000 compliant before January 1,
2000, though no assurances can be given that STAR's compliance testing will not
detect unanticipated Year 2000 compliance problems. Furthermore, STAR does not
yet know the Year 2000 compliance status of integral third parties and is
therefore currently unable to assess the likelihood or the risk to STAR of third
party system failures. However, a system failure by any of STAR's significant
customers or vendors could have a material adverse effect on STAR's operations.
The Company believes that the most reasonably likely worst case scenario
resulting from the century change will be its inability to route telephone
traffic at current rates to desired locations for an indeterminable period of
time. Such worst case scenario could have a material adverse affect on STAR's
results of operations and liquidity.
STAR intends to develop contingency plans to handle a Year 2000 system
failure experienced by its information and non-information technology systems
and to handle any necessary interactions with the computers and technology of
any integral non-complying third party.
88
<PAGE>
BUSINESS OF STAR
OVERVIEW
STAR is an emerging multinational carrier focused primarily on the
international long distance telecommunications market. STAR offers highly
reliable, low-cost switched voice services on a wholesale basis, primarily to
U.S.-based long distance carriers. STAR provides international long distance
service to approximately 220 foreign countries through a flexible network
comprised of various foreign termination relationships, international gateway
switches, leased and owned transmission facilities and resale arrangements with
long distance providers. STAR has grown its revenues rapidly by capitalizing on
the deregulation of international telecommunications markets, combining
sophisticated information systems with flexible routing and leveraging
management's industry expertise. STAR has increased its revenues and net income
from $58.9 million and $3.7 million, respectively, in 1995 to $404.6 million and
$5.8 million, respectively, in 1997.
INDUSTRY BACKGROUND
The international long distance telecommunications services industry
consists of all transmissions of voice and data that originate in one country
and terminate in another. This industry is undergoing a period of fundamental
change which has resulted in substantial growth in international
telecommunications traffic.
From the standpoint of U.S.-based long distance providers, the industry can
be divided into two major segments: the U.S. international market, consisting of
all international calls billed in the U.S., and the overseas market, consisting
of all international calls billed in countries other than the U.S. The U.S.
international market has experienced substantial growth in recent years, with
gross revenues from international long distance services rising from
approximately $8.5 billion in 1990 to approximately $14.9 billion in 1996,
according to FCC data.
STAR believes that a number of trends in the international
telecommunications market will continue to drive growth in international
traffic, including:
- continuing deregulation and privatization of telecommunications markets;
- pressure to reduce international outbound long distance rates paid by end
users driven by increased competition in newly deregulated global markets;
- the dramatic increase in the availability of telephones and the number of
access lines in service around the world;
- the increasing globalization of commerce, trade and travel;
- the proliferation of communications devices such as faxes, cellular
telephones, pagers and data communications devices;
- increasing demand for data transmission services, including the Internet;
and
- the increased utilization of high quality digital undersea cable and
resulting expansion of bandwidth availability.
THE DEVELOPMENT OF THE U.S. AND OVERSEAS MARKETS
The 1984 deregulation of the U.S. telecommunications industry enabled the
emergence of a number of new long distance companies in the U.S. Today, there
are over 500 U.S. long distance companies, most of which are small or
medium-sized companies. In order to be successful, these small and medium-sized
companies need to offer their customers a full range of services, including
international long distance. However, most of these carriers do not have the
critical mass to receive volume discounts on international
89
<PAGE>
traffic from the larger facilities-based carriers such as AT&T, MCI WorldCom and
Sprint. In addition, these small and medium sized companies generally have only
limited capital resources to invest in international facilities. New
international carriers such as STAR emerged to take advantage of this demand for
less expensive international bandwidth. These emerging multinational carriers
acted as aggregators of international traffic for smaller carriers, taking
advantage of larger volumes to obtain volume discounts on international routes
(resale traffic), or investing in facilities when volume on particular routes
justify such investments. Over time, as these emerging international carriers
became established and created a high quality networks, they began to carry
overflow traffic from the larger long distance providers seeking lower rates on
certain routes.
Deregulation and privatization have also allowed new long distance providers
to emerge in foreign markets. By eroding the traditional monopolies held by
single national providers, many of which are wholly or partially government
owned, such as Post Telegraph & Telephone operators ("PTTs"), deregulation is
providing U.S.-based providers the opportunity to negotiate more favorable
agreements with PTTs and emerging foreign providers. In addition, deregulation
in certain foreign countries is enabling U.S.-based providers to establish local
switching and transmission facilities in order to terminate their own traffic
and begin to carry international long distance traffic originated in that
country. STAR believes that growth of traffic originated in markets outside of
the U.S. will be higher than the growth in traffic originated within the U.S.
due to recent deregulation in many foreign markets, relative economic growth
rates and increasing access to telecommunications facilities in emerging
markets.
INTERNATIONAL SWITCHED LONG DISTANCE SERVICES
International switched long distance services are provided through switching
and transmission facilities that automatically route calls to circuits based
upon a predetermined set of routing criteria. The call typically originates on a
local exchange carrier's network and is transported to the caller's domestic
long distance carrier. The domestic long distance provider then carries the call
to an international gateway switch. An international long distance provider
picks up the call at its gateway and sends it directly or through one or more
other long distance providers to a corresponding gateway switch operated in the
country of destination. Once the traffic reaches the country of destination, it
is then routed to the party being called though that country's domestic
telephone network.
International long distance providers can generally be categorized by their
ownership and use of switches and transmission facilities. The largest U.S.
carriers, such as AT&T, MCI WorldCom and Sprint, primarily utilize owned
transmission facilities and generally use other long distance providers to carry
their overflow traffic. Since only very large carriers have transmission
facilities that cover the over 200 countries to which major long distance
providers generally offer service, a significantly larger group of long distance
providers own and operate their own switches but either rely solely on resale
agreements with other long
90
<PAGE>
distance carriers to terminate their traffic or use a combination of resale
agreements and owned facilities in order to terminate their traffic as shown
below:
[GRAPH]
OPERATING AGREEMENTS. Under traditional operating agreements, international
long distance traffic is exchanged under bilateral agreements between
international long distance providers in two countries. Operating agreements
provide for the termination of traffic in, and return traffic to, the
international long distance providers' respective countries at a standard
"accounting rate" with that international provider. Under a traditional
operating agreement, the international long distance provider that originates
more traffic compensates the long distance provider in the other country by
paying a net amount based on the difference between minutes sent and minutes
received and the settlement rate, which is generally one-half of the accounting
rate.
Under a typical operating agreement both carriers jointly own the
transmission facilities between two countries. A carrier gains ownership rights
in a digital fiber optic cable by purchasing direct ownership in a particular
cable prior to the time the cable is placed in service, acquiring an
"Indefeasible Right of Use" ("IRU") in a previously installed cable, or by
leasing or obtaining capacity from another long distance provider that either
has direct ownership or IRUs in the cable. In situations where a long distance
provider has sufficiently high traffic volume, routing calls across directly
owned or IRU cable is generally more cost-effective on a per call basis than the
use of short-term variable capacity arrangements with other long distance
providers or leased cable. However, direct ownership and acquisition of IRUs
require a company to make an initial investment of its capital based on
anticipated usage.
TRANSIT ARRANGEMENTS. In addition to utilizing an operating agreement to
terminate traffic delivered from one country directly to another, an
international long distance provider may enter into transit arrangements
pursuant to which a long distance provider in an intermediate country carries
the traffic to a country of destination. Such transit arrangements involve
agreement among the providers in all the countries involved and are generally
used for overflow traffic or where a direct circuit is unavailable or not volume
justified.
RESALE ARRANGEMENTS. Resale arrangements typically involve the wholesale
purchase and sale of transmission and termination services between two long
distance providers on a variable, per minute basis. The resale of capacity,
which was first permitted in the U.S. market in the 1980s enabled the emergence
of new international long distance providers that rely at least in part on
capacity acquired on a wholesale basis from other long distance providers.
International long distance calls may be routed through a facilities-based
carrier with excess capacity, or through multiple long distance resellers
between the originating long
91
<PAGE>
distance provider and the facilities-based carrier that ultimately terminates
the traffic. Resale arrangements set per minute prices for different routes,
which may be guaranteed for a set time period or subject to fluctuation
following notice. The resale market for international capacity is constantly
changing, as new long distance resellers emerge and existing providers respond
to fluctuating costs and competitive pressures. In order to be able to
effectively manage costs when utilizing resale arrangements, long distance
providers need timely access to changing market data and must quickly react to
changes in costs through pricing adjustments or routing decisions.
ALTERNATIVE TERMINATION ARRANGEMENTS. As the international
telecommunications market has become deregulated, service providers have
developed alternative arrangements to reduce their termination costs by, for
example, routing traffic via third countries to obtain lower settlement rates or
using international private line facilities to bypass the settlement rates
applicable to traffic routed over the PSTN. These arrangements include ISR,
traffic refiling and the acquisition of transmission and switching facilities in
foreign countries so as to self-correspond. Refiling of traffic takes advantage
of disparities in settlement rates between different countries. An originating
operator typically refiles traffic by sending it first to a third country that
enjoys lower settlement rates with the destination country where upon it is
forwarded or refiled to the destination country thereby resulting in a lower
overall termination cost. The difference between transit and refiling is that,
with respect to transit, the operator in the destination country typically has a
direct relationship with the originating operator and is aware of the
arrangement, while with refiling, the operator in the destination country
typically is not aware that it is terminating refiled traffic originated in
another country. While the United States has taken no position with respect to
whether refile comports with international regulation, refile is illegal in many
countries. With ISR, a long distance provider completely bypasses the settlement
system by connecting an IPL to the PSTN on one or both ends. While ISR currently
is only sanctioned by U.S. and other regulatory authorities on some routes, ISR
services are increasing and are expected to expand significantly as deregulation
of the international telecommunications market continues. In addition, new
market access agreements, such as the WTO Agreement, have made it possible for
many international service providers to establish their own transmission and
switching facilities in certain foreign countries, enabling them to
self-correspond and directly terminate traffic. See "--Government Regulation."
The highly competitive and rapidly changing international telecommunications
market has created a significant opportunity for carriers that can offer high
quality, low cost international long distance service. Deregulation,
privatization, the expansion of the resale market and other trends influencing
the international telecommunications market are driving decreased termination
costs, a proliferation of routing options, and increased competition. Successful
companies among both the emerging and established international long distance
companies will need to aggregate enough traffic to lower costs of both
facilities-based or resale opportunities, maintain systems which enable analysis
of multiple routing options, invest in facilities and switches and remain
flexible enough to locate and route traffic through the most advantageous
routes.
THE STAR APPROACH
STAR is an emerging multinational carrier focused primarily on the
international long distance market. STAR offers highly reliable, low-cost
switched voice services on a wholesale basis, primarily to U.S.-based long
distance carriers. STAR provides international long distance service to
approximately 220 foreign countries through a flexible network comprised of
various foreign termination relationships, international gateway switches,
leased and owned transmission facilities and resale arrangements with long
distance providers. STAR has grown its revenues rapidly by capitalizing on the
deregulation of international telecommunications markets, combining
sophisticated information systems with flexible routing and leveraging
management's industry expertise.
STAR markets its services to large global carriers seeking lower rates as
well as to small and medium-sized long distance companies that do not have the
critical mass to invest in their own international
92
<PAGE>
transmission facilities or to obtain volume discounts from the larger
facilities-based carriers. During the fourth quarter of 1997, STAR provided
switched international long distance services to 108 customers and currently
provides these services to nine of the top forty global carriers. STAR has also
recently focused on building a customer base overseas, particularly in Europe,
and has opened offices in Dusseldorf, Frankfurt, Hamburg and Munich, Germany and
London, England. In addition, STAR has begun to market its international long
distance services directly to certain commercial customers in the U.S. and
overseas.
STRATEGY
STAR's objective is to be a leading provider of highly reliable, low-cost
switched international long distance services on a wholesale basis to U.S. and
foreign-based telecommunications companies, as well as on a retail basis to
commercial customers. Key elements of STAR's strategy include the following:
EXPAND SWITCHING AND TRANSMISSION FACILITIES. STAR is continuing to pursue
a flexible approach to expanding and enhancing its network facilities by
investing in both switching and transmission facilities where traffic volumes
justify such investments. STAR has expanded its international gateway switching
facilities through the addition of facilities in Dallas and Miami and
Dusseldorf, Frankfurt, Hamburg and Munich, Germany and plans to put into service
in early 1999 switches in Atlanta, Chicago and Seattle; Paris, France; Geneva,
Switzerland; and Vienna, Austria. STAR's international gateway switch in London,
England went into service in April 1997 and four switches in Germany became
operational in the second quarter of 1998. In addition, STAR is planning to
install a network of switches in selected other European and Asian cities.
CAPITALIZE ON PROJECTED INTERNATIONAL LONG DISTANCE GROWTH. STAR believes
that the international long distance market provides attractive opportunities
due to its higher revenue and profit per minute, and greater projected growth
rate as compared to the domestic long distance market. STAR targets
international markets with high volumes of traffic, relatively high rates per
minute and prospects for deregulation and privatization. STAR believes that the
ongoing trend toward deregulation and privatization will create new
opportunities for STAR in international markets. Although STAR has focused to
date primarily on providing services for U.S.-based long distance providers,
STAR also intends to expand the international long distance services it offers
to foreign-based long distance providers.
LEVERAGE TRAFFIC VOLUME TO REDUCE COSTS. STAR continues to focus on
building its volume of international long distance traffic. Higher traffic
volumes strengthen STAR's negotiating position with vendors, customers and
potential foreign partners, which allows STAR to lower its costs of service. In
addition, higher traffic volumes on particular routes allow STAR to lower its
cost of services on these routes by transitioning from acquiring capacity on a
variable cost per minute basis to fixed cost arrangements such as longer-term
capacity agreements with major carriers, long-term leases and ownership of
facilities.
LEVERAGE INFORMATION SYSTEMS AND SWITCHING CAPABILITIES. STAR leverages its
sophisticated information systems to analyze its routing alternatives, and
select the most cost-effective routing from among STAR owned facilities, network
of resale arrangements with other long distance providers, operating agreements
and alternative termination relationships. STAR has invested significant
resources in the development of software to track specific usage information by
customer and revenue and cost information on specific routes on a daily basis.
STAR's information systems are critical components in managing its customer and
vendor relationships, routing traffic to the most cost-effective alternative,
and targeting its marketing efforts.
MAINTAIN HIGH QUALITY. STAR believes that reliability, call completion
rates, voice quality, rapid set up time and a high level of customer and
technical support are key factors evaluated by U.S. and foreign-based
telecommunications companies and large corporate customers in selecting a
carrier for their international traffic. STAR's state-of-the-art switching
equipment is fully compliant with international C-7
93
<PAGE>
and domestic SS-7 signaling standards. STAR strives to provide a consistently
high level of customer and technical support and has technical support personnel
at its switching facilities 24 hours per day, seven days per week to assist its
customers and to continually monitor network operations.
EXPAND INTO COMMERCIAL MARKET. STAR plans to expand into niche commercial
markets in the U.S. and in other deregulating countries where it believes it can
leverage its international network and where the customer base has a significant
international calling pattern. As an example of this strategy, STAR is using the
LDS telemarketing sales force to target small commercial customers in ethnic
markets to increase traffic to Mexico and Latin America. Additionally, STAR
intends to use UDN's network of independent sales agents to target medium-sized
commercial customers with a demand for international calling services at
competitive rates. Finally, STAR plans to use its direct sales forces to target
larger commercial customers, concentrating at first on potential customers in
Los Angeles and New York. With respect to the offering of commercial services
abroad, STAR initially intends to focus on Germany, the U.K. and selected
European cities where competition for commercial customers is less mature.
GROWTH THROUGH ACQUISITIONS. STAR actively pursues opportunities to enhance
its business through strategic and synergistic acquisitions. These acquisitions
may focus on entering new territories, enlarging STAR's presence in an existing
territory, adding capacity or expanding into new market segments, such as the
commercial market. In addition to expanding its revenue base, STAR plans to
realize operating efficiencies by integrating newly-acquired operations into
STAR's billing, tracking and other systems. On November 30, 1997, STAR acquired
LDS, a long-distance provider focusing on small commercial customers throughout
the United States, for approximately 849,000 shares of STAR Common Stock. On
March 10, 1998, STAR acquired T-One, an international wholesale long distance
provider, for 1,353,000 shares of STAR Common Stock. On November 19, 1997, STAR
entered into an agreement to acquire UDN, a commercial long distance provider.
The acquisition of UDN is subject to approval by UDN's stockholders and to
various regulatory approvals. On August 20, 1998, STAR entered into the Merger
Agreement to acquire PT-1. Each of these transactions, except for the PT-1
acquisition, has been, or will be, accounted for as a pooling of interests.
NETWORK
STAR provides international long distance services to approximately 220
foreign countries through a flexible, switched-based network consisting of
resale arrangements with other long distance providers, various foreign
termination relationships, international gateway switches and leased and owned
transmission facilities. STAR's network employs state-of-the-art digital
switching and transmission technologies and is supported by comprehensive
monitoring and technical support personnel. STAR's switching facilities are
staffed 24 hours per day, seven days per week.
TERMINATION ARRANGEMENTS
STAR seeks to retain flexibility and maximize its termination opportunities
by utilizing a continuously changing mix of routing alternatives, including
resale arrangements, operating agreements and other advantageous termination
arrangements. This diversified approach is intended to enable STAR to take
advantage of the rapidly evolving international telecommunications market in
order to provide low-cost international long distance service to its customers.
STAR utilizes resale arrangements to provide it with multiple options for
routing traffic through its switches to each destination country. Traffic under
resale arrangements typically terminates pursuant to a third party's
correspondent relationships. STAR purchased capacity from 60 vendors in 1997. A
substantial portion of this capacity is obtained on a variable, per minute and
short-term basis, subjecting STAR to the possibility of unanticipated price
increases and service cancellations. STAR's contracts with its vendors provide
that rates may fluctuate, with rate change notice periods varying from five days
to one year, with certain of STAR's longer term arrangements requiring STAR to
make minimum usage commitments in
94
<PAGE>
order to achieve additional volume discounts. As a result of deregulation and
competition in the international telecommunications market, the pricing of
termination services varies by carrier depending on such factors as call traffic
and time of day. Since STAR does not typically enter into long-term contracts
with these providers, pricing can change significantly over short periods of
time. STAR's proprietary information systems enable STAR to track the pricing
variations in the international telecommunications market on a daily basis,
allowing STAR's management to locate and reroute traffic to the most cost-
effective alternatives. See "Risk Factors--Operating Results Subject to
Significant Fluctuations."
STAR currently has operating agreements with carriers in a number of
countries and is in the process of negotiating additional operating agreements
for other countries. STAR has been and will continue to be selective in entering
into operating agreements. STAR also has agreements with international providers
of long distance services for termination of traffic that STAR routes over a its
network to such countries. STAR currently has such termination arrangements with
several carriers in a number of countries, and STAR is in the process of
expanding its coverage of such countries and entering into similar arrangements
in additional countries. The FCC or foreign regulatory agencies may take the
view that certain of STAR's termination arrangements do not comply with current
rules and policies applicable to international settlements, such as current ISR
rules. To the extent that the revenue generated under such arrangements becomes
a significant portion of overall revenue, the loss of such arrangements, whether
as a result of regulatory actions or otherwise, could have a material adverse
effect on STAR's business, operating results and financial condition. In
addition, the FCC could impose sanctions on STAR, including forfeitures, if
certain of STAR's arrangements are found to be inconsistent with FCC rules. See
"--Government Regulation," "Risk Factors--Risks of International
Telecommunications Business," and "--Potential Adverse Effects of Government
Regulation."
SWITCHES AND TRANSMISSION FACILITIES
International long distance traffic to and from the U.S. is generally
transmitted through an international gateway switching facility across undersea
digital fiber optic cable or via satellite to a termination point. International
gateway switches are digital computerized routing facilities that receive calls,
route calls through transmission lines to their destination and record
information about the source, destination and duration of calls. STAR's global
network facilities include both international gateway switches and undersea
digital fiber optic cable.
STAR currently operates international gateway switches in New York, Los
Angeles, Dallas and Miami; London, England and Dusseldorf, Frankfurt, Hamburg,
and Munich, Germany. In early 1999, STAR plans to put into service international
gateway switches in Atlanta, Chicago and Seattle; Paris, France; Geneva,
Switzerland and Vienna, Austria. STAR considers any of its switches to be
international gateway switches if STAR can route international calls across such
switch.
STAR's switching facilities are linked to a proprietary reporting system,
which STAR believes provides it with a competitive advantage by permitting
management on a real-time basis to determine the most cost-effective termination
alternatives, monitor customer usage and manage gross margins by route. STAR has
installed multiple redundancies into its switching facilities to decrease the
risk of a network failure. For example, STAR employs both battery and generator
power back-up and has installed hardware that automatically shifts the system to
auxiliary power during a power outage, rather than relying on manual override.
STAR is in the process of adding a network control center in its Los Angeles
facility, which is expected to be completed in 1998.
STAR currently holds ownership positions in a number of digital undersea
fiber optic cables including TPC-5, Gemini and AC-1, and has plans to acquire
transmission capacity on additional undersea fiber optic cable systems. STAR has
recently entered into a commitment to acquire transmission capacity on the Qwest
domestic Macro Capacity(SM) Fiber Network, which is expected to serve over 130
cities in the U.S. STAR plans to increase its investment in direct and IRU
ownership of cable in situations where STAR
95
<PAGE>
enters into operating agreements and in other situations in which it determines
that such an investment would enhance operating efficiency or reduce
transmission costs.
Through its acquisitions of T-One and UDN, STAR has acquired, or will
acquire, additional switching and transmission facilities. By acquiring T-One,
STAR has added a switch located in the same building as STAR's New York
international gateway switch and has added a number of operating agreements to
countries in Africa and the Middle East, among other locations. In addition,
T-One owns capacity on certain cable and satellite systems. Upon consummation of
the acquisition of UDN, STAR will acquire a switch located in the same building
as STAR's Dallas switch. STAR plans to integrate these facilities into its
existing network.
SALES AND MARKETING
STAR markets its services on a wholesale basis to other telecommunications
companies through its experienced direct sales force and marketing/account
management team who leverage the long-term industry relationships of STAR's
senior management. STAR reaches its customers primarily through domestic and
international trade shows and through relationships gained from years of
experience in the telecommunications industry. STAR had 103 direct sales and
marketing employees and over 140 telemarketing representatives as of September
30, 1998.
In the wholesale market, STAR's sales and marketing employees utilize the
extensive, customer specific usage reports and network utilization data
generated by STAR's sophisticated information systems to effectively negotiate
agreements with customers and prospective customers and to rapidly respond to
changing market conditions. STAR believes that it has been able to compete more
effectively as a result of the personalized service and ongoing senior
management-level attention that is given to each customer.
In connection with STAR's expansion into the commercial market, STAR expects
to target small commercial customers through LDS' existing telemarketing
operation, deliver services to medium-sized commercial customers through UDN's
network of independent sales agents and utilize a direct sales force to approach
larger commercial accounts. Establishment of a sales force capable of
effectively expanding STAR's services into the commercial market can be expected
to require substantial efforts and management and financial resources and may
increase STAR's operating costs. See "Risk Factors--Risks Associated with Growth
of Telecommunications Network and Customer Base."
INFORMATION AND BILLING SYSTEMS
STAR's operations use advanced information systems including call data
collection and call data storage linked to a proprietary reporting system. STAR
also maintains redundant billing systems for rapid and accurate customer
billing. STAR's switching facilities are linked to a proprietary reporting
system, which STAR believes provides it with a competitive advantage by
permitting management on a real-time basis to determine the most cost-effective
termination alternatives, monitor customer usage and manage gross margins by
route. STAR's systems also enable it to ensure accurate and timely billing and
to reduce routing errors. As STAR's systems were designed for the wholesale
marketplace, STAR is currently in the process of modifying its systems in
anticipation of its entrance into the commercial marketplace.
STAR's proprietary reporting software compiles call, price and cost data
into a variety of reports which STAR can use to re-program its routes on a
real-time basis. STAR's reporting software can generate the following reports as
needed:
- customer usage, detailing usage by country and by time period within
country, in order to track sales and rapidly respond to any loss of
traffic from a particular customer;
- country usage, subtotaled by vendor or customer, which assists STAR with
route and network planning;
96
<PAGE>
- vendor rates, through an audit report that allows management to determine
at a glance which vendors have the lowest rates for a particular country
in a particular time period;
- vendor usage by minute, enabling STAR to verify and audit vendor bills;
- dollarized vendor usage to calculate the monetary value of minutes passed
to STAR's vendors, which assists with calculating operating margin when
used in connection with the customer reports;
- loss reports used to rapidly highlight routing alternatives that are
operating at a loss as well as identifying routes experiencing substantial
overflow; and
- LATA (Domestic Call Area) reporting by originating and terminating LATA,
allowing for accurate Local Exchange charge audits, and protecting from
Local Exchange overcharging.
STAR has built multiple redundancies into its billing and call data
collections systems. Nine call collector computers receive call information in
real-time, immediately duplicating data, sending one copy to billing, while the
other copy is used for customer service internally and for traffic analysis.
STAR maintains two independent and redundant billing systems in order to both
verify billing internally and to ensure that bills are sent out on a timely
basis. All of the call data, and resulting billing data, are continuously backed
up on tape drives and redundant storage devices, and are regularly transported
to an off-site safe location.
COMPETITION
The international telecommunications industry is intensely competitive and
subject to rapid change. STAR's competitors in the international wholesale
switched long distance market include large, facilities-based multinational
corporations and PTTs, smaller facilities-based providers in the U.S. and
overseas that have emerged as a result of deregulation, switched-based resellers
of international long distance services and international joint ventures and
alliances among such companies. International wholesale switched long distance
providers compete on the basis of price, customer service, transmission quality,
breadth of service offerings and value-added services. STAR also competes abroad
with a number of dominant telecommunications operators that previously held
various monopolies established by law over the telecommunications traffic in
their countries. See "Risk Factors--Significant Competition." Additionally, the
telecommunications industry is in a period of rapid technological evolution,
marked by the introduction of competitive new product and service offerings,
such as the utilization of the Internet for international voice and data
communications. STAR is unable to predict which of many possible future product
and service offerings will be important to maintain its competitive position or
what expenditures will be required to develop and provide such products and
services. STAR believes that it competes favorably on the basis of price,
transmission quality and customer service. The number of STAR's competitors is
likely to increase as a result of the new competitive opportunities created by
the WTO Agreement. Further, under the terms of the WTO Agreement, the United
States and the other 68 countries participating in the Agreement have committed
to open their telecommunications markets to competition, and foreign ownership
and adopt measures to protect against anticompetitive behavior, effective
starting on February 5, 1998. As a result, STAR believes that competition will
continue to increase, placing downward pressure on prices. Such pressure could
adversely affect STAR's gross margins if STAR is not able to reduce its costs
commensurate with such price reductions.
COMPETITION FROM DOMESTIC AND INTERNATIONAL COMPANIES AND ALLIANCES. A
majority of the U.S.-based international telecommunications services revenue is
currently generated by AT&T, MCI WorldCom and Sprint. STAR also competes with
other U.S.-based and foreign long distance providers, including the RBOCs, which
presently have FCC authority to resell and terminate international
telecommunication services. Many of these companies have considerably greater
financial and other resources and more extensive domestic and international
communications networks than STAR. STAR's business would be materially adversely
affected to the extent that a significant number of such customers limit or
cease doing
97
<PAGE>
business with STAR for competitive or other reasons. Consolidation in the
telecommunications industry could not only create even larger competitors with
greater financial and other resources, but could also adversely affect STAR by
reducing the number of potential customers for STAR's services.
EXPANSION INTO COMMERCIAL MARKET. With the acquisition of LDS, STAR began
providing long distance service to the commercial market, a market that is
subject to intense competition from a number of well capitalized companies. The
commercial market is also characterized by the lack of customer loyalty, with
commercial customers regularly changing service providers. There can be no
assurance that STAR will be able to compete successfully in the commercial
market.
GOVERNMENT REGULATION
STAR's U.S. interstate and international telecommunications service
offerings generally are subject to the regulatory jurisdiction of the FCC.
Certain telecommunication services offered by STAR in the U.S. may also be
subject to the jurisdiction of state regulatory authorities, commonly known as
PUCs. STAR's telecommunications service offerings outside the U.S. are also
generally subject to regulation by national regulatory authorities. In addition,
U.S. and foreign regulatory authorities may affect STAR's international service
offerings as a result of the termination or transit arrangements associated
therewith. U.S. or foreign regulatory authorities may take actions or adopt
regulatory requirements which could adversely affect STAR. See "Risk
Factors--Potential Adverse Effect of Government Regulation."
U.S. REGULATION
STAR's business is subject to various U.S. and foreign laws, regulations,
agency actions and court decisions. STAR's U.S. international telecommunications
service offerings are subject to regulation by the FCC. The FCC requires
international carriers to obtain authorization under Section 214 of the
Communications Act prior to acquiring international facilities by purchase or
lease, or providing international service to the public. Prior FCC approval is
also required to transfer control of a certificated carrier. STAR is also
subject to FCC policies and rules that regulate the manner in which
international telecommunication services may be provided, including, for
instance, the circumstances under which a carrier may provide international
switched services using IPL facilities and under which it may route traffic
through third countries to or from its final destination.
The Communications Act and the FCC's rules and policies also impose certain
other obligations on carriers providing international telecommunication
services. These include the obligation to file at the FCC and to maintain
tariffs containing the rates, terms, and conditions applicable to their
services; to file certain reports regarding international traffic and
facilities; to file certain contracts with correspondent carriers; to disclose
affiliations with foreign carriers and significant foreign ownership interests;
to pay certain regulatory fees based, among other things, upon the carrier's
revenues and ownership of international transmission capacity.
INTERNATIONAL SERVICES. FCC rules require STAR to obtain prior FCC
authorization to acquire and operate international communication circuits in
satellites and undersea fiber optic cables; similar FCC authority is required
for STAR to resell such capacity. STAR holds both facilities-based and resale
international authorizations, including a "global" authorization that provides
broad authority to offer switched and private line international services. STAR
has filed tariffs for international services with the FCC.
FCC INTERNATIONAL PRIVATE LINE RESALE POLICY. The FCC's IPL resale policy
limits the conditions under which a carrier may connect IPLs to the PSTN at one
or both ends to provide switched services, commonly known as ISR. A carrier
generally may only offer ISR services to a foreign country if the FCC has found
(a) the country is a member of the WTO and at least 50% of the U.S. billed and
settled traffic to that country is settled at or below the benchmark settlement
rate adopted by the FCC in IB Docket No. 96-261;
98
<PAGE>
or (b) the country is not a WTO member, but it offers U.S. carriers equivalent
opportunities to engage in ISR and at least 50% of the U.S. billed and settled
traffic is settled at or below the applicable benchmark. Settled traffic refers
to traffic subject to an accounting rate agreement between U.S. and foreign
carriers. An accounting rate is a per minute wholesale charge negotiated by
international carriers for terminating traffic in either direction. Each carrier
is paid a settlement rate for terminating traffic on its own network which
ordinarily is one-half of the accounting rate. STAR's FCC authority currently
permits it to provide ISR service to Canada, the U.K., Sweden, New Zealand,
Australia, the Netherlands, Germany, France, Belgium, Denmark, Norway, Austria,
Switzerland, Luxembourg, Italy, Ireland, Hong Kong and Japan. The FCC is
currently reviewing U.S. carrier applications to provide ISR to Finland and
Mexico, among other routes, and upon grant of any such ISR application to a
given country, the FCC's rules also would permit STAR to provide ISR service to
that country. If ISR is not permitted on a route, absent prior FCC consent, U.S.
facilities based international carriers must terminate switched telephone
traffic in accordance with the ISP which is primarily intended to deter foreign
carriers with market power from discriminating amongst competing U.S. carriers
by, for example, favoring the foreign carrier's U.S. affiliate. The ISP requires
that all U.S. carriers terminate traffic with a foreign carrier on the same
terms (i.e., that settlement rates be equivalent) and receive inbound traffic
only in proportion to the volume of U.S. outbound traffic which they generate.
On a few routes, STAR may use IPLs to terminate international switched
telephone services where ISR has not been authorized. On such routes, therefore,
STAR's termination arrangements may not be consistent with the FCC's ISP. On any
such route, however, to STAR's knowledge the foreign correspondent lacks market
power, no U.S. inbound traffic is involved, and the effective settlement rate is
lower than the prevailing rate. Thus STAR believes its actions are not
inconsistent with the ISP's underlying purpose. If the FCC were to determine, by
its own actions or in response to the filing of a third party that any of STAR's
IPL arrangements violate its ISR policy or STAR's ISR authorization, the FCC
could order STAR to terminate any non-conforming arrangements. In addition, STAR
could be subject to a monetary forfeiture and to other penalties, including the
revocation of STAR's FCC authorizations to operate as an international carrier.
Any such FCC action could have a material adverse effect upon STAR's business,
operating results and financial condition.
FCC INTERNATIONAL SETTLEMENTS POLICY. The FCC's ISP places limits on the
arrangements which U.S. international carriers may enter into with foreign
carriers for exchanging public switched telecommunications traffic, which the
FCC terms International Message Telephone Service. The policy does not apply to
ISR services. The ISP is primarily intended to deter dominant foreign carriers
from discriminating amongst competing U.S. carriers by, for example, favoring
the foreign carrier's U.S. affiliate. Absent FCC consent, the ISP requires that
U.S. carriers receive an equal share of the accounting rate (i.e., that
settlement rates be equivalent) and receive inbound traffic in proportion to the
volume of U.S. outbound traffic which they generate. The ISP and other FCC
policies also prohibit a U.S. carrier from offering or accepting a "special
concession" from a foreign carrier where the foreign carrier possesses
sufficient market power on the foreign end of the route to affect competition
adversely in the U.S. market. A "special concession" is defined by the FCC as an
exclusive arrangement involving services, facilities or functions on the foreign
end of a U.S. international route which are necessary for providing basic
telecommunications, and which are not offered to similarly situated U.S.
carriers authorized to serve that route. U.S. international carriers wishing to
establish settlement arrangements for IMTS which do not comply with the ISP must
obtain a waiver of the FCC's rules or a declaratory ruling from the FCC under
the FCC's "flexibility" policy that the non-standard arrangement is in the
public interest. FCC policy provides that a request by a U.S. international
carrier to establish a non-standard settlement arrangement with a foreign
carrier in a WTO member country is presumptively in the public interest, and
that said presumption generally may be overcome only by a demonstration that the
foreign carrier is not subject to competition in its home market from more than
one facilities-based international carrier. The FCC recently has initiated a
rulemaking proceeding to modify the ISP by, among other things, repealing the
ISP for U.S. international carriers dealing with non-dominant carriers in
countries which are members of the World Trade Organization
99
<PAGE>
(WTO). Notwithstanding these proposals and the FCC's ISP waiver and flexibility
policies, it is possible that the FCC could find that certain of STAR's
arrangements with foreign operators were or are inconsistent with the ISP and
that STAR has not requested prior FCC authority therefor. If the FCC were to
determine by its own actions or in response to the filing of a third party that
STAR has violated the ISP, the FCC could order STAR to terminate any
non-conforming arrangement. In addition, STAR could be subject to a monetary
forfeiture and to other penalties, including revocation of STAR's FCC
authorizations to operate as an international carrier. Any such FCC action could
have a material adverse effect upon STAR's business, operating results and
financial condition.
The FCC's policies also require U.S. international carriers providing IMTS
to negotiate and adopt settlement rates with foreign correspondents for IMTS
which are at or below certain benchmark rates beginning January 1, 1999 for high
income countries. Pending reconsideration, the FCC has stayed a related policy
requiring U.S. international carriers to establish IMTS settlement rates at or
below the benchmark rate with any foreign affiliate beginning April 1, 1998.
STAR expects that any IMTS operating agreement which it has or may have with a
foreign affiliate will satisfy the foregoing benchmarks requirements when
applicable.
STAR currently has IMTS operating agreements with certain foreign
correspondents which provide for settlement rates above the FCC's prescribed
benchmarks. STAR will negotiate in good faith to establish IMTS settlement rates
with its foreign correspondents which satisfy the FCC's benchmarks but there can
be no assurance that such negotiations will succeed. The FCC's order adopting
the foregoing settlement benchmarks and the timetable therefor is currently
being reconsidered by the FCC. Several foreign telecommunications carriers also
have petitioned the U.S. Court of Appeals to vacate the FCC's benchmarks order
arguing that, among other things, the FCC lacks the jurisdiction to prescribe
the settlement rates which foreign carriers may collect from U.S. carriers.
However, subject to FCC reconsideration and action by the Court of Appeals, if
STAR is unable to negotiate benchmark settlement rates with certain foreign
correspondents, the FCC may intervene on its own action or in response to a
filing by a third party. STAR is unable to predict the form which such
intervention may take but it could disrupt STAR's arrangements for transmitting
traffic to certain countries require STAR to suspend direct service to certain
countries or require STAR to make alternative termination arrangements with
certain countries all of which could have a material adverse effect on STAR's
business, operating results and financial condition.
FCC POLICIES ON TRANSIT AND REFILE. International switched
telecommunication traffic is frequently routed indirectly via one or more third
countries to its final destination. When such arrangements are mutually agreed,
they are commonly based on a transit agreement under which settlement payments
are made to all parties. In other cases, traffic may be sent to a third country
and then forwarded or refiled for delivery to its final destination without the
knowledge or consent of the destination carrier. STAR uses both transit and
refile arrangements to terminate its international traffic. The FCC routinely
approves transit arrangements by U.S. international carriers. The FCC's rules
also permit carriers to use ISR facilities in many cases to route traffic via a
third country for refile through the public switched network. However, the
extent to which U.S. carriers may enter into refile arrangements consistent with
the ISP is currently under review by the FCC. In 1997, the FCC stated that
above-cost accounting rates had led an increasing amount of international
traffic to migrate to least cost routes through the use of practices such as
hubbing, refile and reorigination. The FCC stated that such practices are an
economically rational response to inflated settlement rates. Notwithstanding the
FCC's past rules, policies and statements regarding the scope of permissible
transit and refile arrangements, the FCC could find by its own actions or in
response to the filing of a third party, that certain of STAR's transit or
refile arrangements violate the ISP or other FCC policies. In that event, the
FCC could order STAR to terminate any non-conforming transit or refile
arrangements. In addition, STAR could be subject to a monetary forfeiture and to
other penalties, including revocation of STAR's FCC authorizations to operate as
an international carrier. Any
100
<PAGE>
such FCC action could have a material adverse effect on STAR's business,
operating results and financial condition.
REPORTING REQUIREMENTS. International telecommunication carriers also are
required by the FCC's rules timely to file certain reports regarding
international traffic and revenues, the ownership and use of international
facilities; and their affiliations with foreign carriers. The FCC considers a
U.S. carrier to be affiliated with a foreign carrier if it has a 25% interest in
the capital stock of the carrier or it controls the foreign carrier or is under
common ownership or control. The FCC requires these reports so that, among other
things, it may monitor the development of industry competition and the potential
for a dominant foreign carrier to discriminate amongst U.S. carriers. STAR
generally has filed said traffic, facilities and foreign affiliation reports.
The FCC's rules require international telecommunication carriers to file at the
FCC copies of their contracts with other carriers, including operating
agreements, within 30 days of execution. STAR has filed copies of its operating
agreements with the FCC. Competitive U.S. international carriers do not
routinely file other carrier-to-carrier contracts with the FCC and, consistent
with industry practice, STAR has not filed certain other carrier contracts.
Notwithstanding the foregoing FCC filings by STAR, the FCC by its own action or
in response to the filing of a third party could determine that STAR has failed
to meet certain of the foregoing filing and reporting requirements or that
certain Company filings are deficient. In that event, STAR could be directed to
remedy any asserted non-compliance; STAR could also be subject to a monetary
forfeiture and to other penalties, and, although STAR believes that it would be
largely unprecedented in such circumstances, and hence unlikely, the FCC could
revoke STAR's authorizations to operate as an international carrier. Any such
FCC action could have a material adverse effect on STAR's business, results and
financial condition.
REGULATORY FEES. The Communications Act, and FCC rules and policies, impose
certain fees upon carriers providing interstate and international
telecommunication services. These fees are levied, among other things, to defray
the FCC's operating expenses, to underwrite universal telecommunication service
(e.g., by subsidizing certain services used by schools and libraries), such as
Internet access, and by other telecommunications users in areas of the U.S.
where service costs are significantly above average), to fund the
Telecommunications Relay Service ("TRS"), which provides special options for
hearing-impaired users, and to support the administration of telephone numbering
plans.
Carriers that provide domestic interstate services must pay an annual
regulatory fee based on their interstate and international revenues; the fee is
currently 0.11% of net revenue. Carriers that provide domestic interstate
services to end users must pay a universal telecommunications service fee each
month based upon the total estimated demand for U.S. universal service funding.
If applicable, each carrier's share is approximately 4% of the carrier's annual
end user revenues. STAR generally offers its services only to other carriers
which in turn provide services to end-users. Such carrier-to-carrier revenues
are not subject to universal service fees, and thus STAR generally is not liable
to pay universal service fees. Carriers that only offer international service
(i.e., service between the United States and a foreign country or service
between two foreign carriers) also are not subject to the universal service fee.
However, if an international carrier has an affiliate that provides domestic
interstate services, then the carrier's international revenues are subject to
said fee. Until its acquisition of LDS, STAR did not offer domestic interstate
services. As a result of the operations of LDS, any revenue STAR receives from
end users for international services may be subject to universal service fees.
U.S. interstate and international carriers must pay a percentage of their
revenue each year to support the North American Numbering Plan Administrator.
For the 1998 filing year, the contribution rate is less than .003% of net
telecommunications revenue. U.S. carriers must pay a certain percentage of their
interstate and international revenues to support the TRS Fund. For the 1998
filing year, the contribution rate was less than .04% of gross domestic
interstate revenue. STAR has routinely paid the foregoing regulatory fees;
however, approximately $150,000 in additional fees may be owed by STAR to
satisfy its TRS and annual fee obligations for 1996 and 1997 filing years. The
foregoing regulatory fees typically change annually. STAR cannot predict the
future regulatory fees for which it may be liable. Said fees could rise
significantly for STAR and amount to four percent or
101
<PAGE>
more of STAR's gross international and interstate revenues if STAR is no longer
exempt from paying universal service fees because STAR provides service directly
to end users, or because amendments to the Communications Act repeal the
universal service fee exemption for revenues from connecting carriers. Because
the international telecommunication services business is highly competitive, an
increase in the regulatory fees which STAR must pay could impair its market
position and have a material adverse effect on STAR's business, operating
results and financial condition.
RECENT AND POTENTIAL FCC ACTIONS. Recent FCC rulemaking orders and other
actions have lowered the entry barriers for new facilities-based and resale
international carriers by streamlining the processing of new applications and
granting non-dominant carriers greater flexibility in establishing non-standard
settlement arrangements with non-dominant foreign carriers, including the
non-dominant U.S. affiliates of such carriers. The FCC also has proposed further
to liberalize the market entry process for competing carriers by, among other
things, forbearing the current application requirement under Section 214 of the
Communications Act for carriers seeking to serve any foreign point where they do
not have an affiliate. In addition, the FCC's rules implementing the WTO
Agreement presume that competition will be advanced by the U.S. entry of
facilities-based and resale carriers from WTO member countries, thus further
increasing the number of potential competitors in the U.S. market and the number
of carriers which may also offer end-to-end services. The FCC has recently
approved the mergers of AT&T and Teleport Communications Group and LCI
International, Inc. and Qwest Communications International Inc. FCC approval and
the consummation of these mergers increase concentration in the international
telecommunications service industry and the potential market power of STAR's
competitors. The FCC also recently has sought to reduce the foreign termination
costs of U.S. international carriers by prescribing maximum or benchmark
settlement rates which foreign carriers may charge U.S. carriers for terminating
switched telecommunications traffic and, if the FCC's benchmarks order survives
judicial review, the FCC's action may reduce STAR's settlement costs, although
the costs of other U.S. international carriers also may be reduced in a similar
fashion. The FCC has not stated how it will enforce the new settlement
benchmarks if U.S. carriers are unsuccessful in negotiating settlement rates at
or below the prescribed benchmarks, but any future FCC intervention could
disrupt STAR's transmission arrangements to certain countries or require STAR to
modify its existing arrangements; other U.S. international carriers might be
similarly affected. The 1996 amendment to the Communications Act permits the FCC
to forbear enforcement of the tariff provisions in the Act, which apply to all
interstate and international carriers, and the U.S. Court of Appeals is
currently reviewing an FCC order directing all domestic interstate carriers to
detariff their offerings. Subject to the Court's decision, the FCC may forbear
its current tariff rules for U.S. international carriers, such as STAR, or order
such carriers to detariff their services. In that event, STAR would have greater
flexibility in pricing its service offerings and to compete, although any such
FCC action likely would grant other non-dominant international carriers
equivalent freedom. The FCC routinely reviews the contribution rate for various
levels of regulatory fees, including the rate for fees levied to support
universal service, which fees may be increased in the future for various
reasons, including the need to support the universal service programs mandated
by the Communications Act, the total costs for which are still under review by
the FCC. The FCC also is reviewing the extent to which international carriers
may refile traffic using international private line facilities or otherwise.
Future FCC actions regarding refile could affect STAR by, for example, requiring
it to discontinue certain termination arrangements which it now has or to
implement alternative routing arrangements for certain countries; on the other
hand, the FCC may further liberalize its existing rules and policies regarding
refile in which case STAR is likely to be well positioned to expand certain
refile operations even though new opportunities may become available to its
competitors. STAR can not predict the net effect of these or other possible
future FCC actions on its business, operating results and financial condition,
although the net effect could be material.
STATE REGULATION
STATE. The intrastate long distance telecommunications operations of STAR
and its subsidiaries are subject to various state laws and regulations,
including prior certification, notification, registration and/or
102
<PAGE>
tariff requirements. In certain states, prior regulatory approval is required
for changes in control of telecommunications services. The vast majority of
states require STAR and its subsidiaries to apply for certification to provide
intrastate telecommunications services, or at a minimum to register or to be
found to be exempt from regulation, prior to commencing sale of intrastate
services. Additionally, the vast majority of states require STAR or its
subsidiaries to file and maintain detailed tariffs setting forth rates charged
by STAR to its end-users for intrastate services. Many states also impose
various reporting requirements and/or require prior approval for transfers of
control of certificated carriers and assignments of carrier assets, including
customer bases, carrier stock offerings, and incurrence by carriers of
significant debt. Certificates of authority can generally be conditioned,
modified, canceled, terminated or revoked by state regulatory authorities for
failure to comply with state laws and/or rules, regulations and policies of the
state regulatory authorities. Fines and other penalties, including, for example,
the return of all monies received for intrastate traffic from residents of a
state in which a violation has occurred may be imposed.
STAR, along with its regulated subsidiaries, believes it has made the
filings and taken the actions it believes are necessary to provide the
intrastate services it currently provides to end users throughout the U.S. STAR
and/or its subsidiaries are qualified to do business as foreign corporations,
and have received certification to provide intrastate telecommunications
services in all states where certification is required, and have received
approval for changes of control where such approvals are necessary. STAR and its
subsidiaries are required to make periodic filings in order to maintain
certificated status and remain qualified as foreign corporations.
In early 1997, the FCC instituted significant changes to the current
incumbent local exchange carrier access charge structure. These changes were
meant, in part, to bring access charges closer to their actual costs. While
there has been a general trend towards access charge reductions, new primary
interexchange carrier charges (PICCs) were authorized by the FCC to be imposed
on interexchange carriers serving presubscribed access charges closer to their
actual costs. PICCs are a flat-rated, per presubscribed line, per month access
charge imposed upon all facilities-based carriers (although they may be passed
through to resellers). Facilities-based carriers were assessed interstate PICCs
effective January 1, 1998. Intrastate PICCs have also been adopted in the five
state Ameritech region (Michigan, Wisconsin, Illinois, Indiana, and Ohio), and
may be adopted elsewhere. At the same time, STAR may pursue underlying carriers
for pass throughs of any access charge reductions they may realize from
incumbent local exchange carriers.
ACTIONS AGAINST LDS. In 1997, prior to STAR's acquisition of LDS, LDS
settled disputes with the California PUC and with the District Attorney of
Monterey, California regarding LDS' alleged unauthorized switching of long
distance customers. As part of the Settlements, LDS was subject to fines and
restrictions on its business operations in California. In addition, the FCC has
received numerous informal complaints against LDS regarding the alleged
unauthorized switching of long distance customers, which complaints currently
remain under review.
Following STAR's acquisition of LDS and in order to comply with the
Settlements, STAR has imposed strict restrictions on certain former LDS
employees, restricting these employees with respect to California intrastate
telecommunications operations. Additionally, STAR has taken a number of steps to
reduce the risk of a repeat occurrence regarding the alleged unauthorized
switching of commercial customers in California. There can, however, be no
assurance that LDS or STAR will not be subject to further regulatory review by
the California PUC or the FCC.
FOREIGN REGULATION
UNITED KINGDOM. In the U.K., telecommunications services offered by STAR
and through its affiliate, STAR Europe Ltd. ("STAR Europe"), are subject to
regulation by various U.K. regulatory agencies. The U.K. generally permits
competition in all sectors of the telecommunications market, subject to
licensing requirements and license conditions. STAR has been granted a license
to provide international services on a resale basis and STAR Europe has been
granted a license to provide international services over its own facilities,
which licenses are subject to a number of restrictions. Implementation of these
licenses have permitted STAR to engage in cost-effective routing of traffic
between the U.S. and the U.K. and beyond.
103
<PAGE>
GERMANY. In Germany, telecommunications services offered by STAR through
its affiliate, STAR Telecommunications Deutschland GmbH ("STAR Germany"), are
subject to regulation by the Regulierungsbehorde fur Telekommunikation und Post
(which is under the jurisdiction of the Ministry of Economy). Germany permits
the competitive provision of international facilities-based and resale services.
STAR Germany was granted a license for the provision of voice telephony on the
basis of self-operated telecommunications networks on December 4, 1997. Under
this license, STAR Germany has installed telecommunications switching facilities
in Dusseldorf, Frankfurt, Hamburg and Munich and is leasing connection
transmission facilities between these switches and additional facilities. The
network of STAR Germany will be used primarily for routing international
telecommunications traffic between the U.S., the U.K., Germany and beyond. There
can be no assurance that future changes in regulation of the services provided
by STAR Germany will not have a material adverse effect on STAR's business,
operating results and financial condition.
OTHER COUNTRIES. STAR plans to initiate a variety of services in certain
European countries including France and Belgium. These services will include
value-added services to closed user groups and other voice services as
regulatory liberalization in those countries permits. These and other countries
have announced plans or adopted laws to permit varying levels of competition in
the telecommunications market. Under the terms of the WTO Agreement, each of the
signatories has committed to opening its telecommunications market to
competition, foreign ownership and to adopt measures to protect against
anticompetitive behavior, effective starting on January 1, 1998. Although STAR
plans to obtain authority to provide service under current and future laws of
those countries, or, where permitted, provide service without government
authorization, there can be no assurance that foreign laws will be adopted and
implemented providing STAR with effective practical opportunities to compete in
these countries. Moreover, there can be no assurance of the nature and pace of
liberalization in any of these markets. STAR's inability to take advantage of
such liberalization could have a material adverse affect on STAR's ability to
expand its services as planned.
EMPLOYEES
As of September 30, 1998, STAR employed 675 full-time employees. STAR is not
subject to any collective bargaining agreement and it believes that its
relationships with its employees are good.
104
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS OF PT-1
THE FOLLOWING DISCUSSION OF THE FINANCIAL CONDITION AND RESULTS OF
OPERATIONS OF PT-1 SHOULD BE READ IN CONJUNCTION WITH THE FINANCIAL STATEMENTS,
INCLUDING THE NOTES THERETO, AND OTHER DETAILED INFORMATION REGARDING PT-1
INCLUDED ELSEWHERE IN THIS PROXY STATEMENT. THIS DISCUSSION CONTAINS
FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. PT-1'S ACTUAL
RESULTS MAY DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THE FORWARD-LOOKING
STATEMENTS AS A RESULT OF CERTAIN FACTORS, INCLUDING, BUT NOT LIMITED TO THOSE
DISCUSSED UNDER "RISK FACTORS" AND ELSEWHERE IN THIS PROXY STATEMENT.
OVERVIEW
PT-1 is a provider of international long distance services to retail
customers and telecommunications carriers. PT-1 currently provides its retail
services by marketing Prepaid Cards, primarily under the PT-1 brand name,
through an extensive network of distributors and independent retail outlets
throughout the United States. PT-1 targets retail markets with substantial
international long distance calling requirements, such as ethnic communities,
and believes that its Prepaid Cards provide consumers with a convenient,
attractively priced alternative to traditional presubscribed long distance
services. PT-1 has used its significant retail international traffic to
negotiate international termination arrangements with attractive rates and
develop an efficient telecommunication network, enabling PT-1 to market its
services competitively on a wholesale basis to telecommunications carriers.
REVENUES. PT-1 generates revenues through the sale of Prepaid Cards to
distributors and from the provision of transmission service on a wholesale basis
to other carriers as well as retail long distance services through its recently
introduced dial-around service. PT-1 has established itself in the international
long distance market through its Prepaid Card business and is using its
international traffic volume to develop a significant wholesale and retail
customer base. Rates in the international long distance market have declined in
recent years and, as competition in this segment of the telecommunications
industry continues to intensify, PT-1 believes that this downward trend in rates
is likely to continue. In its current fiscal year, PT-1 has experienced slight,
immaterial increases in average rates per minute. PT-1 believes that such
increases will cease and that PT-1 will be subject to the general erosion of
rates experienced by the other international telecommunication providers. PT-1
believes that such reductions in rates over time will be offset in part by
increased volume, efficiencies attributable to the planned expansion of PT-1's
telecommunications network as well as by lower transmission costs per minute
resulting from PT-1's increased volume of minutes.
In July 1995, PT-1 introduced its first Prepaid Card, The PT-1 Card,
initially targeted at ethnic communities with substantial international long
distance calling requirements in the New York city metropolitan area. PT-1
issued its first LAC Card, The New York Phone Card, in July 1996. PT-1 currently
has 14 LAC Cards (The New Jersey Phone Card, The New York Phone Card, The
Florida Card, The Boston Card, The California Card, The Diamond Direct Card, The
Payless Direct Card, The Detroit Card, The Connecticut Card, The Chicago Card,
The D.C.-Maryland-Virginia Card, The Georgia Card, The Texas Card and The
Pennsylvania Card), and the Alo Brasil, Hola Mexico, Hola Dominican Republic and
Hola Columbia Country Calling Cards, targeted to the Brazilian, Mexican,
Dominican Republic and Columbian communities in the U.S., as well as The PT-1
Worldwide Phone Card and other Prepaid Cards.
PT-1 fixes its Prepaid Card rates to attract new customers and to retain its
existing customers. While PT-1's rates to specific domestic and international
destinations are often more attractive to customers than the rates of the four
primary carriers, PT-1 does not, as a policy, fix its rates at a discount to the
rates charged by the four primary carriers, or at a discount to the rates
charged by other carriers.
PT-1 sells its Prepaid Cards to distributors at a discount to their face
values of $5, $10, $20, $25, $50 and $100, and records the sale as deferred
revenue until the card user utilizes the calling time. Revenues from the
wholesale provision of international and domestic long distance services to
other carriers is also recognized at the time of customer usage. PT-1 records
revenue from the sale of dial around services and
105
<PAGE>
presubscribed long distance services upon customer usage and bills its customers
for these services through billing and collection arrangements with LECs. PT-1's
revenues are reported net of certain federal and state excise and use taxes
imposed upon Prepaid Cards.
Although PT-1's reporting currency is the U.S. dollar, PT-1 expects to
derive an increasing percentage of its revenues from international operations.
Accordingly, changes in currency exchange rates may have a significant effect on
PT-1's results of operations. PT-1 may choose to limit its exposure to foreign
currency fluctuations in the future by purchasing forward foreign exchange
contracts or engaging in other similar hedging strategies although to date it
has not done so. The failure by PT-1 to hedge its foreign currency exchange
exposure may result in foreign exchange losses to PT-1 from its non-U.S.
operations. In addition, there can be no assurance that any currency hedging
strategy that PT-1 decides to employ, if any, would be successful in avoiding
currency exchange-related losses.
COST OF SERVICES (EXCLUSIVE OF DEPRECIATION AND AMORTIZATION). Cost of
services (exclusive of depreciation and amortization) primarily includes
payments to other carriers for origination, transport and termination of PT-1's
international and domestic long distance traffic. Historically, origination
costs have consisted largely of payments to other carriers, including LECs and
CLECs, for local access, and transport and termination costs have included
payments to other carriers for completing calls. Most of PT-1's transport costs
are variable payments based upon usage for domestic and international traffic,
and the remainder are fixed cost lease payments for leased lines. As a result,
most of PT-1's transmission cost is variable.
Other components of the cost of services (exclusive of depreciation and
amortization) include the cost of operating PT-1's switches in Jersey City, New
Jersey, Flushing, New York and Miami, Florida, and PT-1's Debit Card Platforms
in Jersey City, New Jersey and Flushing, New York, as well as payments to
InterExchange for operating the Edison Debit Card Platform and PT-1's switch in
Edison, New Jersey. Cost of services (exclusive of depreciation and
amortization) also includes the costs of producing and distributing PT-1's
Prepaid Cards.
SELLING AND MARKETING EXPENSES. Selling and marketing expenses consist
primarily of employee commissions, salaries, freight, advertising and promotion
costs and other expenses associated with the marketing and sale of Prepaid Cards
and other products and services. With the introduction of dial around and
presubscribed long distance services, PT-1 expects selling and marketing
expenses to increase as a percentage of revenues.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
consist primarily of officers' salaries, professional fees, accounting and
office salaries, customer service salaries, depreciation and amortization, an
allowance for doubtful accounts and other corporate overhead costs. PT-1 expects
its expense for uncollectible accounts to increase as a percentage of revenues
as a result of (i) the introduction of dial around and presubscribed long
distance services and other services for which payment is made by its customers
after usage and (ii) PT-1's recent increase in sales of Prepaid Cards to its
distributors on credit. See "Risk Factors--Fraud; Theft of Services;
Uncollectible Accounts."
STOCK BASED COMPENSATION. PT-1 expects to continue to incur an expense for
stock based compensation related to the issuance of certain warrants to
employees of InterExchange and options granted to certain employees. See Note 5
of Notes to Consolidated Financial Statements of PT-1.
TAXES. Since November 1, 1997, PT-1 has been required to collect a three
percent (3%) federal excise tax on sales of Prepaid Cards to its distributors.
The taxation of Prepaid Cards is evolving and is not specifically addressed by
many of the states in which the Company does business. While PT-1 believes that
it has adequately provided for any such taxes it may ultimately be required to
pay, certain states may enact legislation which specifically provides for
taxation of Prepaid Cards or may interpret current laws in a manner resulting in
additional tax liabilities. See "Risk Factors--Taxation of Sale and Use of
Prepaid Cards."
106
<PAGE>
RESULTS OF OPERATIONS
The following table sets forth certain items in PT-1's statements of
operations as a percentage of total revenues for the periods indicated:
<TABLE>
<CAPTION>
PERIOD FROM SIX MONTHS ENDED
INCEPTION TO YEARS ENDED MARCH
MARCH 31, 31, SEPTEMBER 30,
------------- -------------------- --------------------
1996 1997 1998 1997 1998
------------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C>
Revenues......................................................... 100.0% 100.0% 100.0% 100.0% 100.0%
Operating Expenses:
Cost of services (exclusive of depreciation and
amortization)................................................ 115.8 98.0 91.7 91.3 92.3
Selling and marketing.......................................... 2.7 1.0 1.0 1.0 1.6
General and administrative..................................... 5.9 1.5 2.8 2.2 4.8
Merger costs................................................... -- -- -- -- 0.4
Stock based compensation....................................... -- 4.3 .6 1.0 .1
----- --------- --------- --------- ---------
Total operating expenses..................................... 124.4 104.8 96.1 95.5 99.2
----- --------- --------- --------- ---------
Income(loss)from operations (24.4) (4.8) 3.9 4.5 0.8
Income(loss) before provision
for income taxes............................................... (24.4) (4.8) 3.9 4.6 0.6
Provision for income taxes....................................... -- -- (1.2) (1.1) (0.1)
----- --------- --------- --------- ---------
Net income(loss)................................................. (24.4) (4.8) 2.7 3.5 .5
----- --------- --------- --------- ---------
----- --------- --------- --------- ---------
</TABLE>
SIX MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO SIX MONTHS ENDED SEPTEMBER 30,
1997
REVENUES. Revenues increased 43.7% to $268.9 million in the six months
ended September 30, 1998 from $187.0 million in the comparable period of 1997.
Prepaid Card revenues increased 15.8% to $189.4 million in the 1998 period from
$163.5 million in the prior year period. Prepaid Card terminated minutes
increased 49.4% to 1.03 billion in the six months ended September 30, 1998,
compared to 687 million terminated minutes for the comparable period in 1997.
The increase in Prepaid Card revenues and calling volumes were generated
primarily from (i) increased market acceptance of the PT-1 Prepaid Card, (ii)
the introduction of new Prepaid Cards, (iii) an increase in the number of
distributors, and (iv) recognition of revenues related to the expiration of
Prepaid Cards. Prepaid Card terminated minutes increased at a faster pace than
associated Prepaid Card revenues due to decreases in the rates per minute
charged to consumers for domestic and international long distance calls. As a
result of the foregoing, the PINs activated increased from 28.7 million in the
six months ended September 30, 1997 to 30.7 million in the corresponding period
in 1998.
Wholesale and commercial revenues increased 213.6% for the six months ended
September 30, 1998 to $74 million from $23.6 million in the comparable period of
1997. Wholesale and commercial minutes of use increased 198. % to 220.0 million
in the six months ended September 30, 1998 as compared to 73.7 million minutes
of use in the comparable period of 1997. This increase reflects growth in the
number of wholesale and commercial customers to 82 as of September 30, 1998, up
from 33 as of September 30, 1997, as well as an increase in usage by existing
customers. The average wholesale and commercial rate per minute increased to
approximately $0.34 for the 1998 six-month period as compared to $0.32 for the
comparable 1997 period, reflecting a larger proportion of traffic being carried
to higher rate per minute routes. PT-1 does not believe that this immaterial
increase in rates period to period is sustainable and believes that the growth
in wholesale and commercial revenues will be primarily premised on increased
call volume.
Revenues for the six months ended September 30, 1998 also include $5.3
million for dial around services, which commenced in March 1998.
107
<PAGE>
COST OF SERVICES (EXCLUSIVE OF DEPRECIATION AND AMORTIZATION). Cost of
services (exclusive of depreciation and amortization) increased to $248.2
million for the six months ended September 30, 1998 from $170.8 million for the
comparable period of 1997. Cost of services (exclusive of depreciation and
amortization) as a percentage of revenues increased to 92.3% for the 1998 period
compared to 91.3% for the 1997 period, primarily due to the imposition of FCC
charges in 1998 that aggregated $5.85 million for the six months ended September
30, 1998. Decreases in carrier charges for access and termination services
during the six months ended September 30, 1998 helped to mitigate the increase
in cost of services from the prior year period.
SELLING AND MARKETING EXPENSES. Selling and marketing expenses increased
133% to $4.3 million for the six months ended September 30, 1998, from $1.8
million for the comparable period in 1997. Selling and marketing expenses are
principally comprised of commissions, salaries, and advertising and promotion
expenses which accounted for 79.8% of all selling and marketing expenses for the
six months ended September 30, 1998, as compared to 70.9% for the comparable
period of 1997. Increases in commissions, salaries and advertising and promotion
expenses were a result of (i) PT-1's increased sales of Prepaid Cards, (ii) the
opening of additional sales offices, both domestically and internationally,
(iii) the expansion of the wholesale and carrier sales department, (iv)
advertising related to the introduction of PT-1's dial around product, and (v)
advertising campaigns in newly entered markets.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
increased to $12.8 million for the six months ended September 30, 1998, from
$4.1 million for the comparable period in 1997. General and administrative
expenses as a percentage of revenues increased to 4.8% for the six months ended
September 30, 1998 as compared to 2.2% for the 1997 period, primarily due to
salaries relating to recently hired technology and sales personnel, the
concentration of carrier resale and the expansion of PT-1's network. This
increase was primarily attributable to increases in salaries, bad debts,
professional fees, rent and depreciation and amortization expenses, which
comprised 78.3% of general and administrative expenses for the six month period
in 1998, as compared to 86.4% for the comparable period in 1997. Salaries for
customer service, accounting and network operations increased due to (i) the
additional hiring necessitated by the continued growth in traffic volume, (ii)
the expansion of PT-1's network infrastructure and capacity, (iii) the
introduction of new products and services and (iv) the transfer of all
processing for PT-1's Card traffic from an independent service bureau to an
in-house platform. Rent expense increase principally due to the opening of
additional sales and switch POPs. Professional fees increased to $2.2 million
for the six months ended September 30, 1998, as compared to $.7 million for the
comparable 1997 period. This was primarily due to non-recurring costs associated
with PT-1's initial public offering and the pending Merger, and the retention of
consulting professionals for various projects.
STOCK BASED COMPENSATION. For the six months ended September 30, 1998,
stock based compensation expense decreased to $381,664 from $1,855,525 in the
comparable 1997 period. This was primarily due to an option which was granted
and exercised during the six months ended September 30, 1997, by Mr. Pannullo to
purchase 1,048,600 shares of PT-1 Common Stock for an aggregate exercise price
of $0.015. Additionally, certain on-vesting stock based awards granted to PT-1's
former service bureau, which were recorded in the six months ended September 30,
1997, were cancelled in the 1998 period.
OTHER INCOME (DEDUCTIONS). Interest expense increased to approximately
$794,000 for the six months ended September 30, 1998, as compared to
approximately $402,000 for the same period in 1997. This was attributable to
increased bank borrowings and the receipt of $10 million in borrowings from STAR
under an interest bearing one year promissory note payable.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense
increased to $1.7 million for the six months ended September 30, 1998, from
$385,791 for the same period in 1997. Depreciation expense represented $1.03
million for the six months ended September 1998 compared to $312,576 for 1997.
Depreciation expense increased primarily as a result of PT-1's expansion of its
network, which
108
<PAGE>
includes the purchase of switches, telephony equipment, IRU capacity and
computer equipment. Amortization expense of $679,831 was recorded for the six
months ended September 30, 1998, compared to $73,214 for the same period in
1997. This was primarily the result of (i) the issuance of PT-1 Common Stock in
November 1997, for the extension of a noncompete agreement, (ii) additional
leasehold improvements to switch sites and sales offices, and (iii) the purchase
of IRU capacity.
FISCAL YEAR ENDED MARCH 31, 1998 COMPARED TO FISCAL YEAR ENDED MARCH 31, 1997
REVENUES. Revenues increased 154% to $431.5 million for the fiscal year
ended March 31, 1998 from $169.6 million for the fiscal year ended March 31,
1997. Revenues from the usage of Prepaid Cards increased to $356.3 million
during the 1998 fiscal year from $162.5 million in the prior period. This
increase in Prepaid Card revenues was generated primarily from (i) increased
market acceptance of the PT-1 Card, (ii) an increase in the number of
distributors, (iii) the introduction of new Prepaid Country Calling Cards and
(iv) higher selling prices of Prepaid Cards. Revenues from services provided to
other telecommunications providers for resale increased to $75.2 million for the
fiscal year ended March 31, 1998 from $7.1 million in the prior period. This
reflects an increase in resale customers from 9 in 1997 to 64 in 1998, primarily
due to the PT-1's ability to offer favorable rates for transmission and
termination services as a result of increased minutes purchased.
COST OF SERVICES (EXCLUSIVE OF DEPRECIATION AND AMORTIZATION). Cost of
services (exclusive of depreciation and amortization) increased to $395.5
million for the fiscal year ended March 31, 1998 from $166.2 million for the
fiscal year ended March 31, 1997. Cost of services (exclusive of depreciation
and amortization) as a percentage of revenues decreased to 91.7% for the 1998
period compared to 98.0% for the 1997 period. This decrease was primarily the
result of (i) improvements in PT-1's ability to use least-cost-routing to reduce
its per minute transmission costs, (ii) rate per minute decreases negotiated
with underlying carriers as a result of PT-1's substantially increased volume of
traffic, (iii) an increased percentage of telecommunications traffic being
transported over PT-1's leased lines and a corresponding reduction in the
percentage of traffic carried and billed by other carriers on a per minute
basis, and (iv) increased efficiencies in PT-1's telecommunications network
attributable to the addition of switches and other equipment. Cost of services
(exclusive of depreciation and amortization) as a percentage of revenues
decreased from 1997 to 1998 despite several regulatory changes in the
telecommunications industry which increased PT-1's costs of services in 1998.
SELLING AND MARKETING EXPENSES. Selling and marketing expenses increased
154% to $4.5 million for the fiscal year ended March 31, 1998 from $1.8 million
for the fiscal year ended March 31, 1997, and as a percentage of revenue
remained a constant 1%. Selling and marketing expenses were principally
comprised of commissions, salaries, advertising and freight which accounted for
83.2% of all selling and marketing expenses for the fiscal year ended March 31,
1998, as compared to 91.6% for the 1997 period. The increases in commissions,
salaries, advertising and freight expenses were directly related to PT-1's
increased sales of Prepaid Cards.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
increased to $12.1 million for the fiscal year ended March 31, 1998 from $2.6
million for the fiscal year ended March 31, 1997, and increased as a percentage
of total revenues to 2.8% from 1.5%, respectively. This increase was primarily
due to increases in salaries, professional fees, rent and depreciation and
amortization expenses, which comprised 77.7% of general and administrative
expenses for the 1998 period, as compared to 85.0% for the 1997 period. Salaries
for customer service, accounting and network administration increased due to
additional hiring made necessary by the continued increases in traffic volume
and the expansion of PT-1's telecommunications network capacity. Rent expense
increased due to the relocation of PT-1's principal executive offices in May
1997 to accommodate the increased number of employees and the opening of
additional sales offices.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense
increased to $1,534,500 for the year ended March 31, 1998 from $75,017 for the
year ended March 31, 1997. Depreciation expense
109
<PAGE>
represented $908,930 for the year ended March 31, 1998 compared to $75,017 for
the year ended March 31, 1997. Depreciation expense increased as a result of
PT-1's expansion of its network which includes the purchase of switches,
telephony equipment, computer equipment and leasehold improvements for
additional switch sites. Amortization expense of $625,570 was recorded in the
fiscal year ended March 31, 1998 as a result of the (i) purchase of capitalized
software and (ii) issuance of PT-1 Common Stock in consideration for the
extension of a noncompete agreement, respectively.
STOCK BASED COMPENSATION. Stock based compensation during the year ended
March 31, 1998 decreased to $2.7 million from $7.3 million in the year ended
March 31, 1997. Stock based compensation in 1998 reflects PT-1's recording of
the expense related to (i) the issuance on May 9, 1997 to Mr. Joseph Pannullo,
PT-1's Chief Operating Officer, of an option to purchase 1,048,600 shares of
PT-1 Common Stock for an aggregate exercise price of $0.015, (ii) the issuance
on September 30, 1997 to an employee of PT-1 of options to purchase 10,000
shares of PT-1 Common Stock, exercisable at a nominal exercise price, and (iii)
shares of PT-1 Common Stock valued at $850,000 issuable to certain employees of
PT-1 pursuant to certain transactions with Mr. Pannullo. Stock based
compensation for the year ended March 31, 1997 reflects the issuance of shares
on March 27, 1997 to two officers of PT-1 in accordance with commitments made in
July 1995 and March 1996, the dates they joined PT-1. Such shares were issued in
connection with the settlement agreement dated March 27, 1997, described in note
8 to the PT-1 Consolidated Financial Statements included herein, and were valued
as of that date.
INTEREST EXPENSE. Interest expense increased to $1,021,452 for the fiscal
year ended March 31, 1998 from $10,959 for the fiscal year ended March 31, 1997.
The increase was primarily attributable to accrued interest that is payable on a
promissory note to a former officer and founder of PT-1 as part of his
redemption agreement. The balance of interest expense for the fiscal year ended
March 31, 1998 represents amounts paid under bank borrowings which aggregated
$12.76 million in principal at March 31, 1998.
GAINS ON MARKETABLE SECURITIES. During the fiscal year ended March 31,
1998, PT-1 diversified its short-term investments by purchasing various
marketable securities of public corporations. Accordingly, net realized and
unrealized gains and losses are included in the statements of operations.
PROVISION FOR INCOME TAXES. The provision for income taxes for the fiscal
year ended March 31, 1998 was $5.15 million. Based on a net operating loss for
the fiscal year ended March 31, 1997, there was no provision for income taxes in
1997.
FISCAL YEAR ENDED MARCH 31, 1997 COMPARED TO PERIOD FROM APRIL 21, 1995
(INCEPTION) TO MARCH 31, 1996
REVENUES. Revenues increased to $169.6 million for the fiscal year ended
March 31, 1997 from $11.9 million for the period from April 21, 1995 (inception)
to March 31, 1996. Revenues from usage of Prepaid Cards increased to $162.5
million during the 1997 fiscal year from $11.9 million in the prior period. This
increase in Prepaid Card revenues was generated primarily from (i) increased
market acceptance of The PT-1 Card, (ii) an increase in the number of
distributors, (iii) the introduction of new Prepaid Country Calling Cards and
(iv) higher selling prices of Prepaid Cards. Revenues for the 1997 fiscal year
also include $7.1 million from services provided to other telecommunications
providers for resale primarily during the last quarter. PT-1 did not provide
such services during the prior period.
COST OF SERVICES (EXCLUSIVE OF DEPRECIATION AND AMORTIZATION). Cost of
services (exclusive of depreciation and amortization) increased to $166.2
million for the fiscal year ended March 31, 1997 from $13.8 million for the
period from April 21, 1995 (inception) to March 31, 1996. Cost of services
(exclusive of depreciation and amortization) as a percentage of revenues
decreased to 98.0% for the 1997 fiscal year from 115.8% during the prior period,
primarily as a result of (i) increases in the rates to selected destinations,
(ii) decreases in the switching fees from InterExchange, (iii) price decreases
negotiated with vendors for the printing and packaging of PT-1's products, (iv)
rate per minute decreases negotiated with
110
<PAGE>
the underlying carriers as a result of PT-1's substantially increased volume of
traffic and (v) an increasing percentage of telecommunications traffic being
transported over PT-1's leased lines and a corresponding reduction in the
percentage of traffic carried and billed by other carriers on a per minute
basis.
SELLING AND MARKETING EXPENSES. Selling and marketing expenses increased to
$1.8 million for the fiscal year ended March 31, 1997 from $318,000 for the
period from April 21, 1995 (inception) to March 31, 1996. Selling and marketing
expenses were principally comprised of commissions, salaries, freight and
advertising and promotional expenses, which increased in direct relation to the
growth in revenues from 1996 to 1997.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
increased to $2.6 million for the fiscal year ended March 31, 1997 from $704,000
for the period from April 21, 1995 (inception) to March 31, 1996. This increase
was primarily due to the additional salary expense that was incurred for
employees hired to accommodate PT-1's growth during the 1997 fiscal year.
Depreciation and amortization expense, which is included in general and
administrative expense, increased primarily due to the purchase and expansion of
the Edison, New Jersey switch in July 1996, as well as PT-1's increased capital
expenditures for office equipment as a result of the expansion of its employee
base.
STOCK BASED COMPENSATION. Stock based compensation for the year ended March
31, 1997 was $7.3 million as compared to $0 for the period ended March 31, 1996.
Stock based compensation for the year ended March 31, 1997 reflects the issuance
of shares on March 27, 1997 to two officers of PT-1 in accordance with
commitments made in July 1995 and March 1996, the dates they joined PT-1. Such
shares were issued in connection with the settlement agreement dated March 27,
1997, described in note 8 to the financial statements, and were valued as of
that date.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, PT-1 has funded its operating and capital needs primarily
from cash generated by operations. Net cash provided by operating activities is
primarily due to the receipt of cash from distributors generally upon shipment
of PT-1's Prepaid Cards and prior to utilization of PT-1's services and
incurrence by PT-1 of related costs of services. PT-1 expects its working
capital requirements to increase as a result of its (i) introduction of dial
around and presubscribed long distance services and other services for which
payment is made by its customers after services are rendered, and (ii) the
recent increase in sales of Prepaid Cards to its distributors on credit. PT-1
has not experienced significant credit losses to date on receivables from the
sale of Prepaid Cards.
During the fiscal years ended March 31, 1998, 1997 and 1996, PT-1 generated
$25.7 million, $13.5 million and $765,000 of cash from operating activities,
respectively. During the six month period ended September 30, 1998, operating
activities used $1.7 million in cash as compared to the corresponding period in
1997 which provided $19.3 million. The decrease in cash provided by operations
was primarily the result of the recognition of revenue related to the expiration
of Prepaid Cards resulting in a decrease of deferred revenue of $900,000 in 1998
as compared to an increase of $15 million in the corresponding 1997 period.
PT-1's accounts receivable from Prepaid Card sales have increased from
approximately $7.5 million at March 31, 1997 to approximately $29.8 million at
March 31, 1998 and to approximately $37.4 million at September 30, 1998. This
increase in accounts receivable results primarily from an increase in Prepaid
Card sales and a change in PT-1's sales terms to certain of its distributors
from payment on delivery of Prepaid Cards to credit terms.
PT-1's accounts receivable from other carriers increased from approximately
$300,000 at March 31, 1997 to approximately $7.5 million at March 31, 1998 and
to approximately $9.5 million at September 30, 1998. This increase was
attributable to the growth in PT-1's wholesale business where revenues are
billed subsequent to their recognition in the financial statements.
111
<PAGE>
PT-1's working capital deficiency at September 30, 1998 and March 31, 1998
and 1997 amounted to $38.5 million, $21.7 million and $17.4 million,
respectively. In each of these periods, working capital deficiency generally
resulted from PT-1's deferral of revenue from card sales prior to use of calling
time by the ultimate card user. Such deferred revenue is recognized as calling
time and is used in accordance with the terms of its Prepaid Cards. PT-1 expects
deferred revenue will continue to increase, particularly if card sales continue
to increase and that the working capital deficit will ultimately decrease over
time although there can be no assurances that this will be the case.
PT-1 used $22.1 million, $11.3 million and $1.5 million for capital
expenditures during the six months ended September 30, 1998 and the fiscal years
ended March 31, 1998 and 1997, respectively. PT-1 also issued a $650,000
non-interest bearing promissory note, due in ten equal monthly installments, as
a portion of the consideration for certain software licensing rights.
Additionally, PT-1 used excess cash to purchase investments in certificates of
deposit of $10.8 million and $2.1 million during the fiscal years ended March
31, 1998 and 1997, respectively. Sale of a portion of these investments resulted
in cash provided of $6.8 million during fiscal year 1998 and $4.9 million during
the six months ended September 30, 1998.
On March 26, 1997, PT-1 redeemed shares of PT-1 Common Stock from Thomas
Hickey, a former executive officer and director of PT-1, for payment of $5.0
million and the issuance of a promissory note in the principal amount of $10.0
million. The note bears interest at a rate of 8.0% per annum, compounded
semi-annually, and is secured by certain of the repurchased shares. PT-1 repaid
$5.0 million of the principal of the note on March 25, 1998, and must repay the
outstanding principal of $5.0 million and all accrued and unpaid interest on or
prior to March 25, 1999.
On October 8, 1997, PT-1 entered into a $5.0 million revolving credit
facility and a $5.0 million letter of credit facility with Chase Manhattan Bank,
N.A. ("Chase"). As of March 31, 1998, $2.76 million was outstanding under the
credit facility, which bears interest at a rate equal to either the London
Interbank Offered Rate plus 2.25%, the prime rate, or a fixed rate to be
determined pursuant to the credit facility. Borrowings under the credit facility
are secured by PT-1's equipment and accounts receivable. PT-1 may borrow up to
75% of the value of eligible equipment and accounts receivable. PT-1 is
currently negotiating with Chase to extend the term of such credit facility
through 1999. PT-1 expects to continue to meet its current and long-term
obligations through the continued provision of cash from operating activities.
In March 1998, PT-1 entered into a capital lease for $10 million of its
telecommunications equipment. Payments, including interest at 8.76%, are due in
monthly installments of $206,420 through April 2003.
On August 17, 1998, PT-1 entered into a $10.0 million loan arrangement with
STAR payable on August 17, 1999. This loan accrues interest monthly at a rate of
6.75%.
CERTAIN CAPITAL TRANSACTIONS
On February 25, 1997, litigation related to disputed ownership interests and
control of PT-1 was commenced by Peter Vita against PT-1, Thomas Hickey, a
former director and executive officer of PT-1, and Mr. Tawfik. On March 20,
1997, a second action was commenced by Douglas Barley asserting similar claims
against the same defendants. Such litigation involved disputed equity issuance
commitments in connection with the initial capitalization of PT-1 and the
employment of certain key executives. On March 27, 1997, a settlement agreement
among the parties was reached which included the dismissal of litigation,
execution of equity issuance commitments, release of claims, the resignation of
Mr. Hickey as an executive officer and employee of PT-1 and the redemption of
25,052,632 shares of PT-1 Common Stock for $15 million which was satisfied by a
cash payment of $5 million and the issuance of a note in the principal amount of
$10 million (the "Note"). In connection with the March 27, 1997 settlement
agreement, Peter Vita obtained an aggregate of 8.75 million shares of PT-1
Common Stock (6.5 million shares from PT-1 and 2.25 million shares from Mr.
Hickey), and Mr. Barley obtained an aggregate of 3.5 million shares of PT-1
Common Stock (2.6 million shares from PT-1 and 900,000 shares from Mr. Hickey)
in return for agreeing to dismiss the litigation and release the defendants from
the claims
112
<PAGE>
made. The shares transferred were valued at an aggregate of $7.3 million, based
upon the value of the shares redeemed by PT-1 from Mr. Hickey on such date.
Following PT-1's preparation of a draft registration statement on Form S-1
in connection with an initial public offering of shares of PT-1 Common Stock,
which set forth detailed financial and other information regarding PT-1 since
its inception, Mr. Hickey claimed that he was provided inadequate information in
connection with his entering into the March 27, 1997 agreement. On November 7,
1997, Mr. Hickey entered into additional agreements with PT-1 and certain
executive officers of PT-1 which reaffirmed that the March 27, 1997 settlement
agreement remained in full force and effect, contained a broad release by Mr.
Hickey of any and all potential claims against PT-1 or any stockholders of PT-1,
and contained an express covenant not to bring any further claims regarding such
matters. Mr. Hickey also agreed to an extended noncompetition agreement for
consideration of 483,980 shares of PT-1 Common Stock valued at approximately
$3.4 million.
The Note accrued interest at a rate of 8% per annum. PT-1 paid $5 million of
the Note on March 25, 1998 in accordance with its terms and must repay the
remaining outstanding principal and all accrued interest on or prior to March
25, 1999. PT-1 pledged two-thirds of the shares of PT-1 Common Stock it redeemed
from Mr. Hickey as collateral for the Note.
EFFECTS OF NEWLY-ISSUED ACCOUNTING STANDARDS
In June 1997, the FASB issued SFAS 130 "Reporting Comprehensive Income."
This statement is effective for financial statements issued for periods
beginning after December 15, 1997. Management has not yet evaluated the effect
of its financial reporting from the adoption of this statement but does not
expect the adoption of SFAS 130 to have a material effect on PT-1's financial
position or results of operations.
In June 1997, the FASB issued SFAS 131 "Disclosure about Segments of an
Enterprise and Related Information." SFAS 131 requires the reporting of profit
and loss, specific revenue and expense items and assets for reportable segments.
It also requires the reconciliation of total segment revenues, total segment
profit or loss, total segment assets, and other amounts disclosed for segments,
to the corresponding amounts in the general purpose financial statements. SFAS
131 is in effect for fiscal years beginning after December 15, 1997. PT-1 has
not yet determined what additional disclosures may be required, if any, in
connection with the adoption of SFAS 131.
On June 1998, the FASB issued SFAS 133 "Accounting for Derivative
Instruments and Hedging Activities." SFAS 133 requires companies to recognize
all derivatives as either assets or liabilities in the statement of financial
position and measure these instruments at fair value. SFAS 133 is in effect for
all fiscal quarters of fiscal years beginning after June 15, 1999. PT-1 has not
yet determined what additional disclosures may be required, if any, in
connection with the adoption of SFAS 133.
YEAR 2000 COMPLIANCE
Certain information technology equipment and software employs two-digit date
codes to perform computational and decision making functions. On January 1, 2000
and thereafter, such equipment and software may misinterpret "00" as the year
1900 instead of the year 2000, and, as a result, systems, equipment and software
may operate improperly or fail.
PT-1 believes its proprietary internal software is Year 2000 compliant, and
PT-1 believes, based upon representations of manufacturers, that its purchased
information technology ("IT") and non-IT systems are fully Year 2000 compliant.
PT-1 has been advised by the manufacturer of its telecommunications switches
that such switches and embedded software are Year 2000 compliant. PT-1 has begun
a Year 2000 compliance program which is designed to identify, evaluate and
address potential Year 2000 compliance issues with its systems, equipment and
software. The objective of the Year 2000 compliance program is to avoid
interruptions in PT-1's systems and any material adverse effect upon PT-1 which
might result from the foregoing. PT-1 plans to (a) conduct comprehensive tests
of all of its IT and non-IT systems, equipment
113
<PAGE>
and software to determine its Year 2000 compliance status and (b) obtain
certification from its systems, equipment and software vendors as to their Year
2000 compliance by the end of the first quarter of 1999. Although PT-1 will not
be able to determine the total cost of its Year 2000 compliance program prior to
the end of the first quarter of 1999, PT-1 does not currently expect to incur
significant costs in connection with its Year 2000 compliance program. Any costs
incurred in connection with such program will be expensed as incurred.
After the closing of the Merger, PT-1's Year 2000 compliance program will be
incorporated into the Year 2000 compliance program currently being implemented
by STAR. The joint Year 2000 compliance program is expected to include
contingency plans to handle (a) Year 2000 failures of STAR and PT-1's internal
systems, equipment and software and (b) any necessary interactions with the
computers and technology of any non-complying third party after STAR and PT-1
have adequately evaluated the Year 2000 compliance of these parties.
PT-1 believes that the most reasonably likely worst case scenario resulting
from the century change would be the material disruption of PT-1's operations,
impacting the provision of telecommunications services to customers. While
PT-1's management believes that its efforts to address and connect possible Year
2000 failures will be successful, there can be no assurance in that regard.
While PT-1 has not identified any specific material risks associated with
its Year 2000 compliance status, PT-1's Year 2000 compliance program is not yet
completed. PT-1 may be required to incur unanticipated costs in connection with
its Year 2000 compliance or experience lower than expected revenues or incur
higher than expected costs as a result of third parties' failure to be Year 2000
compliant. Such costs could have a material adverse effect on PT-1's financial
condition and results of operations.
114
<PAGE>
BUSINESS OF PT-1
OVERVIEW
PT-1 is a provider of international long distance services to retail
customers and telecommunications carriers. PT-1 provides retail
telecommunications services primarily by marketing Prepaid Cards, principally
under the PT-1 brand name, through an extensive network of distributors, who
directly and indirectly sell PT-1's Prepaid Cards to retail outlets throughout
the United States. PT-1 targets retail markets with substantial international
long distance calling requirements, such as ethnic communities, and believes
that its Prepaid Cards provide consumers with a convenient, attractively priced
alternative to traditional presubscribed long distance services. PT-1 sells its
Prepaid Cards exclusively to distributors and it does not maintain any sales or
marketing relationship with the retail outlets that carry PT-1's Prepaid Cards.
During the six months ended September 30, 1998, PT-1's eight largest sources of
revenues were derived from traffic routed to Mexico (12%), the Dominican
Republic (5%), Colombia, Haiti, Jamaica and India (3%), and Nigeria and Yemen,
which individually represented less than 3% of revenues. For the fiscal year
ended March 31, 1998, traffic to Mexico and the Dominican Republic were the
largest sources of revenues, at 14% and 7% of total revenues, respectively.
During March 1998, PT-1 began to market both dial around and presubscribed long
distance services to retail customers in certain target markets that also have
substantial international long distance calling needs. Over the past several
months, PT-1 has also increased the amount of resources devoted to obtaining
commercial retail customers with significant international long distance
requirements. PT-1 has used its significant retail international traffic to
negotiate international termination arrangements with attractive rates, enabling
PT-1 to market its services competitively on a wholesale basis to
telecommunications carriers and develop an efficient telecommunications network.
For the fiscal year ended March 31, 1998, PT-1 generated revenues and net income
of $431.5 million and $11.6 million, respectively.
INDUSTRY
The telecommunications market is typically segmented into the local exchange
market, the domestic long distance market and the international long distance
market. PT-1 operates in the latter two markets in the United States, targeting
retail and wholesale customers with significant volumes of international long
distance usage. For an overview of the international long distance market, see
"Business of STAR-- Industry Background."
PT-1 APPROACH
PT-1 was founded in April 1995 to capitalize on the growing market for
international long distance services. PT-1 initially entered the retail
international long distance market through the distribution of Prepaid Cards
targeted at ethnic communities. After building significant international
traffic, in 1996 PT-1 began to negotiate reduced transmission rates based upon
volume with underlying carriers and began to invest in switching equipment and
lease transmission capacity to further reduce its cost of service as a
percentage of revenues. In August 1996, PT-1 began to leverage its significant
volume of international traffic by selling international long distance services
on a wholesale basis to other carriers. For the fiscal year ended March 31,
1998, revenues from retail sales and from wholesale sales were $356.3 million
and $75.2 million, respectively.
PT-1 believes its competitive strengths are its (i) established Prepaid Card
brand names, (ii) extensive distribution infrastructure, (iii) substantial
experience in identifying, targeting and marketing to communities and markets
with significant international long distance usage and (iv) efficient
telecommunications network. PT-1 believes that its competitive strengths will
enable it to profitably continue to increase its retail customer bases and its
traffic volume and leverage these increases to negotiate lower
telecommunications costs.
115
<PAGE>
STRATEGY
PT-1's strategic objective is to expand further its presence in the retail
segment of the commercial long distance market. PT-1's strategy for achieving
this goal has the following key elements:
CONTINUE TO TARGET CONSUMERS WITH SIGNIFICANT INTERNATIONAL LONG DISTANCE
USAGE. PT-1 primarily targets consumers with significant international long
distance usage by delivering reliable international long distance services at
attractive rates. PT-1 believes that the international long distance market
provides an appealing opportunity because of its higher revenues and gross
profits per minute and its higher expected growth rate relative to the domestic
long distance market. PT-1 believes its brand awareness, large number of
international retail customers and its international network traffic and
infrastructure will enable it to continue to successfully market international
long distance service originating in countries in North America, Latin America,
Europe and in other countries to which PT-1's domestic customers direct a
substantial volume of calls.
INCREASE DISTRIBUTION OF PT-1'S PRODUCTS. PT-1 intends to increase its
distribution infrastructure by expanding the number of distributors within
existing geographic markets, entering new geographic markets and by bringing
certain of its distributors in-house. PT-1 initially concentrated its marketing
and distribution efforts in the New York metropolitan area and the northeastern
United States, but has expanded and is continuing to expand its market
penetration in other regions of the United States, Canada and Puerto Rico with
significant ethnic populations.
EXPAND OFFERINGS OF RETAIL PRODUCTS AND SERVICES. PT-1 intends to introduce
new LAC Cards in additional metropolitan areas, offer additional Country Calling
Cards and market other innovative Prepaid Cards, further segmenting the Prepaid
Card market. PT-1 also intends to grow its dial around and pre-subscribed long
distance services. PT-1 believes that its brand awareness, large number of
international retail customers and its ability to provide attractively priced
long distance services will enable it to successfully market convenient,
attractively priced dial around and presubscribed long distance service to new
and existing customers.
EXPAND PT-1'S INTERNATIONAL TELECOMMUNICATIONS NETWORK. After consummation
of the Merger, PT-1 intends to continue to expand the international reach of its
telecommunications network through STAR's network expansion and by co-locating
with STAR's switch facilities. In particular, PT-1 intends to piggyback on
STAR's international network expansion into the U.K., Germany and additional
European cities, including Paris, Vienna and Geneva.
TELECOMMUNICATIONS PRODUCTS AND SERVICES
PT-1 offers high quality retail and wholesale telecommunications services
over its own network and by interconnecting its network with the network of
other carriers.
PREPAID CARDS. PT-1's Prepaid Cards can be used at any touch tone telephone
simply by dialing an access number, followed by a PIN assigned to the card, and
the telephone number the customer wishes to reach. Prior to the connection, the
caller is informed of the remaining dollar balance and number of minutes
available. PT-1's Prepaid Cards are designed to appeal to a variety of market
segments in the U.S. that generate high levels of international and domestic
traffic. In March 1998, PT-1 began offering dial around long distance services
targeting its current customer base which has significant international long
distance calling requirements. This method of long distance calling is referred
to as "dial around" because customers are not required to change their
presubscribed long distance carrier to use the service. Rather the customer must
enter a seven digit carrier identification code ("CIC Code") prior to dialing
the long distance number in order to access PT-1's network. PT-1's CIC Code is
1016868.
PT-1 has billing and collection arrangements with local exchange carriers
under which PT-1's dial around customers are billed for PT-1's services as part
of their monthly phone bills. In March 1998, PT-1
116
<PAGE>
also introduced presubscribed long distance services targeted to ethnic
communities, other consumers and commercial accounts. With this service, a
customer's telephone is automatically connected to PT-1's network, and all of
the customer's long distance calls are made over PT-1's network.
PT-1'S PREPAID CARDS
The PT-1 Card (introduced in July 1995) was PT-1's first Prepaid Card and
offers competitively priced domestic and international long distance calling.
Customers using the PT-1 Card access PT-1's network by dialing a toll-free
number.
Local Area Calling Cards ("LAC Cards") are targeted at customers in specific
regions and enable them to access PT-1's network by dialing either a local
number or a toll-free number depending upon the region. PT-1 currently markets
The New York Phone Card (introduced in July 1996), The New Jersey Card
(introduced in February 1997), The Detroit Card (introduced in July 1997), The
Connecticut Card (introduced in September 1997), The Boston Card, The Chicago
Card, The D.C.-Maryland-Virginia Card and The Florida Card (all introduced in
November 1997), The California Card (introduced in May 1998), The Diamond Direct
Card and The Payless Direct Card (both introduced in June 1998), The Georgia
Card and The Texas Card (introduced in August 1998), and The Pennsylvania Card
(introduced in September 1998). PT-1 expects to offer additional LAC Cards in
other target metropolitan markets where PT-1 believes that there is sufficient
demand during 1998.
Country Calling Cards are designed for specific ethnic communities and offer
attractive rates to the countries to which they generate high levels of
international traffic. PT-1 currently markets the Alo Brasil, Hola Mexico, Hola
Dominican Republic and Hola Colombia cards that offer competitive rates to
Brazil, Mexico, the Dominican Republic and Colombia, and are targeted to
Mexican, Brazilian, Dominican Republic and Colombian calling communities in the
U.S. and intends to introduce additional Country Calling Cards that will appeal
to other market segments.
Co-Branded Cards are used by major corporations for national marketing
programs and promotional gifts. Co-Branded Cards are designed and packaged using
logos, trademarks and other design elements linking the benefits of the cards to
the corporation's product and services. PT-1 currently offers an Amoco Prepaid
Card pursuant to an agreement with Amoco Oil Company, a Ramada Express Hotel and
Casino Prepaid Card and a Playboy Prepaid Card and expects to offer additional
cards.
The World Card (introduced in September 1996), which offers both a different
commission structure to PT-1's distributors and different rates, is designed to
appeal to a variety of market segments.
INTERNATIONAL ORIGINATION. PT-1 intends to capitalize on its brand
awareness in certain ethnic communities in the United States by offering
international long distance services, through the sale of Prepaid Cards, to
consumers located in the U.K., Canada and other countries to which PT-1's U.S.
customers direct a substantial number of calls.
In addition, PT-1 intends to offer additional retail services in 1998 to
increase customer retention and loyalty, broaden distribution channels, appeal
to new customer groups and increase usage of PT-1's services by its existing
customers.
There can be no assurance that PT-1 will be able to introduce such services
or that, if introduced, such services will be successful.
THE TELECOMMUNICATIONS NETWORK
OVERVIEW
PT-1 currently manages its own telecommunications network and also utilizes
the transmission capacity of more than 40 different local and long distance
carriers.
117
<PAGE>
NETWORK AND OPERATIONS
SWITCHING FACILITIES. PT-1 manages a state-of-the-art digital switch based
network consisting of more than 130,000 switch ports, approximately 50,000
Prepaid Card processing ports, and a central switching center located at PT-1's
headquarters in Flushing, New York. PT-1 has selected Northern Telecom
("Nortel") as its primary switch vendor and has entered into a support agreement
with Nortel to provide 24 hours per day, 365 days per year support services to
PT-1, including technical assistance, trouble resolution and network
maintenance. PT-1 currently has Nortel DMS250 Supernode switches installed at
its corporate headquarters in Flushing, New York, in Jersey City, New Jersey and
in Miami, Florida.
POINTS OF PRESENCE. As of June 30, 1998 PT-1 had network POPs in
approximately 100 cities in more than 25 states. In areas where PT-1 has network
POPs, calls are transported to PT-1's network POPs by local exchange carriers or
CLECs and then transported from the network POPs to PT-1's switches over leased
transmission lines. PT-1 intends to double the number of network POPs by the end
of 1998.
TELECOMMUNICATIONS NETWORK MANAGEMENT AND INFORMATION SYSTEMS. PT-1's
network management and information systems enable it to (i) economically and
efficiently route traffic over PT-1's network and the networks of other
carriers, (ii) offer reliable services with high call completion rates and voice
quality and (iii) focus its marketing efforts. PT-1 believes that these systems,
particularly their ability to provide high quality service to international
destinations, provide it with a competitive advantage relative to many other
providers of telecommunication services. PT-1 monitors its network and initiates
changes to its overall switch network and traffic routing where appropriate to
optimize routing and minimize costs. Because a substantial portion of the
traffic carried by PT-1 terminates overseas and call completions vary by
carrier, PT-1 closely monitors the call completion efficiencies of its
suppliers. PT-1 tracks call completions to all destinations for all carriers on
an hourly basis and re-routes its traffic accordingly. PT-1 intends to configure
large portions of its network with Common Channel Signaling System 7 (SS7). This
network protocol reduces call setup and connect time delays and provides
additional technical capabilities and efficiencies for call routing and network
engineering. With the installation of the switch in Jersey City, New Jersey,
PT-1 has duplicated the functional network management capabilities in this
alternate site in accordance with its ongoing review of site diversity and
disaster recovery procedures. See "--Information Systems; Debit Card Platforms."
INFORMATION SYSTEMS; DEBIT CARD PLATFORMS
PT-1 markets a wide variety of Prepaid Cards, each with a specific rate
table (updated periodically). In addition, each Prepaid Card distributed by PT-1
is assigned a unique PIN and a face value ranging from $5 to $100. The Prepaid
Card's dollar balance is reduced by the cost of each call, which is based upon a
number of factors, including the type of Prepaid Card, destination and special
promotions then in effect. The cost of each call is decremented by one of PT-1's
Debit Card Platforms at the time of the call.
The ability to maintain accurate Prepaid Card dollar balances and to
decrement these balances at the proper rates is essential to PT-1's continued
success. Accordingly, PT-1 has invested significant resources in the
acquisition, development and maintenance of its Debit Card Platforms and
information systems and software. PT-1's information systems enable it to track
real-time customer usage and to quickly generate cost and profit reports (by
route). The information systems also produce more than 100 daily reports
concerning network routing, call completion rates and usage for the preceding
day, as well as a variety of weekly and monthly reports. PT-1's Prepaid Card
systems are supported by redundant systems and databases. Critical Prepaid Card
information is backed up, depending on the sensitivity of the information, on a
daily, weekly or monthly basis.
MARKETING AND DISTRIBUTION
Since inception, PT-1 has focused on building a substantial network of
wholesale distributors located primarily in the Northeast. These distributors
then sell PT-1's Prepaid Cards to sub-distributors and
118
<PAGE>
directly to retail outlets including convenience stores, grocery stores, gas
stations, supermarkets and news stands. Approximately 25% of PT-1's distributors
are located in the State of New York and the remainder are located in 35 other
states. The sub-distributors generally sell only to retail outlets. For the year
ended March 31, 1998, sales of Prepaid Card to two distributors, Worldwide
Telecom, Inc. and Diamond Phone Card, represented approximately 18% and 16% of
net Prepaid Card sales, respectively. At September 30, 1998, Worldwide Telecom,
Inc. represented approximately 28% of the net accounts receivable balance. See
"Risk Factors--Fraud; Theft of Services; Uncollectible Accounts."
PT-1 believes that a majority of Prepaid Cards directly sold to its
distributors are resold to sub-distributors (sometimes called route salespeople)
who resell the cards to retail outlets. The remainder of the cards are resold by
distributors directly to retail outlets. PT-1 has approximately 200
distributors, of which approximately 20% are individuals. The majority of PT-1's
distributors are corporations or other business entities. A majority of
distributors sell only PT-1 Prepaid Cards, though many others carry Prepaid
Cards offered by competitive telecommunications carriers. Most distributors work
from an office. PT-1 believes that while certain distributors have formal
arrangements for the supply of Prepaid Cards to retail outlets, the majority of
distribution arrangements are unwritten, informal agreements based upon
historical relationships.
PT-1's relationships with its distributors are also based upon past
relationships and buying patterns rather than formalized written agreements.
Additionally, PT-1 believes that the distributor relationships between PT-1 and
its distributors and among PT-1's distributors and their subdistributors, route
salespeople and retail outlet customers are based on past relationships and
buying patterns and do not rely on written contracts. Thus, as a matter of
practice, formal written agreements are virtually non-existent in the PT-1
Prepaid Card chain of supply. PT-1 typically sells the Prepaid Cards to its
distributors at a prearranged discount of the card's face value. PT-1 believes
that distributors then resell the cards at a discount that is less than the
discount applied to their purchase of the cards from PT-1, thereby generating a
profit. In certain cases, to incentivize distributors, PT-1 will provide
additional discounts and/or rebates to distributors purchasing a set dollar
amount of cards.
Distributors are typically identified and recruited through relationships
with existing distributors and retail outlets, telemarketing and related
promotional activities and direct inquiries from potential distributors. PT-1
competes with other Prepaid Card providers for sales to Prepaid Card
distributors. PT-1 believes that its ability to maintain and grow its
relationships with distributors depends primarily upon continuing to offer
Prepaid Cards that are attractive to end users.
PT-1 has targeted heavily populated metropolitan areas, with an emphasis on
areas with substantial ethnic community populations which generate significant
international calling volume, in the development and expansion of its
distribution network. Many of PT-1's distributors are members of such ethnic
communities or otherwise have personal or business relationships in such
communities. In developing relationships with distributors, PT-1 also focuses on
expansion into new geographic and metropolitan areas, again with an emphasis on
those areas with substantial ethnic community populations. PT-1 believes that
the success of its Prepaid Cards has created significant brand loyalty and
encourages distributors and retail outlets to actively market PT-1's products.
PT-1 regularly provides distributors and retail outlets with point-of-purchase
advertising and explanatory materials including posters of various sizes
presenting certain of PT-1's current rates, and detailed rate sheets. PT-1
frequently adds new Prepaid Card products to its service offerings, and adjusts
its pricing for particular traffic segments in order to target certain customer
groups, respond to competitive pressures and otherwise increase market share.
PT-1 has two unrelated exclusive sales distribution centers, which are
distribution sites owned and operated by independent distributors that sell only
PT-1 Prepaid Cards. In return for selling PT-1 Prepaid Cards exclusively, these
distributors are given certain rights to use the PT-1 name for promotional
purposes. In general, other distributors may advertise that they are independent
distributors of PT-1 products but otherwise may not use the PT-1 name.
Approximately 10.1% of PT-1's sales of Prepaid Cards
119
<PAGE>
for the quarter ended September 30, 1998 were made to these unrelated exclusive
sales distribution centers. Because of the exclusivity of these arrangements,
PT-1 typically is more willing to extend credit terms to the distributors
operating such sales distribution centers than to other distributors. PT-1's
arrangement with each of these two unrelated distribution centers is based upon
past relationships rather than formalized written agreements. As such, PT-1 has
no written agreements with either party.
PT-1 has recently expanded its internal sales department to focus on larger
retail chains and department stores, the tourist industry, airport and hotel
gift shops, gas stations and other retail outlets owned or franchised by larger
companies.
CUSTOMER SERVICE
PT-1 believes that effective and convenient multilingual customer service is
essential to attracting and retaining customers. Because a substantial portion
of PT-1's existing and future customers are foreign-born, PT-1 believes that it
is critical to provide customer service on a multilingual basis. PT-1's customer
service center handles an average of 6,000 to 7,000 customer inquiries per day,
including inquiries relating to Prepaid Card balances, Prepaid Card
availability, rates, international calling service, billing and becoming a
distributor. PT-1 currently employs 50 full-time customer service
representatives ("CSRs"), eight senior CSRs, a manager and a director of
customer service. All CSRs are fluent in both English and Spanish, and some are
fluent in Portuguese. PT-1's customer service center is operational ten hours
per day, six days per week. PT-1 intends to expand the customer service center
and its hours of operation during the next twelve months. Calls coming into
PT-1's customer service center are categorized by Prepaid Card product. PT-1's
internal software system provides real-time access to on-screen call records,
complete with historical detail, to track, resolve, protect and support the
individual needs of PT-1's entire customer base.
PREPAID CARD PRODUCTION AND INVENTORY CONTROL
PT-1 controls its Prepaid Card inventory by PIN and by physical count.
Generally, Prepaid Cards are received by, stored at and shipped from the
warehouse facility located at PT-1's headquarters. Physical inventory is counted
on a daily basis and reconciled against all incoming card deliveries and
outgoing shipments to distributors. PT-1 utilizes multiple print vendors for
card production and packaging.
All PINs are inactive when the Prepaid Cards arrive at PT-1's storage
facilities. Calls cannot be completed until PINs are activated by PT-1. PINs are
activated only shortly before the cards are shipped from PT-1's warehouses to
distributors, in order to minimize the number of cards with activated PINs in
its warehouse.
PINs are created electronically with unique inventory and batch codes. PT-1
has developed PIN generation and database management software enabling the Debit
Card Platforms to quickly locate Prepaid Card information while limiting fraud
and other forms of unauthorized access. In addition, if security or financial
controls have been compromised, PT-1 also maintains the ability to deactivate
specified PINs and block calls from specified telephone numbers.
COMPETITION
The telecommunications services industry is intensely competitive. PT-1
competes with other providers of Prepaid Cards and with providers of
telecommunications services in general. Many of the largest telecommunications
providers currently offer Prepaid Cards, in addition to the other
telecommunications services PT-1 intends to provide in the future. As a service
provider in the long distance telecommunications industry, PT-1 competes with
three dominant providers, AT&T, MCI WorldCom and Sprint, all of which are
substantially larger and have greater financial, technical, engineering,
personnel and marketing resources, longer operating histories, greater name
recognition and larger customer bases than PT-1. PT-1 also competes with
smaller, emerging carriers in both the Prepaid Card retail market and in the
wholesale
120
<PAGE>
market, including IDT Corporation, RSL Communications, SmarTalk Teleservices,
Inc., Pacific Gateway Exchange, Inc., FaciliCom International, Inc. and
Telegroup, Inc. To the extent PT-1 begins providing services to customers
outside the U.S. market, it may compete with the large operators such as BT in
the U.K. PT-1 believes that its success will attract additional competitors to
the Prepaid Card market. However, PT-1 believes it has certain advantages that
may discourage potential competitors from entering the Prepaid Card market,
including brand loyalty, its established distribution network, its ability to
offer competitive rates and its Debit Card Platforms and associated hardware and
software. See "Risk Factors-- Significant Competition."
The telecommunications industry is rapidly evolving and subject to constant
technological change. PT-1 believes that existing competitors are likely to
continue to expand their service offerings and to develop new sales channels.
The ability of PT-1 to compete effectively in the telecommunications services
industry will depend in part upon PT-1's continued ability to develop additional
products appealing to increasingly specialized segments of the market for
telecommunications service.
Recent changes in the regulation of the telecommunications industry may
affect PT-1's competitive position. The Communications Act is expected to open
the long distance market to competition from the RBOCs. The entry of these
well-capitalized and well-known entities into the long distance market likely
will increase competition for long distance customers, including customers who
use Prepaid Cards to make long distance calls. The Communications Act also
grants the FCC the authority to deregulate other aspects of the
telecommunications industry, which in the future may, if authorized by the FCC,
facilitate the offering of telecommunications services by regulated entities,
including the RBOCs, in competition with PT-1. See "Risk Factors--Potential
Adverse Effects of Government Regulation" and "--Government Regulation."
GOVERNMENT REGULATION
PT-1's business operations are subject to extensive U.S. federal and state
regulation. The Communications Act and FCC regulations apply to interstate
telecommunications and international telecommunications that originate or
terminate in the United States. State regulatory authorities have jurisdiction
over telecommunications that originate and terminate within the state. In its
provision of services in the U.K., PT-1 is subject to the regulations of Oftel,
the telecommunications regulator in the U.K. See "Risk Factors--Potential
Adverse Effects of Government Regulation."
FEDERAL
The Communications Act bars the 50 states from restricting competition for
local exchange services, and establishes a framework for additional competition
in the long distance market by the RBOCs. The Communications Act also grants the
FCC the authority to deregulate other aspects of the telecommunications industry
and to implement certain policy objectives, including access charge reform and
establishment of the Universal Service Fund. Pursuant to an FCC order, the
Universal Service Order, Universal Service Fund contributions are generally
equal to approximately 4% of a carrier's interstate and international and
approximately 1% of its intra-state "end user" gross revenues, effective January
1, 1998. However, the FCC will adjust the amount of these contributions each
calendar quarter, and they may increase significantly in future periods.
The FCC requires international carriers to obtain authorization under
Section 214 of the Communications Act prior to acquiring international
facilities by purchase or lease, or providing international service to the
public. Prior FCC approval is also required to transfer control of a
certificated carrier. PT-1 is also subject to FCC policies and rules that
regulate the manner in which international telecommunication services may be
provided, including, for instance, the circumstances under which a carrier may
provide international switched services using IPL facilities and under which it
may route traffic through third countries to or from its final destination.
121
<PAGE>
The Communications Act and the FCC's rules and policies also impose certain
other obligations on carriers providing interstate and international
telecommunication services. These include the obligation to file at the FCC and
to maintain tariffs containing the rates, terms, and conditions applicable to
their services; to file certain reports regarding international traffic and
facilities; to file certain contracts with correspondent carriers; to disclose
affiliations with foreign carriers and significant foreign ownership interests;
to pay certain regulatory fees based, among other things, upon the carrier's
revenues.
PT-1 holds both facilities-based and resale international authorizations,
including a perpetual "global" authorization that provides broad authority to
offer switched and private line international services. PT-1 has filed tariffs
for its interstate and international services with the FCC.
Interstate carriers are also subject to a variety of miscellaneous
regulations that, for instance, govern the documentation and verifications
necessary to change a consumer's long distance carriers, and limit the use of
toll-free numbers for pay-per-call services.
STATE
PT-1's intrastate services are subject to various state laws and
regulations, including prior certification, notification and registration
requirements. In certain states, prior regulatory approval may be required for
changes in control of telecommunications operations. Most states require PT-1 to
apply for certification to provide telecommunications services, or at least to
register, before commencing intrastate service. In most of the states where
certification or registration is required, PT-1 must file and maintain detailed
tariffs listing rates for intrastate service. Many states also impose various
reporting requirements and/or require prior approval for transfers of control of
certified carriers and assignments of carrier assets, including customer bases,
carrier stock offerings and incurrence by carriers of significant debt
obligations. Certificates of authority can generally be conditioned, modified,
canceled, terminated or revoked by state regulatory authorities for failure to
comply with state law and/or the rules, regulations and policies of the state
regulatory authorities. Fines and other penalties, including revocation, may be
imposed for such violations. In addition, states may establish their own
intrastate universal service funding programs, to which PT-1 may in some cases
be required to contribute.
PT-1 has made and is continuing to make the filings and taken the actions it
believes are necessary to become certified or tariffed to provide intrastate
telecommunications services. PT-1 is certified to do business as a domestic or
foreign corporation in all 50 states and in Puerto Rico and provides intrastate
telecommunications services in 25 states. PT-1 expects to obtain intrastate
telecommunications authority as necessary in the remaining states in which it
intends to sell its Prepaid Cards to its distributors. See "Risk
Factors--Potential Adverse Effects of Government Regulation."
UNITED KINGDOM
In the U.K., telecommunications services offered by PT-1 are subject to
regulation by various U.K. regulatory agencies. The U.K. generally permits
competition in all sectors of the telecommunications market, subject to
licensing requirements and license conditions. PT-1 currently has an ISVR
license (which is valid through December 2002) and an IFL license (which is
perpetual), which permits PT-1 to directly own interests in undersea cables
landing in the U.K. as well as other telecommunication facilities and to
originate end-user long distance traffic in the U.K.
The loss of PT-1's U.K. licenses, or the placement of significant
restrictions thereon, could have a material adverse effect on the business,
financial condition or results of operations of PT-1. See "Risk
Factors--Potential Adverse Effects of Government Regulation."
122
<PAGE>
CANADA
In Canada, PT-1 is registered with the Canadian Radio-television and
Telecommunications Commission ("CRTC") as a reseller. Under this registration,
PT-1 may resell switched services or private lines to provide Canada-Canada,
Canada-U.S., or Canada-overseas telecommunications services. In its provision of
services in Canada, PT-1 is subject to the Canadian Telecommunications Act of
1991 (the "Canadian Act") and, to a limited degree, to the rules and policies of
the CRTC. CRTC policy currently prohibits PT-1 from routing Canada-Canada,
Canada-overseas, or overseas-Canada traffic through the United States, although
said policy is expected to be repealed by the end of 1998. In addition, although
the Canadian Act currently prohibits the CRTC from imposing licensing
requirements or imposing other significant regulations on resellers such as
PT-1, legislation pending in the Canadian Parliament, if enacted, would allow
the CRTC to require resellers such as PT-1 to obtain a license and to abide by
certain requirements.
TRADEMARKS AND SERVICE MARKS
PT-1 uses the names "PT-1 Communications" and "PT-1" as its primary business
names and has filed for federal trademark protection of these service marks. In
addition, filings have been made at the U.S. Patent and Trademark Office to
register the distinctive PT-1 logo, as well as over 30 names which PT-1 uses or
intends to use to identify its Prepaid Cards. These filings are all pending and
PT-1 has no assurance that they will be granted. PT-1 regards its trademarks,
service marks and trade names as valuable assets and believes they have value in
the marketing of its products and services. See "Risk Factors--Limited
Protection of PT-1's Proprietary Rights; Risks of Infringement."
EMPLOYEES
As of September 30, 1998, PT-1 had 279 full-time employees. None of PT-1's
employees are members of a labor union or are covered by a collective bargaining
agreement. Management believes that PT-1's relationship with its employees is
good.
PROPERTIES
PT-1 leases certain office space under operating leases and subleases,
including PT-1's principal headquarters in Flushing, New York. The principal
offices, warehouses, sales offices and switch sites currently leased or
subleased by PT-1 are as follows:
<TABLE>
<CAPTION>
SQUARE
LOCATION FOOTAGE LEASE EXPIRATION
- ---------------------------------------------------------------- --------- ------------------
<S> <C> <C>
Flushing, New York (headquarters and warehouse)................. 34,800 March 2002
Miami, Florida.................................................. 10,400 March 2008
Jersey City, New Jersey......................................... 5,600 January 2008
Houston, Texas.................................................. 4,000 August 2000
Seattle, Washington............................................. 3,148 November 2000
Toronto, Canada................................................. 2,750 March 2000
Staten Island, New York......................................... 2,700 October 2001
New York, New York.............................................. 2,627 June 1999
West New York, New Jersey....................................... 2,000 June 2003
Cleveland, Ohio................................................. 1,500 June 2000
Columbus, Ohio.................................................. 1,200 June 2000
Rio Pedras, Puerto Rico......................................... 1,200 June 2000
</TABLE>
LEGAL PROCEEDINGS
In July 1997, PT-1 was notified by the FTC and the NYAG that it was the
subject of an investigation alleging deceptive advertising practices in
connection with the sale of its Prepaid Cards. The FTC alleged
123
<PAGE>
that PT-1's point of sale posters for its Prepaid Cards, which did disclose the
existence of additional first minute connection charges for certain calls, did
not sufficiently disclose the specific amount of connection charges for such
calls. PT-1 modified these point of sale materials more than one year ago, and
all point of sale materials now routinely set forth the exact amount of all call
connection charges. Subsequently, the FTC and the NYAG indicated that they were
also reviewing whether PT-1 properly decremented minutes from its Prepaid Cards.
PT-1 has been informed that the NYAG has ended its investigation without taking
any action. The FTC has also completed its investigation and has determined not
to take any formal action regarding PT-1's Prepaid Card decrementation
practices. With regard to prior advertising of Prepaid Cards by PT-1, PT-1 and
representatives of the FTC have entered into an agreement in principle, which is
subject to final approval by the FTC, pursuant to which, in complete resolution
of all allegations regarding allegedly deceptive advertising; (1) PT-1 will pay
to the FTC the sum of $300,000; (2) PT-1 does not admit any of the allegations;
and (3) on a going forward basis, PT-1 has agreed to comply with certain
standards regarding advertising (which are consistent with PT-1's current
advertising practices) and certain record keeping requirements. The agreement
with the FTC was entered into on July 17, 1998 but remains subject to full FTC
approval. PT-1 expects such approval of the settlement agreement within the next
thirty (30) days.
PT-1 is not aware of any pending legal proceedings against PT-1 which,
individually or in the aggregate, PT-1 would expect to have a material adverse
effect on its business, financial condition or operating results. PT-1 is, from
time to time, involved in various regulatory proceedings before various public
utilities commissions, as well as before the FCC. See "Risk Factors--Potential
Adverse Effects of Government Regulation."
124
<PAGE>
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT OF STAR COMMON STOCK
The following table sets forth certain information known to the Company
regarding beneficial ownership of STAR's Common Stock as of January 14, 1999 by
(i) each person who is known by the Company to own beneficially more than five
percent of the Company's Common Stock, (ii) each director, (iii) each of the
executive officers of STAR, and (iv) all current officers and directors as a
group.
<TABLE>
<CAPTION>
AMOUNT OF SHARES
BENEFICIALLY PERCENTAGE OF SHARES
NAME AND ADDRESS OF BENEFICIAL OWNER(1) OWNED BENEFICIALLY OWNED(2)
- ------------------------------------------------------------------------- ----------------- -----------------------
<S> <C> <C>
Gordon Hutchins, Jr.(3).................................................. 188,600 *
John R. Snedegar(4)...................................................... 10,250 *
Mark Gershien(5)......................................................... 10,250 *
Arunas A. Chesonis....................................................... -- --
Christopher E. Edgecomb.................................................. 12,702,807 30.1%
Mary A. Casey............................................................ 1,596,613 3.8%
David Vaun Crumly(6)..................................................... 891,416 2.1%
James E. Kolsrud(7)...................................................... 174,022 *
Kelly D. Enos(8)......................................................... 214,337 *
All directors and executive officers as a group (9 persons)(9)........... 15,788,295 37.4%
</TABLE>
- ------------------------
* Represents beneficial ownership of less than 1% of the outstanding shares of
STAR Common Stock.
(1) Beneficial ownership is determined in accordance with the rules of the
Securities and Exchange Commission and includes voting or investment power
with respect to securities. The address for each listed director and officer
is c/o STAR Telecommunications, Inc., 223 East De La Guerra Street, Santa
Barbara, California 93101. To STAR's knowledge, except as indicated in the
footnotes to this table and pursuant to applicable community property laws,
the persons named in the table have sole voting and investment power with
respect to all shares of STAR Common Stock.
(2) Percentage of beneficial ownership is based on shares of STAR Common Stock
outstanding as of January 14, 1999. The number of shares of STAR Common
Stock beneficially owned includes the shares issuable pursuant to stock
options that are exercisable within sixty days of January 14, 1999.
(3) Consists of 188,600 shares of STAR Common Stock issuable upon the exercise
of stock options exercisable within sixty days of January 14, 1999.
(4) Consists of 10,250 shares of STAR Common Stock issuable upon the exercise of
stock options exercisable within sixty days of January 14, 1999.
(5) Consists of 10,250 shares of STAR Common Stock issuable upon the exercise of
stock options exercisable within sixty days of January 14, 1999.
(6) Consists of 737,666 shares of STAR Common Stock, and 153,750 shares of STAR
Common Stock issuable upon the exercise of stock options exercisable within
sixty days of January 14, 1999.
(7) Consists of 101,250 shares of STAR Common Stock, 20,497 shares of STAR
Common Stock held in joint tenancy and 52,275 shares of STAR Common Stock
issuable upon the exercise of stock options exercisable within sixty days of
January 14, 1999.
(8) Consists of 96,720 shares of STAR Common Stock and 117,617 shares of STAR
Common Stock issuable upon the exercise of stock options exercisable within
sixty days of January 14, 1999.
(9) Includes 532,742 shares of STAR Common Stock issuable upon the exercise of
stock options exercisable within sixty days of January 14, 1999.
125
<PAGE>
DESCRIPTION OF STAR CAPITAL STOCK
The authorized capital stock of STAR consists of 100,000,000 shares of
Common Stock, $0.001 par value, and 5,000,000 shares of Preferred Stock, $0.001
par value.
COMMON STOCK
As of January 14, 1999, there were approximately 42,246,521 shares of STAR
Common Stock outstanding that were held of record by approximately 158
stockholders. There will be approximately 57,546,521 shares of STAR Common Stock
outstanding (assuming no exercise after January 14, 1999 of outstanding options)
after giving effect to the issuance of shares of STAR Common Stock in the
Merger.
The holders of STAR Common Stock are entitled to one vote per share on all
matters to be voted upon by the stockholders. Subject to preferences that may be
applicable to any outstanding Preferred Stock, the holders of STAR Common Stock
are entitled to receive ratably such dividends, if any, as may be declared from
time to time by the Board out of funds legally available therefor. In the event
of the liquidation, dissolution, or winding up of STAR, the holders of STAR
Common Stock are entitled to share ratably in all assets remaining after payment
of liabilities, subject to prior distribution rights of Preferred Stock, if any,
then outstanding. The STAR Common Stock has no preemptive or conversion rights
or other subscription rights. There are no redemption or sinking fund provisions
applicable to the STAR Common Stock. All outstanding shares of STAR Common Stock
are fully paid and nonassessable, and the shares of STAR Common Stock to be
issued upon completion of this offering will be fully paid and nonassessable.
PREFERRED STOCK
Pursuant to STAR's Amended and Restated Certificate of Incorporation, the
Board has the authority to issue up to 5,000,000 shares of Preferred Stock in
one or more series and to fix the rights, preferences, privileges and
restrictions thereof, including dividend rights, dividend rates, conversion
rights, voting rights, terms of redemption, redemption prices, liquidation
preferences and the number of shares constituting any series or the designation
of such series, without further vote or action by the stockholders. The issuance
of Preferred Stock may have the effect of delaying, deferring or preventing a
change in control of STAR without further action by the stockholders and may
adversely affect the voting and other rights of the holders of STAR Common
Stock. The issuance of Preferred Stock with voting and conversion rights may
adversely affect the voting power of the holders of STAR Common Stock, including
the loss of voting control to others. At present, STAR has no plans to issue any
of the Preferred Stock.
ANTI-TAKEOVER EFFECTS OF PROVISIONS OF THE CERTIFICATE OF INCORPORATION, BYLAWS
AND DELAWARE LAW
CERTIFICATE OF INCORPORATION AND BYLAWS. STAR's Amended and Restated
Certificate of Incorporation provides that the Board be divided into three
classes of directors, with each class serving a staggered three-year term. The
classification system of electing directors may tend to discourage a third party
from making a tender offer or otherwise attempting to obtain control of STAR and
may maintain the incumbency of the Board, as the classification of the Board
generally increases the difficulty of replacing a majority of the directors. The
Amended and Restated Certificate of Incorporation also provides that all
stockholder actions must be effected at a duly called meeting and not by a
consent in writing. Further, provisions of the Bylaws and the Amended and
Restated Certificate of Incorporation provide that the stockholders may amend
the Bylaws or certain provisions of the Amended and Restated Certificate of
Incorporation only with the affirmative vote of 75% of STAR's capital stock.
These provisions of the Amended and Restated Certificate of Incorporation and
Bylaws could discourage potential acquisition proposals and could delay or
prevent a change in control of STAR. These provisions are intended to enhance
the likelihood of continuity and stability in the composition of the Board and
in the policies formulated by the Board and to discourage certain types of
transactions that may involve an actual or threatened change of control of STAR.
These provisions are designed to reduce the vulnerability of STAR to an
unsolicited acquisition
126
<PAGE>
proposal. The provisions also are intended to discourage certain tactics that
may be used in proxy fights. However, such provisions could have the effect of
discouraging others from making tender offers for STAR's shares and, as a
consequence, they also may inhibit fluctuations in the market price of STAR's
shares that could result from actual or rumored takeover attempts. Such
provisions also may have the effect of preventing changes in the management of
STAR. See "Risk Factors--Effect of Certain Charter Provisions; Anti-takeover
Effects of Certificate of Incorporation, Bylaws and Delaware Law."
DELAWARE TAKEOVER STATUTE. STAR is subject to Section 203 of the Delaware
General Corporation Law ("Section 203"), which, subject to certain exceptions,
prohibits a Delaware corporation from engaging in any business combination with
any interested stockholder for a period of three years following the date that
such stockholder became an interested stockholder, unless: (i) prior to such
date, the board of directors of the corporation approved either the business
combination or the transaction that resulted in the stockholder becoming an
interested stockholder; (ii) upon consummation of the transaction that resulted
in the stockholder becoming an interested stockholder, the interested
stockholder owned at least 85% of the voting stock of the corporation
outstanding at the time the transaction commenced, excluding for purposes of
determining the number of shares outstanding those shares owned (x) by persons
who are directors and also officers and (y) by employee stock plans in which
employee participants do not have the right to determine confidentially whether
shares held subject to the plan will be tendered in a tender or exchange offer;
or (iii) on or subsequent to such date, the business combination is approved by
the board of directors and authorized at an annual or special meeting of
stockholders, and not by written consent, by the affirmative vote of at least
66 2/3% of the outstanding voting stock that is not owned by the interested
stockholder.
Section 203 defines business combination to include: (i) any merger or
consolidation involving the corporation and the interested stockholder; (ii) any
sale, transfer, pledge or other disposition of 10% or more of the assets of the
corporation involving the interested stockholder; (iii) subject to certain
exceptions, any transaction that results in the issuance or transfer by the
corporation of any stock of the corporation to the interested stockholder; (iv)
any transaction involving the corporation that has the effect of increasing the
proportionate share of the stock of any class or series of the corporation
beneficially owned by the interested stockholder; or (v) the receipt by the
interested stockholder of the benefit of any loans, advances, guarantees,
pledges or other financial benefits provided by or through the corporation. In
general, Section 203 defines an interested stockholder as any entity or person
beneficially owning 15% or more of the outstanding voting stock of the
corporation and any entity or person affiliated with or controlling or
controlled by such entity or person.
REGISTRATION RIGHTS
Holders of approximately 2,202,000 shares of STAR Common Stock are currently
entitled to certain rights with respect to the registration of such shares under
the Securities Act. Under the terms of the agreement between STAR and the
holders of such registrable securities, if STAR proposes to register any of its
securities under the Securities Act, either for its own account or for the
account of other security holders exercising registration rights, such holders
are entitled to notice of such registration and are entitled to include shares
of such Common Stock therein. These registration rights are subject to certain
conditions and limitations, among them the right of the underwriters of an
offering to limit the number of shares included in such registration.
TRANSFER AGENT AND REGISTRAR
The Transfer Agent and Registrar for the STAR Common Stock is U.S. Stock
Transfer Corporation, 1745 Gardena Avenue, Glendale, California 91204, and its
telephone number is (818) 502-1404.
127
<PAGE>
OTHER BUSINESS
The Company is not aware of any other business to be presented at the
Special Meeting. All shares represented by Company proxies will be voted in
favor of the Proposal described herein unless otherwise indicated on the form of
the proxy. If any other matters properly come before the meeting, Company proxy
holders will vote thereon according to their best judgment.
SUBMISSION OF STOCKHOLDER PROPOSALS
Any stockholder who wishes to present a proposal for action at the annual
meeting of stockholders to be held in 1999 and who wishes to have it set forth
in the corresponding proxy statement and identified in the corresponding form of
proxy prepared by management must notify the Company no later than January 31,
1999 in such form as required under the rules and regulations promulgated by the
Commission.
If a stockholder proposal is introduced at the 1999 Annual Meeting without
any discussion of the proposal in the proxy statement, and if the proponent does
not notify the Company on or before March 1, 1999, as required by Rule
14a-4(c)(1) under the Securities Exchange Act of 1934, as amended, of the intent
to raise such proposal at the 1999 Annual Meeting, the proxies received by the
Company for the 1999 Annual Meeting will be voted by the persons named as
proxies in their discretion in regard to such proposal. Notice is to be given to
the Company in writing at its principal office, 223 East De La Guerra Street,
Santa Barbara, California 93101, directed to the attention of the Secretary.
EXCHANGE ACT FILINGS
All documents filed by STAR pursuant to Section 13(a), 13(c), 14 or 15(d) of
the Exchange Act subsequent to the date of this Proxy Statement and prior to the
date of the Special Meeting shall be deemed to be incorporated by reference
herein and to be a part hereof from the date of filing of such documents. Any
statement contained in a document incorporated or deemed to be incorporated by
reference herein shall be deemed to be modified or superseded for purposes of
this Proxy Statement to the extent that a statement contained herein or in any
other subsequently filed document that also is or is deemed to be incorporated
by reference herein modifies or supersedes such statement. Any such statement so
modified or superseded shall not be deemed, except as so modified or superseded,
to constitute a part of this Proxy Statement.
By Order of the Board of Directors
/s/ MARY A. CASEY
Mary A. Casey
SECRETARY
Santa Barbara, California
January 15, 1999
128
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
-----
<S> <C>
Report of Independent Public Accountants................................................................... F-2
Consolidated Balance Sheets as of December 31, 1996 and 1997............................................... F-3
Consolidated Statements of Operations for the years ended December 31, 1995, 1996 and 1997................. F-4
Consolidated Statements of Stockholders' Equity for the years ended December 31, 1995, 1996 and 1997....... F-5
Consolidated Statements of Cash Flows for the years ended December 31, 1995, 1996 and 1997................. F-6
Notes to Consolidated Financial Statements................................................................. F-7
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders
of STAR Telecommunications, Inc. and Subsidiaries:
We have audited the accompanying consolidated balance sheets of STAR
TELECOMMUNICATIONS, INC. (a Delaware corporation) AND SUBSIDIARIES, as of
December 31, 1996 and 1997, and the related consolidated statements of
operations, stockholders' equity and cash flows for each of the three years in
the period ended December 31, 1997. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of STAR Telecommunications,
Inc. and Subsidiaries as of December 31, 1996 and 1997, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1997 in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Los Angeles, California
February 12, 1998
(except with respect
to the T-One acquisition as
described in Note 1 and to
the stock split discussed in
Note 14 as to which the
date is March 31, 1998)
F-2
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------------
1996 1997
------------- -------------
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents............. $ 1,845,000 $ 1,903,000
Short-term investments................ 1,656,000 18,631,000
Accounts receivable, net of allowance
of $6,262,000 and $7,955,000
at December 31, 1996 and 1997,
respectively........................ 35,178,000 46,675,000
Receivable from related parties....... 115,000 --
Other receivables..................... 284,000 2,198,000
Prepaid expenses...................... 960,000 4,712,000
Prepaid taxes......................... 677,000 --
Deferred income taxes................. -- 3,699,000
Other current assets.................. 874,000 87,000
------------- -------------
Total current assets................ 41,589,000 77,905,000
------------- -------------
PROPERTY AND EQUIPMENT:
Operating equipment................... 10,245,000 31,340,000
Leasehold improvements................ 4,362,000 6,477,000
Furniture, fixtures and equipment..... 2,555,000 4,711,000
------------- -------------
17,162,000 42,528,000
Less--Accumulated depreciation and
amortization........................ (1,964,000) (6,569,000)
------------- -------------
15,198,000 35,959,000
------------- -------------
OTHER ASSETS:
Investments........................... 153,000 27,000
Deposits.............................. 5,630,000 6,055,000
Other................................. 484,000 370,000
------------- -------------
6,267,000 6,452,000
------------- -------------
Total assets........................ $ 63,054,000 $ 120,316,000
------------- -------------
------------- -------------
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Revolving lines of credit............. $ 7,814,000 $ --
Revolving lines of credit with
stockholder......................... 26,000 138,000
Current portion of long-term debt..... 498,000 480,000
Current portion of note payable....... -- 284,000
Current portion of obligations under
capital leases...................... 872,000 2,495,000
Accounts payable...................... 17,930,000 14,009,000
Taxes payable......................... -- 2,156,000
Related party payable................. 269,000 --
Accrued line costs.................... 19,494,000 38,403,000
Accrued expenses...................... 2,415,000 5,609,000
Other current liabilities............. -- 571,000
------------- -------------
Total current liabilities........... 49,318,000 64,145,000
------------- -------------
LONG-TERM LIABILITIES:
Long-term debt, net of current
portion............................. 1,435,000 968,000
Capital lease obligations, net of
current portion..................... 4,936,000 11,139,000
Deferred compensation................. 116,000 57,000
Deposits.............................. -- 164,000
Other long-term liabilities........... 352,000 642,000
------------- -------------
Total long-term liabilities......... 6,839,000 12,970,000
------------- -------------
STOCKHOLDERS' EQUITY:
Series A Preferred Stock, $.001 par
value, authorized--5,000,000 shares;
issued and outstanding--2,802,446 at
December 31, 1996 and none at
December 31, 1997................... 3,000 --
Common Stock, $.001 par value,
authorized--50,000,000 shares issued
and outstanding-- 24,576,810 and
35,031,519 at December 31, 1996 and
1997, respectively.................. 25,000 35,000
Additional paid-in capital............ 10,225,000 41,662,000
Deferred compensation................. (118,000) (30,000)
Retained deficit...................... (3,238,000) 1,534,000
------------- -------------
Stockholders' equity................ 6,897,000 43,201,000
------------- -------------
Total liabilities and
stockholders' equity............. $ 63,054,000 $ 120,316,000
------------- -------------
------------- -------------
</TABLE>
The accompanying notes are an integral part of these consolidated balance
sheets.
F-3
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
---------------------------------------------
1995 1996 1997
------------- -------------- --------------
<S> <C> <C> <C>
REVENUES......................................................... $ 58,937,000 $ 259,697,000 $ 404,605,000
OPERATING EXPENSES:
Cost of services............................................... 44,270,000 225,957,000 351,821,000
Selling, general and administrative expenses................... 10,452,000 35,956,000 36,496,000
Depreciation and amortization.................................. 368,000 1,442,000 4,637,000
Merger expense................................................. -- -- 286,000
------------- -------------- --------------
55,090,000 263,355,000 393,240,000
------------- -------------- --------------
Income (loss) from operations................................ 3,847,000 (3,658,000) 11,365,000
OTHER INCOME (EXPENSES):
Interest income................................................ 22,000 110,000 492,000
Interest expense............................................... (64,000) (609,000) (1,738,000)
Legal settlement and expenses.................................. -- (100,000) (1,653,000)
Other income (expense)......................................... (33,000) 39,000 208,000
------------- -------------- --------------
(75,000) (560,000) (2,691,000)
------------- -------------- --------------
Income (loss) before provision for income taxes.............. 3,772,000 (4,218,000) 8,674,000
PROVISION FOR INCOME TAXES....................................... 66,000 577,000 2,905,00
------------- -------------- --------------
NET INCOME (LOSS)................................................ $ 3,706,000 $ (4,795,000) $ 5,769,000
------------- -------------- --------------
------------- -------------- --------------
Income (loss) before provision for income taxes.............. 3,772,000 (4,218,000) 8,674,000
PRO FORMA INCOME TAXES (UNAUDITED)............................... 1,632,000 1,520,000 3,100,000
------------- -------------- --------------
PRO FORMA NET INCOME (LOSS) (UNAUDITED).......................... $ 2,140,000 $ (5,738,000) $ 5,574,000
------------- -------------- --------------
------------- -------------- --------------
Income (loss) per common share................................... $ 0.19 $ (0.21) $ 0.19
------------- -------------- --------------
------------- -------------- --------------
Diluted income (loss) per common share........................... $ 0.19 $ (0.21) $ 0.17
------------- -------------- --------------
------------- -------------- --------------
Pro forma basic income (loss) per common share (unaudited)....... $ 0.11 $ (0.25) $ 0.18
------------- -------------- --------------
------------- -------------- --------------
Pro forma diluted income (loss) per common share (unaudited)..... $ 0.11 $ (0.25) $ 0.17
------------- -------------- --------------
------------- -------------- --------------
</TABLE>
The accompanying notes are an integral part of these consolidated statements.
F-4
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
<TABLE>
<CAPTION>
PREFERRED STOCK COMMON STOCK ADDITIONAL RETAINED
-------------------- ------------------- PAID-IN DEFERRED EARNINGS
SHARES AMOUNT SHARES AMOUNT CAPITAL COMPENSATION (DEFICIT) TOTAL
---------- -------- ---------- ------- ----------- ------------ ----------- -----------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1994.... -- $ 18,808,959 $19,000 $ 1,560,000 $ -- $ 1,377,000 $ 2,956,000
Issuance of common stock...... -- 1,843,339 2,000 101,000 -- 103,000
Conversion of debt to
equity...................... -- -- -- 990,000 -- 990,000
Stockholder contributions..... -- -- -- 269,000 -- 269,000
Net income.................... -- -- -- -- 3,706,000 3,706,000
Cash distributions to
stockholders................ -- -- -- -- (4,216,000) (4,216,000)
---------- -------- ---------- ------- ----------- ------------ ----------- -----------
Balance, December 31, 1995.... -- -- 20,652,298 21,000 2,920,000 -- 867,000 3,808,000
Effect of terminating the
S-corporation election...... -- -- -- (690,000) -- 690,000 --
Conversion of capital to
debt........................ -- -- -- (1,200,000) -- (1,200,000)
Compensation expense relating
to stock options............ -- -- -- 168,000 (118,000) -- 50,000
Issuance of common stock...... -- -- 3,924,512 4,000 5,564,000 -- -- 5,568,000
Issuance of preferred stock... 2,802,446 3,000 -- -- 7,497,000 -- 7,500,000
Net loss...................... -- -- -- -- -- -- (4,795,000) (4,795,000)
Cash distributions to
stockholders................ -- -- -- (4,034,000) -- -- (4,034,000)
---------- -------- ---------- ------- ----------- ------------ ----------- -----------
Balance, December 31, 1996.... 2,802,446 3,000 24,576,810 25,000 10,225,000 (118,000) (3,238,000) 6,897,000
Effect of L.D Services
terminating the
S-corporation election...... -- -- -- (61,000) -- 61,000 --
Conversion of redeemable
preferred stock to common
stock....................... (2,802,446) (3,000) 1,868,284 2,000 1,000 -- -- --
Initial public offering of
common stock................ -- -- 8,097,500 8,000 30,936,000 -- -- 30,944,000
Exercise of stock options..... -- -- 488,925 447,000 -- -- 447,000
Compensation expense relating
to stock options............ -- -- -- -- 88,000 -- 88,000
Tax benefit from non-qualified
stock options............... -- -- -- 114,000 -- -- 114,000
Cash distributions to
stockholders................ -- -- -- -- -- (1,058,000) (1,058,000)
Net income.................... -- -- -- -- -- 5,769,000 5,769,000
---------- -------- ---------- ------- ----------- ------------ ----------- -----------
Balance, December 31, 1997.... $ 35,031,519 $35,000 $41,662,000 $(30,000) $ 1,534,000 $43,201,000
---------- -------- ---------- ------- ----------- ------------ ----------- -----------
---------- -------- ---------- ------- ----------- ------------ ----------- -----------
</TABLE>
The accompanying notes are an integral part of these consolidated statements.
F-5
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
----------------------------------------------
1995 1996 1997
-------------- -------------- --------------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss).............................................. $ 3,706,000 $ (4,795,000) $ 5,769,000
Adjustments to reconcile net income (loss) to net cash provided
by (used in) operating activities:
Depreciation and amortization................................ 368,000 1,442,000 4,637,000
Loss on investment........................................... 80,000 --
Loss on disposal of equipment................................ -- -- 42,000
Compensation expense relating to stock options............... -- 50,000 88,000
Provision for doubtful accounts.............................. 217,000 16,284,000 7,791,000
Deferred income taxes........................................ (6,000) (15,000) (3,699,000)
Deferred compensation........................................ -- 116,000 (59,000)
Decrease (increase) in assets:
Accounts receivable............................................ (14,305,000) (29,491,000) (19,288,000)
Receivable from related parties................................ 129,000 (65,000) 115,000
Other receivables.............................................. (268,000) -- (1,914,000)
Prepaid expenses............................................... (114,000) (830,000) (3,752,000)
Deposits....................................................... (630,000) (4,948,000) (425,000)
Prepaid taxes.................................................. -- (677,000) 677,000
Other current assets........................................... (11,000) (859,000) 804,000
Increase (decrease) in liabilities:
Accounts payable............................................... 12,329,000 109,000 (3,921,000)
Taxes payable.................................................. -- -- 2,270,000
Related party payables......................................... 320,000 (51,000) (269,000)
Accrued line costs............................................. 476,000 19,018,000 18,909,000
Accrued expenses............................................... 194,000 1,865,000 3,194,000
Deposits....................................................... -- -- 164,000
-------------- -------------- --------------
Net cash provided by (used in) operating activities........ 2,485,000 (2,847,000) 11,133,000
-------------- -------------- --------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures........................................... (1,664,000) (8,480,000) (13,760,000)
Investments.................................................... -- (153,000) 126,000
Short-term investments......................................... (1,000) (1,631,000) (16,975,000)
Other.......................................................... -- (139,000) 639,000
-------------- -------------- --------------
Net cash used in investing activities...................... (1,665,000) (10,403,000) (29,970,000)
-------------- -------------- --------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Stockholders' distributions.................................... (4,216,000) (4,034,000) (1,058,000)
Borrowings under lines of credit............................... 1,460,000 14,746,000 34,211,000
Repayments under lines of credit............................... (130,000) (8,262,000) (42,025,000)
Borrowings under lines of credit with stockholder.............. 3,418,000 701,000 583,000
Repayments under lines of credit with stockholder.............. (1,319,000) (3,073,000) (471,000)
Borrowings under long-term debt................................ -- 2,000,000 193,000
Payments under long-term debt.................................. -- (67,000) (1,983,000)
Payments under capital lease obligations....................... (52,000) (358,000) (1,946,000)
Issuance of common stock....................................... -- 5,568,000 30,944,000
Capital contribution........................................... 269,000 --
Stock options exercised........................................ -- 447,000
Issuance of preferred stock.................................... -- 7,500,000 --
-------------- -------------- --------------
Net cash (used in) provided by financing activities........ (570,000) 14,721,000 18,895,000
-------------- -------------- --------------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS................. 250,000 1,471,000 58,000
CASH AND CASH EQUIVALENTS, beginning of year..................... 124,000 374,000 1,845,000
-------------- -------------- --------------
CASH AND CASH EQUIVALENTS, end of year........................... $ 374,000 $ 1,845,000 $ 1,903,000
-------------- -------------- --------------
-------------- -------------- --------------
</TABLE>
The accompanying notes are an integral part of these consolidated statements.
F-6
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1997
(1) NATURE OF BUSINESS
STAR Telecommunications, Inc., a Delaware corporation, and Subsidiaries (the
"Company" or "STAR"), is an emerging multinational carrier focused primarily on
the international long distance market. The Company offers highly reliable,
low-cost switched voice services on a wholesale basis primarily to U.S.-based
long distance carriers. STAR provides international long distance service
through a flexible network comprised of foreign termination relationships,
international gateway switches, leased and owned transmission facilities and
resale arrangements with other long distance providers. While the Company was
incorporated in 1993, it did not commence its current business as a provider of
long distance services until the second half of 1995. During the six months
ended June 1995, the Company primarily acted as an agent for, and provided
various consulting services to, companies in the telecommunications industry.
During 1996 and 1997, the Company established several wholly-owned foreign
subsidiaries to further expand its international network. The Company made
substantial investments to install switch facilities in two of these
subsidiaries, Star Europe Limited (SEL) which is located in London, England, and
Star Telecommunications Deutschland (GmbH) which is located in Frankfurt,
Germany. The Company plans to use these switch facilities to decrease
international traffic termination costs and to initiate outbound calls from
these local markets.
In December 1997, the Company entered into the domestic commercial
long-distance market through the acquisition of L.D. Services, Inc., also known
as LCCR Inc. ("LDS"). LDS is a retail long-distance service provider throughout
the United States. The merger constituted a tax-free reorganization and has been
accounted for as a pooling of interests under Accounting Principles Board
Opinion No. 16. Accordingly, all prior period consolidated financial statements
presented have been restated to include the results of operations, financial
position and cash flows of LDS as though it had always been a part of STAR (see
Note 8). The pro forma results of operations and pro forma income or loss per
common share for 1995, 1996 and 1997 assumes that both STAR and LDS had been
C-Corporations for all periods presented.
In March 1998, the Company consummated a merger with T-One Corp. ("T-One").
The merger constituted a tax-free reorganization and has been accounted for as a
pooling of interests under Accounting Principles Board Opinion No. 16.
Accordingly, all consolidated financial statements presented have been restated
to include the results of operations, financial position, and cash flows of
T-One (see Note 8).
On March 31, 1998, the Company effected a 2.05 for 1 stock split in the
nature of a stock dividend. The stock split has been retroactively reflected in
the condensed consolidated financial statements for all periods presented.
The Company is subject to various risks in connection with the operation of
its business. These risks include, but are not limited to, regulations (both
domestic and foreign), dependence on transmission facilities-based carriers and
suppliers, price competition and competition from larger industry participants.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements include the accounts of
STAR Telecommunications, Inc. and its wholly-owned subsidiaries. All significant
intercompany balances and transactions have been eliminated.
F-7
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REVENUE RECOGNITION
The Company records revenues for telecommunications sales at the time of
customer usage. Finance charges for customer late payments are included in
revenues and amount to $32,000, $1,467,000 and $2,747,000 for the years ended
December 31, 1995, 1996 and 1997, respectively.
COST OF SERVICES
Cost of services for wholesale long distance services represents direct
charges from vendors that the Company incurs to deliver service to its
customers. These include leasing costs for the dedicated phone lines, which form
the Company's network, and rate-per-minute charges from other carriers that
terminate traffic on behalf of the Company. In addition, retail long distance
service cost includes billing and collection service fees from local exchange
carriers and call rating services.
ACCOUNTING FOR INTERNATIONAL LONG DISTANCE TRAFFIC
The Company has carrier service agreements with telecommunication carriers
in foreign countries under which international long distance traffic is both
originated and terminated on the Company's network. The Company records revenues
and related costs as the traffic is recorded in the switch. Revenue from foreign
customers equalled $178,000 and $6,577,000 for the years ended December 31, 1996
and 1997, respectively. The Company recognized settlement costs relating to
foreign carrier agreements of $152,000 in 1996 and $12,314,000 in 1997, which
are included in cost of services in the consolidated statements of operations.
The Company had no revenues or costs relating to foreign customers during 1995.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents consist of demand deposits and money market funds,
which are highly liquid short-term instruments with original maturities of three
months or less. Cash and cash equivalents are stated at cost, which approximates
market.
FINANCIAL INSTRUMENTS
The carrying amounts of notes payable and capital lease obligations
approximate their fair value because interest rates approximate market rates for
similar instruments.
Off balance sheet derivative financial instruments at December 31, 1997
consist of foreign currency exchange agreements.
The Company enters into foreign currency exchange contracts to manage
foreign currency exposures. The principle objective of such contracts is to
minimize the risks and/or costs associated with financial and global operating
activities. The Company does not utilize financial instruments for trading or
other speculative purposes. The counterparty to these contractual arrangements
is a multinational financial institution with which the Company also has other
financial relationships.
The Company enters into forward currency exchange contracts in the normal
course of business to manage its exposure against foreign currency fluctuations
on payable positions resulting from fixed asset
F-8
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
purchases and other contractual expenditures denominated in foreign currencies.
At December 31, 1997, gains and losses on foreign exchange contracts are not
material to the consolidated financial statements.
The fair values of foreign currency contracts are estimated by obtaining
quotes from brokers. At December 31, 1997, the Company has foreign currency
contracts outstanding with the notional value of $6,305,000 which had an
estimated fair value to receive $6,218,000 worth of German marks and British
pounds, the difference of which has been recognized in operations.
The following table summarizes outstanding commitments to purchase foreign
currency at December 31, 1997:
<TABLE>
<CAPTION>
NOTIONAL
MATURITY DATE AMOUNT FAIR VALUE DIFFERENCE
-------------------------- ------------ ------------ ----------
<S> <C> <C> <C> <C>
British Pounds........... 1/29/98 through 3/27/98 $ 364,000 $ 373,000 $ 9,000
Deutsche Mark............ 1/05/98 through 1/26/98 5,941,000 5,845,000 (96,000)
------------ ------------ ----------
$ 6,305,000 $ 6,218,000 $ (87,000)
------------ ------------ ----------
------------ ------------ ----------
</TABLE>
MARKETABLE SECURITIES
Marketable securities consists of interest bearing securities with original
maturities in excess of three months. At December 31, 1997, the fair market
value of temporary investments, classified as "available for sale securities",
approximated cost, thus no unrealized holding gains or losses were reported in
the accompanying balance sheets. During fiscal year 1997, the Company realized
gains from the sale of securities of approximately $48,000.
PROPERTY AND EQUIPMENT
Property and equipment are carried at cost. Depreciation and amortization of
property and equipment are computed using the straight-line method over the
following estimated useful lives:
<TABLE>
<S> <C>
Operating equipment............................... 5-25 years
Leasehold improvements............................ Life of lease
Computer equipment................................ 3-7 years
Furniture and fixtures............................ 5-7 years
</TABLE>
Operating equipment includes assets financed under capital lease obligations
of $6,218,000 and $15,921,000 at December 31, 1996 and 1997, respectively.
Accumulated amortization related to assets financed under capital leases was
$391,000 and $2,123,000 at December 31, 1996 and 1997, respectively.
In addition, operating equipment includes seven Indefeasible Rights of Use
(IRU) in cable systems amounting to $110,000 and $2,669,000 and four ownership
interests in an international cable amounting to $148,000 and $1,534,000 at
December 31, 1996 and 1997, respectively. These assets are amortized over the
life of the agreements of 14 to 25 years (see Note 5).
F-9
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Replacements and betterments, renewals and extraordinary repairs that extend
the life of the asset are capitalized; other repairs and maintenance are
expensed. The cost and accumulated depreciation applicable to assets sold or
retired are removed from the accounts and the gain or loss on disposition is
recognized in other income or expense.
DEPOSITS AND OTHER ASSETS
Deposits represent payments made to long distance providers to secure lower
rates. These deposits are refunded or applied against future services. Other
assets at December 31, 1996 primarily represent initial public offering
expenses, which were subsequently charged to additional paid in capital during
1997 at the time of the initial public offering.
ACCRUED LINE COSTS
Accrued line costs represent accruals for services to transmit and terminate
long distance telephone traffic, which has been provided to the Company but not
yet billed. It also includes differences between billings received by the
Company and the liability computed by the Company's own systems which are being
resolved by the Company and its vendors. Such disputed amounts have not been
material to the results of operations for each statement of operations period
presented.
CONSOLIDATED STATEMENTS OF CASH FLOWS
During the years ended December 31, 1995, 1996 and 1997 cash paid for
interest was $45,000, $541,000 and $1,462,000, respectively. For the same
periods, cash paid for income taxes amounted to $51,000, $1,262,000 and
$3,761,000, respectively.
Non-cash investing and financing activities are as follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
----------------------------------------
1995 1996 1997
------------ ------------ ------------
<S> <C> <C> <C>
Equipment purchased through capital leases.............................. $ 1,052,000 $ 5,166,000 $ 9,772,000
Notes issued for asset purchases........................................ -- -- 1,890,000
Debt converted to equity................................................ 1,093,000 -- --
Operating agreement acquired through issuance of note................... -- -- 350,000
Equity converted to debt................................................ -- 1,200,000 --
Tax benefits related to stock options................................... -- -- 114,000
</TABLE>
These non-cash transactions are excluded from the consolidated statements of
cash flows.
F-10
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
NET INCOME (LOSS) PER COMMON SHARE
The following schedule summarizes the information used to compute pro forma
net income or loss per common share for the years ended December 31, 1995, 1996
and 1997:
<TABLE>
<CAPTION>
1995 1996 1997
------------- ------------- -------------
<S> <C> <C> <C>
Pro forma net income (loss)......................................... $ 2,140,000 $ (5,738,000) $ 5,574,000
------------- ------------- -------------
------------- ------------- -------------
Weighted average number of common shares used to compute basic
earnings (loss) per share......................................... 19,373,000 23,292,000 30,221,000
Weighted average common share equivalents........................... -- -- 2,757,000
------------- ------------- -------------
Weighted average number of common shares and common share
equivalents used to compute diluted net income (loss) per common
share............................................................. 19,373,000 23,292,000 32,978,000
------------- ------------- -------------
------------- ------------- -------------
Basic pro forma net income (loss) per common share (unaudited)...... $ 0.11 $ (0.25) $ 0.18
Diluted pro forma net income (loss) per common share (unaudited).... $ 0.11 $ (0.25) $ 0.17
</TABLE>
CONCENTRATIONS OF RISK
The Company's two largest customers account for approximately 21 percent and
6 percent of gross accounts receivable at December 31, 1996 and 1997,
respectively. The Company's largest customer and second largest customer in 1997
represent 2 percent and 4 percent of accounts receivable as of December 31,
1997, respectively. The Company's largest customer in 1996 was Cherry
Communications, Inc. The second largest customer in 1996 was Hi-Rim
Communications, Inc. Only one customer, Cherry Communications, Inc. had a
receivable balance exceeding 10 percent of gross accounts receivable at December
31, 1996 and no individual customer has an account receivable balance greater
than 10 percent of gross accounts receivable at December 31, 1997.
The two largest customers represent approximately 14 percent, 26 percent and
16 percent of revenues during the years ended December 31, 1995, 1996 and 1997,
respectively. During 1995 and 1996, only sales to Cherry Communications, Inc.
exceeded 10 percent of total sales. For the year ended December 31, 1997, no
customer exceeded 10 percent of revenues.
The Company performs ongoing credit evaluations of its customers. The
Company analyzes daily traffic patterns and concludes whether or not the
customer's credit status justifies the traffic volume. If the customer is deemed
to carry too large a volume in relation to its credit history, the traffic
received by the Company's switch is reduced to prevent further build up of the
receivable from this customer. The Company's allowance for doubtful accounts is
based on current market conditions.
Purchases from the four largest vendors for the years ended December 31,
1995 and 1996 amounted to 53 percent and 44 percent of total purchases,
respectively. Purchases from the four largest vendors for the year ended
December 31, 1997 amounted to 34 percent of total purchases.
F-11
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Included in the Company's balance sheets at December 31, 1996 and 1997 are
approximately $840,000 and $7,028,000 of equipment which is located in foreign
countries.
USE OF ESTIMATES
The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the consolidated
financial statements and the reported amounts of revenues and expenses during
the reporting period. Actual results could differ from those estimates.
RECENTLY ISSUED ACCOUNTING STANDARDS
In February 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per
Share". The statement replaces primary EPS with basic EPS, which is computed by
dividing reported earnings available to common stockholders by weighted average
shares outstanding. The provision requires the calculation of diluted EPS. The
Company adopted this statement in 1997 and all prior year earnings per share
amounts have been recalculated based on the provisions of SFAS No. 128.
TRANSLATION OF FOREIGN CURRENCY
Management determined that the functional currency of its foreign
subsidiaries is still the U.S. dollar. Thus all foreign translation gains or
losses are reflected in the results of operations in other income (expense).
The foreign subsidiary balance sheets are translated into U.S. dollars using
the year-end exchange rates except for prepayments, property, other long-term
assets, and stockholders' equity accounts, which are translated at rates in
effect when these balances were originally recorded. Revenues and expenses are
translated at average rates during the year except for depreciation and
amortization, which are translated at historical rates.
(3) ACCRUED EXPENSES
Accrued expenses at December 31, 1996 and 1997 consist of the following:
<TABLE>
<CAPTION>
1996 1997
------------ ------------
<S> <C> <C>
Payroll and related............................................... $ 783,000 $ 943,000
Management bonuses................................................ 25,000 152,000
Professional services............................................. 669,000 384,000
Sales and other taxes............................................. 10,000 295,000
Line and billing cost............................................. 324,000 2,592,000
Legal settlement.................................................. 300,000 --
Other............................................................. 304,000 1,243,000
------------ ------------
$ 2,415,000 $ 5,609,000
------------ ------------
------------ ------------
</TABLE>
F-12
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(4) LINES OF CREDIT
BANK LINE OF CREDIT
Effective September 30, 1997, the Company executed an agreement with Sanwa
Bank, California for a $25 million line of credit, which expires on July 1,
1999. The facility has certain financial and non-financial covenants that
include, among other restrictions, the maintenance of minimum levels of tangible
net worth. Borrowings on the facility are limited to 75 percent of eligible
accounts receivable and are secured by substantially all of the assets of the
Company. The credit facility provides for borrowings at an interest rate based
upon the bank's cost of funds plus 1.75 percent (7.47 percent at December 31,
1997). The Company plans to use the credit facility to support letters of credit
and for working capital or other general corporate purposes. At December 31,
1997, no amounts were outstanding, however the Company's availability under this
credit facility was reduced to $20.1 million due to $4.9 million in letters of
credit which were outstanding at December 31, 1997.
The weighted average interest rate on short term debt during the years ended
December 31, 1995, 1996 and 1997 was 10.21 percent, 9.68 percent and 9.12
percent, respectively.
LINES OF CREDIT WITH STOCKHOLDER
At December 31, 1996 and 1997, the Company's revolving lines of credit with
the founder and chief executive officer of the Company totalled $1,448,000. The
debt matures on March 30, 1998 with interest payable at maturity at a rate of 9
percent. There was $1,422,000 and $1,310,000 available to be borrowed against
these lines of credit at December 31, 1996 and 1997, respectively. The Company
recognized interest expense related to this debt of $11,000, $34,000 and $9,000
for the years ended December 31, 1995, 1996 and 1997, respectively.
(5) LONG-TERM DEBT
The Company finances some of its telecommunication equipment under capital
lease arrangements or through notes payable as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
---------------------------
1996 1997
------------ -------------
<S> <C> <C>
Bank debt at prime plus 1.5 percent........................................ $ 733,000 $ --
Bank promissory note, payable in $30,000 monthly installments including
interest at prime plus 1.25 percent, (9.75 percent at December 31, 1997)
through December 31, 1999................................................ 1,200,000 904,000
Notes payable for Indefeasible Rights of Use on submarine cable, payable in
quarterly installments of principal plus interest at LIBOR plus 6 percent
(11.72 percent at December 31, 1997) through September 1999.............. -- 762,000
Note payable for Indefeasible Right of Use, payable in quarterly
installments of $9,000 plus interest at LIBOR plus 6 percent through
September 1999........................................................... -- 66,000
Obligations under capital leases........................................... 5,808,000 13,634,000
------------ -------------
$ 7,741,000 $ 15,366,000
------------ -------------
------------ -------------
</TABLE>
F-13
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(5) LONG-TERM DEBT (CONTINUED)
Minimum future lease payments under capital leases at December 31, 1997 are
as follows:
<TABLE>
<CAPTION>
YEAR ENDING DECEMBER 31,
- -----------------------------------------------------------------------------------------
<S> <C>
1998..................................................................................... $ 3,944,000
1999..................................................................................... 3,943,000
2000..................................................................................... 3,614,000
2001..................................................................................... 2,927,000
2002..................................................................................... 2,505,000
Thereafter............................................................................... 814,000
-------------
17,747,000
Less: Amount representing interest....................................................... (4,113,000)
-------------
13,634,000
Less: Current portion.................................................................... (2,495,000)
-------------
$ 11,139,000
-------------
-------------
</TABLE>
(6) COMMITMENTS AND CONTINGENCIES
OPERATING LEASES
The Company leases office space, dedicated private telephone lines,
equipment and other items under various agreements expiring through 2006. At
December 31, 1997, the minimum aggregate payments under non-cancelable operating
leases are summarized as follows:
<TABLE>
<CAPTION>
DEDICATED
FACILITIES PRIVATE
YEAR ENDING DECEMBER 31, AND EQUIPMENT LINES TOTAL
- ----------------------------------------------------------- ------------- ------------ -------------
<S> <C> <C> <C>
1998....................................................... $ 3,561,000 $4,969,000 $ 8,530,000
1999....................................................... 3,506,000 1,906,000 5,412,000
2000....................................................... 3,471,000 372,000 3,843,000
2001....................................................... 3,134,000 -- 3,134,000
2002....................................................... 2,843,000 -- 2,843,000
Thereafter................................................. 8,484,000 -- 8,484,000
------------- ------------ -------------
$ 24,999,000 $7,247,000 $ 32,246,000
------------- ------------ -------------
------------- ------------ -------------
</TABLE>
Facility and equipment rent expense for the years ended December 31, 1995,
1996 and 1997 was approximately $255,000, $1,137,000 and $3,333,000,
respectively. Dedicated private line expense was approximately $604,000,
$7,045,000 and $9,414,000, for those same periods and is included in cost of
services in the accompanying consolidated statements of operations.
EMPLOYMENT AGREEMENTS
The Company has employment agreements through December 31, 2000 with several
employees and executives. Some of these agreements provide for a continuation of
salaries in the event of a termination,
F-14
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(6) COMMITMENTS AND CONTINGENCIES (CONTINUED)
with or without cause, following a change in control of the Company. One
agreement provides for a payment of at least $1,500,000 in the event of a change
in control of the Company.
The Company expensed $116,000 and $64,000 of deferred compensation relating
to these agreements for the years ended December 31, 1996 and 1997,
respectively.
PURCHASE COMMITMENTS
The Company is obligated under various service agreements with long distance
carriers to pay minimum usage charges. The Company anticipates exceeding the
minimum usage volume with these vendors. Minimum future usage charges at
December 31, 1997 are as follows:
<TABLE>
<CAPTION>
YEAR ENDING DECEMBER 31,
- -------------------------------------------------------------------------------
<S> <C>
1998........................................................................... $ 44,053,000
1999........................................................................... 8,356,000
2000........................................................................... 2,949,000
2001........................................................................... 65,000
2002........................................................................... 65,000
Thereafter..................................................................... 774,000
-------------
$ 56,262,000
-------------
-------------
</TABLE>
The Company has entered into six fixed asset purchase agreements. These
commitments are to purchase IRU's, switches, and leasehold improvements for
switch sites. The total commitment approximates $63 million. The Company plans
to finance the majority of these costs through capital lease arrangements.
LEGAL MATTERS
The Company is subject to litigation from time to time in the normal course
of business. Although it is not possible to predict the outcome of such
litigation, based on the facts known to the Company and after consultation with
counsel, management believes that such litigation will not have a material
adverse effect on its financial position or results of operations.
On September 4, 1997, prior to the merger between LDS and the Company, LDS
entered into a settlement agreement with the Consumer Services Division of the
California Public Utilities Commission (PUC). The agreement settles the alleged
unauthorized switching of long-distance customers to LDS between the years 1995
and 1996. It includes a payment of $760,000 to the PUC for restitution to
affected customers as defined in the agreement. Additionally, LDS agreed to a
voluntary revocation of its operating authority in the State of California.
Under the agreement, service to all California customers has to be terminated
within 120 days after approval of the agreement by the PUC. On November 19,
1997, the PUC approved the agreement along with a transfer of control to STAR.
On November 15, 1997, LDS settled a civil suit with the District Attorney of
Monterey, California for a monetary payment of $700,000 and various non-monetary
concessions as defined in the agreement. This
F-15
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(6) COMMITMENTS AND CONTINGENCIES (CONTINUED)
suit was of the same nature as the above action of the PUC and covers complaints
from the years 1994 through 1997.
LETTERS OF CREDIT
At December 31, 1997, the Company has nine standby letters of credit
outstanding, which expire between January 20, 1998 and December 19, 1998. These
letters of credit, most of which are secured by the bank line of credit, total
approximately $5 million.
(7) RELATED PARTY TRANSACTIONS
The founder and chief executive officer of the Company owns Star Aero
Services, Inc. (Star Aero). Star Aero's principal assets represent airplanes
which it provides to the Company for business travel on an as needed basis. In
return, the Company pays for costs related to the airplanes. Star Aero
reimburses the Company for certain costs relating to the maintenance of the
planes. For the years ended December 31, 1995, 1996 and 1997, the Company paid
$144,000, $68,000 and $171,000, respectively, in costs related to the use of
Star Aero services. As of December 31, 1995 and 1996, the Company had
receivables from Star Aero of $50,000 and $115,000, respectively. The Company
had no receivables from Star Aero at December 31, 1997.
During 1997, the Company provided a short-term loan to the chief executive
officer for $8,000,000. The loan carried interest of 7 percent per annum, was
secured by $30,000,000 of the stockholder's stock in the Company, and was repaid
in seven days.
During 1995, the Company invested $128,000 in a company related to an
employee of STAR. During 1996 and 1997, the Company provided services to this
company in the amounts of $167,000 and $926,000. As of December 31, 1996 and
1997, accounts receivable from this related party amounted to $57,000 and
$41,000, respectively.
During 1995, 1996 and 1997, the Company purchased consulting services from a
company owned by a board member in the amount of $60,000, $154,000 and $72,000,
respectively.
During 1996 and 1997, the Company purchased consulting services from a
company owned in part by an employee and a significant stockholder for $37,000
and $256,000, respectively. In addition, the Company purchased equipment and
services from this company in the amount of $1,114,000 in 1997. This significant
stockholder is also a 30 percent investor in a company, whose subsidiary
provided consulting services to the Company in the amount of $12,000 in 1996 and
$213,000 in 1997. In addition, the Company purchased telecommunication services
from three related companies for $240,000 during 1996 and paid legal fees on
behalf of these companies in the amount of $131,000.
During the years ended December 31, 1995, 1996 and 1997, the Company also
provided long distance telephone service to a company controlled by another
board member in the amount of $43,000, $250,000 and $1,141,000, respectively.
Accounts receivable for these services total $721,000 as of December 31, 1997.
In addition, the Company loaned $2,500,000 to this related party. The Company
has announced its intention to merge the two companies (see Note 14).
F-16
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(8) BUSINESS COMBINATIONS
In November 1997, the Company acquired LDS, a domestic commercial long
distance telecommunications provider, in a transaction that was accounted for as
a pooling of interests. The Company issued 849,298 shares of its common stock to
LDS' shareholders in exchange for all outstanding LDS shares plus shares of
certain non-operating entities owned by LDS' shareholders and majority ownership
in an affiliated telephone retailer controlled by LDS. On March 10, 1998, the
Company acquired T-One, an international wholesale long distance
telecommunications provider based in New York, in a transaction that was
accounted for as a pooling of interests. The Company issued 1,353,000 shares of
its common stock to the T-One shareholder in exchange for all outstanding T-One
shares. The accompanying consolidated financial statements have been restated to
include the financial position and results of operations of LDS and T-One for
all periods presented.
Revenues and historical net income (loss) of the combining companies for the
last three years are as follows:
<TABLE>
<CAPTION>
1995 1996 1997
------------- -------------- --------------
<S> <C> <C> <C>
Revenues:
STAR....................................... $ 16,125,000 $ 208,086,000 $ 348,738,000
LDS........................................ 30,158,000 29,905,000 27,460,000
T-ONE...................................... 12,654,000 22,432,000 30,438,000
Eliminations............................... -- (726,000) (2,031,000)
------------- -------------- --------------
Total.................................... $ 58,937,000 $ 259,697,000 $ 404,605,000
------------- -------------- --------------
------------- -------------- --------------
Net income (loss):
STAR....................................... $ (568,000) $ (6,644,000) $ 5,605,000
LDS........................................ 4,541,000 2,424,000 (37,000)
T-ONE...................................... (267,000) (575,000) 201,000
------------- -------------- --------------
$ 3,706,000 $ (4,795,000) $ 5,769,000
------------- -------------- --------------
------------- -------------- --------------
</TABLE>
(9) INCOME TAXES
Through December 31, 1995, the Company had elected to be taxed as an
S-Corporation for both federal and state income tax purposes. While the election
was in effect, all taxable income, deductions, losses and credits of the Company
were included in the tax returns of the shareholders. Accordingly, for federal
income tax purposes, no tax benefit, liability or provision has been reflected
in the accompanying historical consolidated financial statements for the year
ended December 31, 1995. For state tax purposes, an S-Corporation is subject to
a 1.5 percent tax on taxable income, with a minimum tax of approximately $1,000
annually. Effective January 1, 1996, the Company terminated its S-Corporation
election and is now taxable as a C-Corporation.
In addition, the results of operations and provision for income taxes for
LDS through November 30, 1997 reflects LDS' status as an S-Corporation. The
unaudited pro forma income taxes, pro forma net income (loss), and pro forma
earnings per share information reflected in the consolidated statements of
operations assumes that both STAR and LDS were taxed as C-Corporations for all
periods presented.
F-17
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(9) INCOME TAXES (CONTINUED)
The Company accounts for income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes," under which deferred assets and liabilities are
provided on differences between financial reporting and taxable income using
enacted tax rates. Deferred income tax expenses or credits are based on the
changes in deferred income tax assets or liabilities from period to period.
Under SFAS No. 109, deferred tax assets may be recognized for temporary
differences that will result in deductible amounts in future periods. A
valuation allowance is recognized if, on the weight of available evidence, it is
more likely than not that some portion or all of the deferred tax asset will not
be realized.
The Company has recorded a net deferred tax asset of $3,699,000 at December
31, 1997. Realization is dependent on generating sufficient taxable income in
the future. Although realization is not assured, management believes it is more
likely than not that the net deferred tax asset recorded will be realized.
The components of the net deferred tax assets at December 31, 1996 and 1997
are as follows:
<TABLE>
<CAPTION>
1996 1997
------------- -------------
<S> <C> <C>
Deferred tax asset:
Reserve for accounts and note receivable...................... $ 3,129,000 $ 4,215,000
Accrued line cost............................................. 201,000 798,000
Vacation accrual.............................................. 24,000 138,000
Deferred compensation......................................... 47,000 38,000
Accrued bonuses............................................... 25,000 --
Accrued services.............................................. -- 276,000
Legal settlement.............................................. 123,000 --
Net operating losses.......................................... 228,000 684,000
State income taxes............................................ 48,000 392,000
Change in tax method.......................................... 120,000 60,000
------------- -------------
3,945,000 6,601,000
Deferred tax liability:
Depreciation.................................................. (561,000) (786,000)
------------- -------------
Subtotal........................................................ 3,384,000 5,815,000
Valuation reserve............................................... (3,384,000) (2,116,000)
------------- -------------
Net deferred tax asset.......................................... $ -- $ 3,699,000
------------- -------------
------------- -------------
</TABLE>
In prior years, T-One generated net operating losses ("NOL") for financial
statement and income tax purposes which are available for carryforwards against
future income. As of December 31, 1997, T-One has NOL deductions available for
carryforward in the amount of approximately $500,000. These NOL will expire
through 2010. The Company also has foreign NOL of approximately $600,000.
F-18
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(9) INCOME TAXES (CONTINUED)
The provision for income taxes for the years ended December 31, 1995, 1996
and 1997 are as follows:
<TABLE>
<CAPTION>
HISTORICAL PRO FORMA
------------------------------------ -----------------------------------------
1995 1996 1997 1995 1996 1997
--------- ---------- ------------- ------------ ------------ -------------
(UNAUDITED)
<S> <C> <C> <C> <C> <C> <C>
Current
Federal taxes................. $ 4,000 $ 280,000 $ 4,900,000 $ 1,369,000 $ 1,118,000 $ 5,282,000
State taxes................... 68,000 164,000 1,147,000 418,000 359,000 1,270,000
--------- ---------- ------------- ------------ ------------ -------------
72,000 444,000 6,047,000 1,787,000 1,477,000 6,552,000
--------- ---------- ------------- ------------ ------------ -------------
Deferred
Federal taxes................. (6,000) 133,000 (2,273,000) (127,000) 63,000 (2,512,000)
State taxes................... -- -- (869,000) (28,000) (20,000) (940,000)
--------- ---------- ------------- ------------ ------------ -------------
(6,000) 133,000 (3,142,000) (155,000) 43,000 (3,452,000)
--------- ---------- ------------- ------------ ------------ -------------
Provision for income taxes...... $ 66,000 $ 577,000 $ 2,905,000 $ 1,632,000 $ 1,520,000 $ 3,100,000
--------- ---------- ------------- ------------ ------------ -------------
--------- ---------- ------------- ------------ ------------ -------------
</TABLE>
Differences between the provision for income taxes and income taxes at the
statutory federal income tax rate for the years ended December 31, 1995, 1996
and 1997 are as follows:
<TABLE>
<CAPTION>
HISTORICAL PRO FORMA
------------------------------------------- ------------------------------------------
1995 1996 1997 1995 1996 1997
------------- ------------- ------------- ------------ ------------- -------------
(UNAUDITED)
<S> <C> <C> <C> <C> <C> <C>
Income taxes at the statutory
federal rate................ $ 1,282,000 $ (1,434,000) $ 3,036,000 $ 1,282,000 $ (1,434,000) $ 3,036,000
State income taxes, net of
federal income tax effect... 230,000 (257,000) 498,000 230,000 (257,000) 498,000
Foreign taxes at rates
different than U.S. taxes... -- -- 187,000 -- -- 187,000
Change in valuation reserve... 112,000 3,124,000 (1,268,000) 112,000 3,124,000 (1,268,000)
Permanent differences......... 104,000 35,000 13,000 108,000 309,000
Effect of STAR S-Corp status
until December 31, 1995..... 223,000 -- -- -- -- --
Effects of LDS S-Corp status
until November 30, 1997..... (1,808,000) (958,000) 152,000 -- -- --
Other......................... 27,000 (2,000) 265,000 (5,000) (21,000) 338,000
------------- ------------- ------------- ------------ ------------- -------------
$ 66,000 $ 577,000 $ 2,905,000 $ 1,632,000 $ 1,520,000 $ 3,100,000
------------- ------------- ------------- ------------ ------------- -------------
------------- ------------- ------------- ------------ ------------- -------------
</TABLE>
F-19
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(10) STOCK OPTIONS
On January 22, 1996, the Company adopted the 1996 Stock Incentive Plan (the
"Plan"). The Plan, which was amended on March 31, 1996, provides for the
granting of stock options to purchase up to 1,476,000 shares of common stock and
terminates January 22, 2006. Options granted become exercisable at a rate of not
less than 20 percent per year for five years.
During 1996, the Company entered into three separate stock option agreements
outside the Plan. The first agreement, dated March 1, 1996, provided for 410,000
non-incentive stock options exercisable immediately. The options were
exercisable at fair market value at the date of issuance, which was $0.98 per
share, to expire in 10 years. The second stock option agreement was entered into
on May 1, 1996 for an additional 410,000 shares to also be issued at $0.98 per
share. Of these options half vested on March 1, 1997 and half expired. On May
15, 1996, the Company granted 205,000 options, valued at $1.46 per share at the
date of issuance to a director. Of these options 34 percent were exercisable
immediately. The remaining options are exercisable equally on May 15, 1997 and
1998.
At December 31, 1996 and 1997, 1,025,000 and 820,000 options, respectively,
issued outside of a plan were outstanding.
On September 23, 1996, the Company adopted the 1996 Supplemental Stock
Option Plan. This plan, which expires on August 31, 2006, replaces the Plan and
has essentially the same features. The Company can issue options or other rights
to purchase up to 2,050,000 shares of stock which expire up to 10 years after
the date of grant, except for incentive options issued to a holder of more than
10 percent of the common stock outstanding, which expire five years after the
date of grant.
In December 1996, the Company issued 174,000 options at $4.00 per share. The
Board of Directors determined the market value of the December options to be
$4.68 per share. The Company is recognizing the difference between the market
value at the date of grant and the exercise price as compensation expense over
the vesting period.
At December 31, 1996 and 1997, 2,358,000 and 1,873,000 options,
respectively, were outstanding under the aggregate of the 1996 Stock Incentive
Plan and the Supplemental Stock Option Plan.
On May 14, 1996, the Company adopted the 1996 Outside Director Nonstatutory
Stock Option Plan (the "Director Plan"). The number of shares which may be
issued under this plan upon exercise of options may not exceed 410,000 shares.
The exercise price of an option is determined by the Board of Directors and may
not be less than 85 percent of the fair market value of the common stock at the
time of grant and has to be 110 percent of the fair market value of the common
stock at the time of grant if the option is granted to a holder of more than 10
percent of the common stock outstanding. At the discretion of the administrator,
the options vest at a rate of not less than 20 percent per year, which may
accelerate upon a change in control, as defined. The plan expires on May 14,
2006. At December 31, 1996 and 1997, 82,000 and 41,000 options, respectively,
were outstanding under the Director Plan.
On January 30, 1997, the Board of Directors approved the 1997 Omnibus Stock
Incentive Plan (the "Omnibus Plan") to replace the existing 1996 Supplemental
Stock Option Plan upon the effective date of the initial public offering. The
plan provides for awards to employees, outside directors and consultants in the
form of restricted shares, stock units, stock options and stock appreciation
rights and terminates on January 22, 2007. The maximum number of shares
available for issuance under this plan may not exceed 1,025,000 shares plus the
number of shares still unissued under the Supplemental Stock Option Plan.
F-20
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(10) STOCK OPTIONS (CONTINUED)
Options granted to any one optionee may not exceed more than 1,025,000 common
shares per year subject to certain adjustments. Incentive stock options may not
have a term of more than 10 years from the date of grant. At December 31, 1997,
763,000 options were outstanding under the Omnibus Plan.
Information regarding the Company's stock option plans and nonqualified
stock options as of December 31, 1995, 1996 and 1997, and changes during the
years ended on those dates is summarized as follows:
<TABLE>
<CAPTION>
WEIGHTED-AVERAGE
SHARES EXERCISE PRICE
---------- -----------------
<S> <C> <C>
December 31, 1995.............................................. -- $ --
Granted...................................................... 3,491,355 1.89
Exercised.................................................... --
Forfeited.................................................... (26,855) 1.95
---------- -----
December 31, 1996.............................................. 3,464,500 1.89
---------- -----
Granted...................................................... 914,296 7.91
Exercised.................................................... (488,925) 0.89
Forfeited.................................................... (392,774) 2.40
---------- -----
December 31, 1997.............................................. 3,497,097 $ 3.54
---------- -----
---------- -----
</TABLE>
At December 31, 1996, 912,425 options were exercisable at a weighted average
exercise price of $1.10 per share. At December 31, 1997, 1,275,645 options were
exercisable at a weighted average exercise price of $1.51 per share. The options
outstanding at December 31, 1997 expire in various years through 2007.
Information about stock options outstanding at December 31, 1997 is
summarized as follows:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING
---------------------------------------------------
WEIGHTED
AVERAGE WEIGHTED- NUMBER WEIGHTED-
NUMBER REMAINING AVERAGE EXERCISABLE AVERAGE
OUTSTANDING AT CONTRACTED EXERCISE AT EXERCISE
RANGE OF EXERCISE PRICES 12/31/97 LIFE PRICE 12/31/97 PRICE
- ------------------------------------------------- -------------- ------------- ----------- ---------- -----------
<S> <C> <C> <C> <C> <C>
$0.73 to $1.46................................... 1,807,126 8.28 $ 1.17 1,113,695 $ 1.14
$4.00 to $6.83................................... 1,146,721 8.96 $ 4.68 161,950 $ 4.07
$8.11 to $11.10.................................. 543,250 9.66 $ 9.06 -- $ --
-------------- --- ----- ---------- -----
3,497,097 8.72 $ 3.54 1,275,645 $ 1.51
-------------- --- ----- ---------- -----
-------------- --- ----- ---------- -----
</TABLE>
The Company has elected to adopt FASB No. 123 for disclosure purposes only
and applies Accounting Principle Board (APB) Opinion No. 25 and related
interpretations in accounting for its employee stock options. Approximately
$50,000 and $88,000 in compensation cost was recognized relating to consultant
options for the years ended December 31, 1996 and 1997, respectively. Had
compensation cost for stock options awarded under these plans been determined
based on the fair value at the dates of grant consistent with the methodology of
FASB No. 123, the Company's net income or loss and basic and diluted income or
F-21
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(10) STOCK OPTIONS (CONTINUED)
loss per share for the years ended December 31, 1996 and 1997 would have
reflected the following pro forma amounts:
<TABLE>
<CAPTION>
1996 1997
------------- ------------
<S> <C> <C>
Pro forma Net Income (Loss) Per Share
Pro forma Net Income (Loss).................................... $ (6,111,000) $ 4,957,000
Pro forma Basic Net Income (Loss) per share.................... $ (0.26) $ 0.16
Pro forma Diluted Net Income (Loss) per share.................. $ (0.26) $ 0.15
</TABLE>
The fair value of each option grant is estimated on the date of grant using
the minimum value method of option pricing with the following assumptions used
for the grants; weighted average risk-free interest rate of 6.4 and 6.2 percent
and an expected life of ten years and six years for the years ended December 31,
1996 and 1997, respectively. Expected volatility for 1997 was 31.05 percent and
it is assumed that no dividends would be issued during the option term. Because
the Company did not have a stock option program prior to 1996, the resulting pro
forma compensation cost may not be representative of that to be expected in
future years.
(11) CAPITAL STOCK
During 1994, the Company issued 16,606,661 shares of stock to the Company's
founder for $10,000. During 1995, this stockholder converted $990,000 of debt
into capital for no additional shares. During 1995, the Company also issued
1,843,339 shares to another executive of the Company on conversion of a loan.
On February 23, 1996, the Company sold 2,049,980 shares of common stock to
various investors for $1,500,000. On July 12, 1996, the Company sold 1,874,532
shares of common stock to an investor for $4,068,000.
On July 25, 1996, the Company sold 2,802,446 shares of Series A preferred
stock to a group of investors for $7,500,000. In connection with this
transaction, the Company and buyers of the preferred shares entered into an
investor's rights agreement which obligated the Company to file up to two
registration statements to register such shares. These preferred shares
converted to common stock at a ratio of 3-for-2 as a result of the public
offering in accordance with the investors rights agreement.
In June 1997, the Company completed its Initial Public Offering ("IPO") of
9,430,000 shares of common stock of which 8,097,500 shares were sold by the
Company and 1,332,500 shares were sold by certain selling shareholders. The net
proceeds to the Company (after deducting underwriting discounts and offering
expenses of approximately $4.6 million) from the sale of shares was
approximately $30.9 million.
On November 30, 1997, the Company completed the acquisition of LDS pursuant
to the terms of the agreement and 849,298 shares were issued for all of the
outstanding shares to LDS.
Since inception of T-One through December 31, 1994, the sole shareholder of
T-One contributed $1,221,000 in the form of cash and equipment to T-One. During
1995, he contributed an additional $269,000 and in 1996, exercised an available
election to convert $1,200,000 of the contributed capital into a note payable.
Concurrent with the conversion of capital to debt, T-One entered into a note
agreement with
F-22
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(11) CAPITAL STOCK (CONTINUED)
a bank for the same amount. Proceeds of the bank borrowings were used to repay
the amounts due to the shareholder (see Note 5).
(12) BUSINESS SEGMENTS
At December 31, 1997, Star has two business segments, wholesale long
distance and commercial long distance telecommunications. The wholesale segment
provides long distance services to U.S. and foreign based telecommunications
companies and the commercial segment, obtained by acquisition of LDS, provides
commercial long distance services to small retailers throughout the United
States.
The accounting policies of the segments are the same as those described in
the significant accounting policies, however, the Company evaluates performance
based on profit or loss from operations before income taxes and non-recurring
gains or losses. There are no intercompany sales among the wholesale and
commercial segments and both segments are managed separately.
Reportable segment information for the years ended December 31, 1995, 1996
and 1997 are as follows:
<TABLE>
<CAPTION>
WHOLESALE COMMERCIAL ALL OTHER TOTAL
-------------- ------------- ---------- --------------
<S> <C> <C> <C> <C>
1995
Revenues from external customers................... $ 28,779,000 $ 30,158,000 $ -- $ 58,937,000
Interest income.................................... -- 22,000 -- 22,000
Interest expense................................... 64,000 -- -- 64,000
Depreciation and amortization...................... 310,000 58,000 368,000
Segment net income (loss).......................... (835,000) 4,541,000 -- 3,706,000
Other significant non-cash items:
Capital lease additions.......................... 888,000 164,000 -- 1,052,000
Debt converted to equity......................... 1,093,000 -- -- 1,093,000
Segment assets..................................... 20,143,000 5,447,000 -- 25,590,000
Expenditures for segment assets.................... 1,603,000 61,000 -- 1,664,000
1996
Revenues from external customers................... $ 229,792,000 $ 29,905,000 $ -- $ 259,697,000
Interest income.................................... 83,000 27,000 -- 110,000
Interest expense................................... 597,000 12,000 -- 609,000
Depreciation and amortization...................... 1,364,000 78,000 -- 1,442,000
Segment net income (loss).......................... (7,219,000) 2,424,000 -- (4,795,000)
Other significant non-cash items:
Capital lease additions.......................... 5,097,000 69,000 -- 5,166,000
Equity converted to debt......................... 1,200,000 -- -- 1,200,000
Segment assets..................................... 57,728,000 5,326,000 -- 63,054,000
Expenditures for segment assets.................... 8,466,000 14,000 -- 8,480,000
</TABLE>
F-23
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(12) BUSINESS SEGMENTS (CONTINUED)
<TABLE>
<CAPTION>
WHOLESALE COMMERCIAL ALL OTHER TOTAL
-------------- ------------- ---------- --------------
<S> <C> <C> <C> <C>
1997
Revenues from external customers................... $ 377,145,000 $ 27,460,000 $ -- $ 404,605,000
Interest income.................................... 519,000 -- (27,000) 492,000
Interest expense................................... 1,738,000 27,000 (27,000) 1,738,000
Depreciation and amortization...................... 4,581,000 56,000 -- 4,637,000
Segment net income (loss).......................... 5,806,000 (37,000) -- 5,769,000
Other significant non-cash items:
Capital lease additions.......................... 9,772,000 -- -- 9,772,000
Property additions financed by notes payable..... 1,890,000 -- -- 1,890,000
Operating agreement acquired through issuance of
note........................................... 350,000 -- -- 350,000
Segment assets..................................... 113,472,000 6,844,000 -- 120,316,000
Expenditures for segment assets.................... 13,743,000 17,000 -- 13,760,000
</TABLE>
The Company had no customers, collectively, representing more than 10
percent of consolidated revenue in any foreign country.
(13) QUARTERLY CONSOLIDATED INFORMATION (UNAUDITED)
The following table presents unaudited quarterly operating results,
including the results of LDS and T-One, for each of the Company's eight quarters
in the two-year period ended December 31, 1997 (amounts in thousands):
<TABLE>
<CAPTION>
QUARTER ENDED
----------------------------------------------
MARCH 31, JUNE 30, SEPT. 30, DEC. 31,
----------- --------- ---------- ----------
<S> <C> <C> <C> <C>
1996
Net sales........................................................ $ 48,353 $ 55,491 $ 73,860 $ 81,993
Operating income (loss).......................................... 1,955 1,816 1,074 (8,503)
Pro forma net income (loss)...................................... 1,098 915 491 (8,242)
1997
Net sales........................................................ $ 84,827 $ 95,250 $ 103,297 $ 121,231
Operating income................................................. 2,561 2,871 3,072 2,861
Pro forma net income............................................. 1,347 1,037 981 2,209
</TABLE>
(14) SUBSEQUENT EVENTS
ACQUISITIONS
In November 1997, the Company signed a merger agreement with United Digital
Network, Inc. ("UDN"). The Company intends to account for the transaction as a
pooling of interests. At December 31, 1997, the Company has accounts receivable
from UDN in the amount of $721,000 and a note receivable of $2.5 million plus
accrued interest of $28,000. Both the accounts receivable and the note have been
fully
F-24
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1997
(14) SUBSEQUENT EVENTS (CONTINUED)
reserved at December 31, 1997. Subsequent to year end, the Company loaned an
additional $2 million to UDN which has also been fully reserved since the time
of issuance.
EQUITY TRANSACTIONS
On February 3, 1998 the Company announced a 2.05 for 1 stock split in the
nature of a stock dividend. The stock split is effective March 31, 1998 and has
been retroactively reflected in the accompanying consolidated financial
statements for all periods presented.
(15) EVENTS SUBSEQUENT TO THE DATE OF AUDITORS REPORT (UNAUDITED)
LINE OF CREDIT
On March 18, 1998, the Company amended the line of credit agreement with
Sanwa Bank by adjusting the borrowing base to 55 percent of aggregate eligible
accounts receivable, revising certain covenants and releasing all pledged
collateral.
PUBLIC OFFERING
On May 4, 1998, the Company completed a public offering of 6,000,000 shares
of common stock of which 5,685,000 were sold by the Company and 315,000 shares
were sold by a selling stockholder. The net proceeds to the Company (after
deducting underwriting discounts and offering expenses) from the sale of such
shares of common stock were approximately $145 million.
COMMITMENT
On June 25, 1998, the Company announced a 20-year, $70 million agreement to
purchase capacity on the Qwest nationwide Macro Capacity (SM) Fiber Network.
AUTHORIZED CAPITAL
On July 1, 1998, the Company's stockholders voted to amend and restate the
certificate of incorporation to increase the number of shares of the Company's
authorized common stock from 50 million shares to 100 million shares.
PT-1 ACQUISITION
On August 20, 1998, the Company entered into an Amended and Restated
Agreement and Plan of Merger with PT-1 Communications, Inc. (PT-1). Per the
agreement, as amended on September 1, 1998 and December 29, 1998, the Company
will issue 15,050,000 shares of common stock and $19,500,000 cash or short term
promissory notes for all outstanding shares, options and warrants of PT-1 plus
an additional 250,000 shares to certain PT-1 distributors. On August 17, 1998,
the Company provided a $10 million loan to PT-1 at 6.75 percent interest and due
on August 17, 1999.
F-25
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
INDEX TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
---------
<S> <C>
Condensed Consolidated Balance Sheets As Of December 31, 1997 and September 30, 1998....................... F-27
Condensed Consolidated Statements Of Income For The Three and Nine Month Periods Ended September 30, 1997
and 1998................................................................................................. F-28
Condensed Consolidated Statements Of Cash Flows For The Nine Month Periods Ended
September 30, 1997 and 1998.............................................................................. F-29
Notes To Condensed Consolidated Financial Statements....................................................... F-30
</TABLE>
F-26
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
DECEMBER 31, SEPTEMBER 30,
1997 1998
------------ -------------
(UNAUDITED)
<S> <C> <C>
Current Assets:
Cash and cash equivalents......................................................... $ 1,903 $ 11,808
Short-term investments............................................................ 18,631 92,390
Accounts and notes receivable, net................................................ 46,675 80,721
Receivable from related parties................................................... -- 330
Other current assets.............................................................. 10,696 27,580
------------ -------------
Total current assets.......................................................... 77,905 212,829
------------ -------------
Property and equipment, net......................................................... 35,959 113,851
Other assets........................................................................ 6,452 7,340
------------ -------------
Total assets.................................................................. $ 120,316 $ 334,020
------------ -------------
------------ -------------
Current Liabilities:
Revolving lines of credit with stockholder........................................ $ 138 $ 5
Current portion of long-term obligations.......................................... 3,259 7,595
Accounts payable and other accrued expenses....................................... 22,345 36,200
Accrued network cost.............................................................. 38,403 52,464
------------ -------------
Total current liabilities..................................................... 64,145 96,264
------------ -------------
Long-Term Liabilities:
Long-term obligations, net of current portion..................................... 12,107 31,053
Other long-term liabilities....................................................... 863 1,638
------------ -------------
Total long-term liabilities................................................... 12,970 32,691
------------ -------------
Stockholders' Equity:
Common Stock $.001 par value:
Authorized--100,000,000 shares.................................................. 35 42
Additional paid-in capital........................................................ 41,662 194,138
Deferred compensation............................................................. (30) --
Accumulated other comprehensive income............................................ -- 219
Retained earnings (deficit)....................................................... 1,534 10,666
------------ -------------
Total stockholders' equity.................................................... 43,201 205,065
------------ -------------
Total liabilities and stockholders' equity.................................... $ 120,316 $ 334,020
------------ -------------
------------ -------------
</TABLE>
See accompanying notes to the condensed consolidated financial statements.
F-27
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- ---------------------
1997 1998 1997 1998
-------- --------- --------- ---------
(UNAUDITED) (UNAUDITED)
<S> <C> <C> <C> <C>
Revenue........................................... $103,297 $ 164,333 $ 283,374 $ 425,531
Operating expenses:
Cost of services................................ 90,100 139,324 246,712 363,794
Selling, general and administrative expenses.... 8,898 15,922 25,118 38,853
Depreciation and amortization................... 1,227 3,439 3,040 8,055
Merger expense.................................. -- -- -- 314
-------- --------- --------- ---------
100,225 158,685 274,870 411,016
-------- --------- --------- ---------
Income from operations...................... 3,072 5,648 8,504 14,515
-------- --------- --------- ---------
Other income (expense):
Interest income................................. 293 1,839 367 3,511
Interest expense................................ (453) (740) (1,289) (2,080)
Other........................................... (794) 87 (1,499) (171)
-------- --------- --------- ---------
(954) 1,186 (2,421) 1,260
-------- --------- --------- ---------
Income before provision for income taxes.... 2,118 6,834 6,083 15,775
Provision for income taxes........................ 1,255 2,812 2,406 6,643
-------- --------- --------- ---------
Net income........................................ $ 863 $ 4,022 $ 3,677 $ 9,132
-------- --------- --------- ---------
-------- --------- --------- ---------
Income before provision for income taxes.... 2,118 6,083
Pro forma income taxes............................ 1,137 2,718
-------- ---------
Pro forma net income.............................. $ 981 $ 3,365
-------- ---------
-------- ---------
Basic income per share............................ $ 0.02 $ 0.10 $ 0.13 $ 0.23
-------- --------- --------- ---------
-------- --------- --------- ---------
Diluted income per share.......................... $ 0.02 $ 0.09 $ 0.12 $ 0.22
-------- --------- --------- ---------
-------- --------- --------- ---------
Pro forma basic income per share.................. $ 0.03 $ 0.12
-------- ---------
-------- ---------
Pro forma diluted income per share................ $ 0.03 $ 0.11
-------- ---------
-------- ---------
</TABLE>
See accompanying notes to the condensed consolidated financial statements.
F-28
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------
1997 1998
--------- ----------
(UNAUDITED)
<S> <C> <C>
Cash Flows From Operating Activities:
Net income............................................................................. $ 3,677 $ 9,132
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization........................................................ 3,040 8,055
Loss on disposal of equipment........................................................ 42 --
Compensation expense relating to stock options....................................... 60 30
Provision for doubtful accounts...................................................... 4,068 3,952
Deferred income taxes................................................................ -- (511)
Deferred compensation................................................................ (66) 62
Increase in assets:
Accounts and notes receivable...................................................... (8,214) (37,998)
Receivable from related parties.................................................... (174) (330)
Other assets....................................................................... (1,495) (6,038)
Increase (decrease) in liabilities:
Accounts payable and other accrued expenses........................................ (1,470) 13,855
Accrued network cost............................................................... 13,042 14,061
Other liabilities.................................................................. 63 48
--------- ----------
Net cash provided by operating activities........................................ 12,573 4,318
--------- ----------
Cash Flows From Investing Activities:
Capital expenditures................................................................... (6,649) (57,847)
Short-term investments................................................................. (19,206) (73,759)
Other long-term assets................................................................. 385 (5,084)
--------- ----------
Net cash used in investing activities............................................ (25,470) (136,690)
--------- ----------
Cash Flows From Financing Activities:
Borrowing under lines of credit........................................................ 34,211 --
Repayments under lines of credit....................................................... (42,025) --
Borrowing under lines of credit with stockholders...................................... 583 --
Repayments under lines of credit with stockholder...................................... (423) (133)
Payments under long-term debt and capital lease obligations............................ (3,061) (4,818)
Stockholder distributions for LDS...................................................... (794) --
Issuance of common stock............................................................... 30,914 144,711
Other financing activities............................................................. -- (12)
Stock options exercised................................................................ 67 2,310
--------- ----------
Net cash provided by financing activities........................................ 19,472 142,058
--------- ----------
Effects of Foreign Currency Translation.................................................. -- 219
Increase in cash and cash equivalents.................................................... 6,575 9,905
Cash and cash equivalents, beginning of period........................................... 1,845 1,903
--------- ----------
Cash and cash equivalents, end of period................................................. 8,420 11,808
--------- ----------
--------- ----------
</TABLE>
See accompanying notes to the condensed consolidated financial statements.
F-29
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(1) GENERAL
The financial statements included herein are unaudited and have been
prepared in accordance with generally accepted accounting principles for interim
financial reporting and Securities Exchange Commission ("SEC") regulations.
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. In
management's opinion, the financial statements reflect all adjustments (of a
normal and recurring nature) which are necessary to present fairly the financial
position, results of operations, stockholders' equity and cash flows for the
interim periods. These financial statements should be read in conjunction with
the audited financial statements for the year ended December 31, 1997 of STAR
Telecommunications, Inc. ("STAR" or the "Company"), set forth in this Proxy
Statement. The results for the three and nine month periods ended September 30,
1998, are not necessarily indicative of the results that may be expected for the
year ending December 31, 1998.
In March 1998, the Company consummated a merger with T-One Corp. ("T-One").
The merger constituted a tax-free reorganization and has been accounted for as a
pooling of interests under Accounting Principles Board Opinion No. 16.
Accordingly, all prior period consolidated financial statements presented have
been restated to include the results of operations, financial position, and cash
flows of T-One.
(2) BUSINESS AND PURPOSE
STAR is an emerging multinational carrier focused primarily on the
international long-distance market. The Company offers highly reliable, low-cost
switched voice services through a flexible network comprised of foreign
termination relationships, international gateway switches, leased and owned
transmission facilities, and resale arrangements with other long-distance
providers.
During 1996 and 1997, the Company established several wholly-owned foreign
subsidiaries to further expand its international network. The company made
substantial investments to install switch facilities in two of these
subsidiaries, Star Europe Limited (SEL) which is located in London, England, and
Star Telecommunications Deutschland (GmbH) which is located in Frankfurt,
Germany. The Company plans to use these switch facilities to decrease
international traffic termination cost and to initial outbound calls from these
local markets.
In December 1997, the Company entered into the domestic long-distance market
through the acquisition of L.D. Services, Inc. ("LDS"). In addition, the Company
established a domestic long-distance provider Arvilla Telecommunication, Inc.
("Arvilla"). Effective September 25, 1998, LDS and Arvilla were merged into a
wholly-owned subsidiary, CEO Telecommunications, Inc. ("CEO").
(3) NET INCOME PER COMMON SHARE
In February 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per
Share". The statement replaces primary EPS with basic EPS, which is computed by
dividing reported earnings available to common stockholders by weighted average
shares outstanding. The provision requires the calculation of diluted EPS. The
Company adopted this statement in 1997 and prior year earnings per share
information has been restated to be consistent with SFAS No. 128.
F-30
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(3) NET INCOME PER COMMON SHARE (CONTINUED)
The following schedule summarizes the information used to compute net income
per common share for the three and nine months ended September 30, 1997 and 1998
(in thousands):
<TABLE>
<CAPTION>
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- --------------------
1997 1998 1997 1998
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Weighted number of common shares used to compute basic
earnings per share................................... 34,589 42,087 28,650 39,147
Weighted average common share equivalents.............. 2,114 1,245 2,930 1,774
--------- --------- --------- ---------
Weighted average number of common share and share
equivalents used to compute diluted earnings per
share................................................ 36,703 43,332 31,580 40,921
--------- --------- --------- ---------
--------- --------- --------- ---------
</TABLE>
(4) PRO FORMA INCOME TAXES
The results of operations and provision for income taxes for the three and
nine months ended September 30, 1997 reflect LDS' status as an S-Corporation
prior to the merger with STAR. The pro-forma income taxes, pro-forma net income,
and pro-forma earnings per share information reflected in the condensed
consolidated statements of income assumes that both STAR and LDS were taxed as
C-Corporations for all periods presented.
(5) COMPREHENSIVE INCOME
On January 1, 1998, the Company adopted SFAS No. 130, "Reporting
Comprehensive Income". For year end financial statements, SFAS 130 requires that
comprehensive income, which is the total of net income and all other non-owner
changes in equity, be displayed in a financial statement with the same
prominence as other consolidated financial statements. Under SFAS No. 130, the
Company's foreign currency translation adjustments are considered to be
components of other comprehensive income. During the three and nine month
periods ended September 30, 1997, comprehensive income equaled net income.
During the three and nine month periods ended September 30, 1998, comprehensive
income equaled approximately $4,241,000 and $9,351,000, respectively.
(6) CHANGE IN ACCOUNTING ESTIMATE
As of July 1, 1998, the Company prospectively revised the remaining lives of
certain operating equipment from five to ten years. The increase in the
estimated life of these assets was based on the knowledge gained by the Company
in making the transition from a reseller of telephone services to a facility
based provider, as well as to the fact that the Company is purchasing more
sophisticated telephone switches and has transitioned from a Stromberg platform
to a Nortel based telecommunications platform. All such assets will be amortized
over their respective useful lives. This change increased income before
provision for income taxes for the three and nine-month periods ended September
30, 1998 by approximately one million dollars. The difference between
depreciating all switch equipment over a 5 year life versus a 10 year life since
acquisition would represent approximately $945,000 for the 3 month period and
F-31
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(6) CHANGE IN ACCOUNTING ESTIMATE (CONTINUED)
$1,770,000 for the 9 month period, or 1 cent or 3 cent per diluted share for the
3 and 9 month periods, respectively.
(7) SIGNIFICANT EVENTS
In November 1997, the Company signed a merger agreement with United Digital
Network, Inc. ("UDN"). The Company intends to account for the transaction as a
pooling of interests. In August 1998, the Company signed an amended and restated
agreement to acquire PT-1 Communications, Inc. ("PT-1") which will be accounted
for as a purchase. The Company anticipates closing these transactions in the
fourth quarter.
According to SFAS 52, "Foreign Currency Translation," the functional
currency of a foreign subsidiary of a U.S. company ordinarily will be the
currency of the country in which the entity is located or the U.S. dollar. The
determination of the functional currency is basically a matter of fact. On July
1, 1998, due to changes in facts and circumstances, the Company changed the
functional currency of its German subsidiary from the U.S. dollar to the German
mark.
(8) STATEMENTS OF CASH FLOWS
During the nine month periods ended September 30, 1997 and 1998, cash paid
for interest was approximately $1,175,000 and $2,342,000 respectively. For the
same periods, cash paid for income taxes amounted to approximately $2,693,000
and $2,545,000 respectively.
Non-cash investing and financing activities are as follows (in thousands):
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
--------------------
1997 1998
--------- ---------
<S> <C> <C>
Equipment purchased through notes and capital leases.................... $ 10,230 $ 28,100
Tax benefits related to stock options................................... -- 5,474
--------- ---------
$ 10,230 $ 33,574
--------- ---------
--------- ---------
</TABLE>
F-32
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(9) SEGMENT INFORMATION
At September 30, 1998, STAR has two business segments, North American and
European long distance telecommunications.
<TABLE>
<CAPTION>
NORTH
THREE MONTHS ENDED, SEPTEMBER 30, 1997 AMERICA EUROPE TOTAL
- ----------------------------------------------------------- ---------- --------- ----------
<S> <C> <C> <C>
Revenue.................................................... $ 103,297 $ -- $ 103,297
Interest income............................................ 293 -- 293
Interest expense........................................... 356 97 453
Depreciation and amortization.............................. 1,084 143 1,227
Segment profit (loss)...................................... 1,451 (588) 863
Segment assets............................................. $ 102,097 $ 5,965 $ 108,062
</TABLE>
<TABLE>
<CAPTION>
NORTH
THREE MONTHS ENDED, SEPTEMBER 30, 1998 AMERICA EUROPE TOTAL
- ----------------------------------------------------------- ---------- --------- ----------
<S> <C> <C> <C>
Revenue.................................................... $ 157,584 $ 6,749 $ 164,333
Interest income............................................ 1,814 25 1,839
Interest expense........................................... 356 384 740
Depreciation and amortization.............................. 2,384 1,055 3,439
Segment profit (loss)...................................... 9,733 (5,711) 4,022
Segment assets............................................. $ 285,381 $ 48,639 $ 334,020
</TABLE>
<TABLE>
<CAPTION>
NORTH
NINE MONTHS ENDED, SEPTEMBER 30, 1997 AMERICA EUROPE TOTAL
- ----------------------------------------------------------- ---------- --------- ----------
<S> <C> <C> <C>
Revenue.................................................... $ 283,374 $ -- $ 283,374
Interest income............................................ 367 -- 367
Interest expense........................................... 1,153 136 1,289
Depreciation and amortization.............................. 2,824 216 3,040
Segment profit............................................. 4,895 (1,218) 3,677
Segment assets............................................. $ 102,097 $ 5,965 $ 108,062
</TABLE>
<TABLE>
<CAPTION>
NORTH
NINE MONTHS ENDED, SEPTEMBER 30, 1998 AMERICA EUROPE TOTAL
- ---------------------------------------------------------- ---------- ---------- ----------
<S> <C> <C> <C>
Revenue................................................... $ 418,588 $ 6,943 $ 425,531
Interest income........................................... 3,486 25 3,511
Interest expense.......................................... 1,116 964 2,080
Depreciation and amortization............................. 6,033 2,022 8,055
Segment profit (loss)..................................... 19,944 (10,812) 9,132
Segment assets............................................ 285,381 48,639 334,020
</TABLE>
The Company provides wholesale and commercial long distance telephone
service. The commercial segment represents less than 10% of revenue, net income
or assets of the Company for the periods presented.
F-33
<PAGE>
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(10) NEW PRONOUNCEMENTS
In June 1998, the AICPA issued statement of Financial Accounting Standards
No. 133 "Accounting For Derivative Instruments and Hedging Activities." The
Company has not yet analyzed the impact of this new standard. The Company will
adopt the standard in January of 2000.
(11) SUBSEQUENT EVENTS
In November 1998, the Company signed a twenty year, $31 million dollar
indefeasible right of use (IRU) agreement with IXC Communication, Inc. ("IXC")
to purchase capacity on IXC's U.S. based digital fiber network.
F-34
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
---------
<S> <C>
Independent Auditors' Report............................................................................... F-36
Consolidated Balance Sheets as of March 31, 1997 and 1998 and September 30, 1998 (unaudited)............... F-37
Consolidated Statements of Operations for the period from April 21, 1995 (inception) to March 31, 1996, for
the years ended March 31, 1997 and 1998 and for the six months ended September 30, 1998 and 1997
(unaudited).............................................................................................. F-38
Consolidated Statements of Cash Flows for the period from April 21, 1995 (inception) to March 31, 1996, for
the years ended March 31, 1997 and 1998 and for the six months ended September 30, 1998 and 1997
(unaudited).............................................................................................. F-39
Consolidated Statements of Stockholders' Deficiency for the period from April 21, 1995 (inception) to March
31, 1996, for the years ended March 31, 1997 and 1998 and for the six months ended September 30, 1998
(unaudited).............................................................................................. F-40
Notes to Consolidated Financial Statements................................................................. F-41
</TABLE>
F-35
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders
PT-1 Communications, Inc.:
We have audited the accompanying consolidated balance sheets of PT-1
Communications, Inc. and subsidiary as of March 31, 1997 and 1998 and the
related consolidated statements of operations, stockholders' deficiency and cash
flows for the period from April 21, 1995 (inception) to March 31, 1996 and for
the years ended March 31, 1997 and 1998. These consolidated financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these consolidated financial statements based on our
audits.
We conducted our audits in accordance with generally accepting auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
PT-1 Communications, Inc. and subsidiary as of March 31, 1997 and 1998, and the
results of their operations and their cash flows for the period from April 21,
1995 (inception) to March 31, 1996 and for the years ended March 31, 1997 and
1998 in conformity with generally accepted accounting principles.
KPMG PEAT MARWICK LLP
New York, New York
June 22, 1998,
except for the third paragraph
of Note 8, for which the date
is September 1, 1998.
F-36
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
ASSETS
<TABLE>
<CAPTION>
MARCH 31,
----------------------------
1997 1998 SEPTEMBER 30, 1998
------------- ------------- ------------------
(UNAUDITED)
<S> <C> <C> <C>
Current assets:
Cash and cash equivalents...................................... $ 5,577,238 $ 12,389,554 $ 5,381,815
Marketable securities.......................................... -- 1,082,872 1,036,483
Short-term investments (notes 1 and 3)......................... 668,994 3,674,392 1,111,744
Accounts receivable, less allowance for doubtful accounts of
$391,000, $478,000 and $1,137,000, respectively (notes 4 and
6)........................................................... 7,540,474 29,771,970 37,433,981
Due from carriers.............................................. 269,153 7,516,370 9,506,461
Inventory...................................................... 317,390 842,793 975,697
Prepaid expenses............................................... 827,755 690,939 814,241
Deferred tax asset............................................. -- 2,505,217 3,600,000
------------- ------------- ------------------
Total current assets......................................... 15,201,004 58,474,107 59,860,422
Long-term investments (notes 1 and 3)............................ 1,472,000 2,406,440 5,305
Property and equipment, net (notes 1, 2 and 5)................... 1,483,823 22,609,454 43,480,486
Deposits......................................................... 403,729 507,333 524,517
Officer loans receivable (note 6)................................ 338,528 202,820 588,401
Intangible assets................................................ -- 2,991,457 2,492,876
Deferred offering costs (note 11)................................ -- 485,790 --
------------- ------------- ------------------
Total assets................................................. $ 18,899,084 $ 87,677,401 $ 106,952,007
------------- ------------- ------------------
------------- ------------- ------------------
LIABILITIES AND STOCKHOLDERS' DEFICIENCY
Current liabilities:
Accounts payable and accrued expenses.......................... $ 1,902,210 $ 7,940,817 $ 12,275,147
Accrued taxes payable.......................................... 4,374,679 10,599,910 9,195,103
Due to carriers................................................ 870,259 9,086,026 13,112,500
Notes payable (notes 5 and 8).................................. 5,000,000 5,130,000 5,000,000
Short-term debt (note 10)...................................... -- 2,760,000 15,000,000
Current portion of capital lease obligation.................... -- 1,746,001 1,735,513
Deferred revenue............................................... 20,479,361 42,931,616 42,025,892
------------- ------------- ------------------
Total current liabilities.................................... 32,626,509 80,194,370 98,344,155
------------- ------------- ------------------
Capital lease obligation (note 9)................................ -- 8,253,999 7,512,418
Note payable (note 8)............................................ 5,000,000 -- --
Deferred tax liability........................................... -- 450,000 700,000
------------- ------------- ------------------
Total liabilities............................................ 37,626,509 88,898,369 106,556,573
------------- ------------- ------------------
Stockholders' equity (deficiency):
Preferred stock, no par value. Authorized 15,000,000 shares; no
shares issued and outstanding................................ -- -- --
Common stock, par value $.01 per share. Authorized 150,000,000
shares; 70,000,000 shares issued and 44,947,368 outstanding
in 1997 and 73,459,180 shares issued and 48,406,548
outstanding in 1998.......................................... 700,000 734,592 734,592
Additional paid-in capital..................................... 6,602,613 15,784,614 16,166,278
Retained earnings (accumulated deficit)........................ (11,030,038) 550,357 1,919,237
Treasury stock, at cost 25,052,632 shares in 1997 and 1998
(note 8)..................................................... (15,000,000) (15,000,000) (15,000,000)
Less: Note receivable from stockholder (note 8) $3,570,000 face
amount, noninterest bearing until April 15, 1999 (less
unamortized discount of $279,469, based on imputed interest
of 8%)....................................................... -- (3,290,531) (3,424,673)
------------- ------------- ------------------
Total stockholders' equity (deficiency)...................... (18,727,425) (1,220,968) 395,434
------------- ------------- ------------------
Total liabilities and stockholders' equity (deficiency)...... $ 18,899,084 $ 87,677,401 $ 106,952,007
------------- ------------- ------------------
------------- ------------- ------------------
</TABLE>
See accompanying notes to consolidated financial statements.
F-37
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
PERIOD FROM APRIL SIX MONTHS ENDED SEPTEMBER 30,
21, 1995 YEARS ENDED MARCH 31,
(INCEPTION) TO ------------------------------ ------------------------------
MARCH 31, 1996 1997 1998 1997 1998
----------------- -------------- -------------- -------------- --------------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Revenue.......................... $ 11,922,606 $ 169,635,313 $ 431,519,685 $ 187,043,760 $ 268,919,366
Operating expenses:
Cost of services............... 13,812,202 166,184,501 395,500,937 170,752,512 248,222,120
Selling and marketing
expenses..................... 318,070 1,761,650 4,485,214 1,828,395 4,274,320
Merger costs................... -- -- -- -- 975,439
General and administrative
expenses..................... 704,429 2,612,894 12,112,035 4,108,778 12,766,070
Stock based compensation....... -- 7,300,000 2,661,166 1,855,525 381,664
----------------- -------------- -------------- -------------- --------------
Total operating expenses..... 14,834,701 177,859,045 414,759,352 178,545,210 266,619,613
----------------- -------------- -------------- -------------- --------------
Operating (loss) income...... (2,912,095) (8,223,732) 16,760,333 8,498,550 2,299,753
Interest income.................. 2,115 114,633 517,304 186,459 268,630
Interest expense................. -- (10,959) (1,021,452) (401,535) (793,534)
Net gains on marketable
securities..................... -- -- 507,170 243,785 (50,542)
Loss on disposition of fixed
assets......................... -- -- (32,960) -- --
----------------- -------------- -------------- -------------- --------------
(Loss) income before income
taxes...................... (2,909,980) (8,120,058) 16,730,395 8,527,259 1,724,307
Income tax expense............... -- -- 5,150,000 2,018,000 355,427
----------------- -------------- -------------- -------------- --------------
Net (loss) income............ $ (2,909,980) $ (8,120,058) $ 11,580,395 $ 6,509,259 $ 1,368,880
----------------- -------------- -------------- -------------- --------------
----------------- -------------- -------------- -------------- --------------
Net earnings (loss) per common
share:
Basic.......................... $ (.05) $ (.13) $ 0.25 $ 0.14 $ 0.03
Diluted........................ $ (.05) $ (.13) $ 0.24 $ 0.14 $ 0.03
Weighted average number of common
shares outstanding
Basic.......................... 60,900,000 60,681,000 46,922,000 45,708,000 48,407,000
Diluted........................ 60,900,000 60,681,000 47,720,000 46,987,000 48,587,000
</TABLE>
F-38
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
PERIOD FROM APRIL SIX MONTHS ENDED
21, 1995 YEARS ENDED MARCH 31, SEPTEMBER 30,
(INCEPTION) TO ------------------------- ------------------------
MARCH 31, 1996 1997 1998 1997 1998
----------------- ----------- ------------ ----------- -----------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Cash provided by operating activities:
Net (loss) income........................ $(2,909,980) $(8,120,058) $ 11,580,395 $ 6,509,259 $ 1,368,880
Adjustments to reconcile net (loss)
income to net cash provided by
operating activities:
Depreciation and amortization.......... 4,943 75,017 1,534,500 385,791 1,713,754
Noncash compensation................... -- 7,300,000 2,661,166 1,855,525 381,664
Sales of marketable securities......... -- -- 3,156,836 1,608,019 532,003
Purchases of marketable securities..... -- -- (4,034,562) (1,509,159) (518,822)
Unrealized (gain) loss on marketable
securities........................... -- -- (204,346) (98,960) 61,750
Amortization of discount on stock
subscription receivable.............. -- -- (122,964) -- (134,142)
Loss on disposal of property, plant and
equipment............................ -- -- 32,960 -- --
Provision for doubtful accounts........ 80,000 311,194 86,569 43,730 659,613
(Increase) in accounts receivable...... (1,042,305) (6,889,363) (22,318,065) (10,469,986) (8,321,624)
Decrease (increase) in due from
carriers............................. (331,347) 62,194 (7,247,217) 182,117 (1,990,091)
(Increase) decrease in officer loans
receivable........................... -- (338,528) 135,708 (30,984) (385,581)
Increase in inventory.................. (36,200) (281,190) (525,403) (70,203) (132,904)
(Increase) decrease in prepaid
expenses............................. (5,804) (821,951) 136,816 618,993 (123,307)
Increase in deposits................... (87,155) (316,574) (103,604) (181,268) (17,184)
Increase in deferred income taxes...... -- -- (2,055,217) (272,000) (844,783)
Increase in accounts payable and
accrued expenses..................... 390,761 1,511,449 6,038,607 1,894,916 4,334,330
Increase (decrease) in accrued taxes
payable.............................. 605,000 3,769,679 6,225,231 427,276 (1,404,807)
Increase (decrease) in due to
carriers............................. 2,251,398 (1,381,139) 8,215,767 3,493,483 4,026,474
Increase (decrease) in deferred
revenue.............................. 1,846,023 18,633,338 22,452,255 14,929,538 (905,724)
----------------- ----------- ------------ ----------- -----------
Net cash provided by (used in)
operating activities............... 765,334 13,514,068 25,645,432 19,316,087 (1,700,501)
----------------- ----------- ------------ ----------- -----------
Cash flows from investing activities:
Purchases of investments in certificates
of deposit............................. -- (2,140,994) (10,783,000) (9,629,887) --
Proceeds from maturities of investments
in certificates of deposit............. -- -- 6,842,362 5,047,371 4,935,246
Capital expenditures..................... (74,319) (1,489,464) (11,254,715) (7,949,355) (22,086,205)
Purchase of capitalized software......... -- -- (391,973) (350,000) --
----------------- ----------- ------------ ----------- -----------
Net cash used in investing
activities......................... (74,319) (3,630,458) (15,587,326) (12,881,871) (17,150,959)
----------------- ----------- ------------ ----------- -----------
Cash flows from financing activities:
Proceeds from issuance of common stock... 2,600 13 -- -- --
Proceeds from loans...................... -- -- 2,760,000 -- 12,240,000
Payment for treasury stock............... -- (5,000,000) -- -- --
Payment on notes payable................. -- -- (5,520,000) (130,000) (130,000)
Payments of capital lease obligation..... -- -- -- -- (752,069)
Offering costs........................... -- -- (485,790) (335,950) 485,790
----------------- ----------- ------------ ----------- -----------
Net cash (used in) provided by
financing activities............... 2,600 (4,999,987) (3,245,790) (465,950) 11,843,721
----------------- ----------- ------------ ----------- -----------
Net increase (decrease) in cash and
cash equivalents................... 693,615 4,883,623 6,812,316 5,968,266 (7,007,739)
Cash and cash equivalents at beginning of
year..................................... -- 693,615 5,577,238 5,577,238 12,389,554
----------------- ----------- ------------ ----------- -----------
Cash and cash equivalents at end of year... $ 693,615 $ 5,577,238 $ 12,389,554 $11,545,504 $ 5,381,815
----------------- ----------- ------------ ----------- -----------
----------------- ----------- ------------ ----------- -----------
Supplemental information:
Cash paid for interest................... $ -- $ -- $ 211,923 $ -- $ 517,572
----------------- ----------- ------------ ----------- -----------
----------------- ----------- ------------ ----------- -----------
Cash paid for income taxes............... $ -- $ -- $ 5,250,000 $ 100,000 $ 2,183,475
----------------- ----------- ------------ ----------- -----------
----------------- ----------- ------------ ----------- -----------
</TABLE>
See accompanying notes to consolidated financial statements.
F-39
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY)
PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996,
THE YEARS ENDED MARCH 31, 1997 AND 1998,
AND THE SIX MONTHS ENDED SEPTEMBER 30, 1998
(UNAUDITED)
<TABLE>
<CAPTION>
RETAINED NOTE TOTAL
ADDITIONAL EARNINGS TREASURY STOCK RECEIVABLE STOCKHOLDERS'
PAID-IN (ACCUMULATION ------------------------ FROM EQUITY
SHARES AMOUNT CAPITAL DEFICIT) SHARES AMOUNT STOCKHOLDER (DEFICIENCY)
---------- -------- ----------- -------------- ---------- ------------ ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance at April 21,
1995
(inception)....... -- $ -- $ -- $ -- -- $ -- $ -- $ --
Issuance of common
stock............. 60,900,000 609,000 (606,400) -- -- -- -- 2,600
Net loss............ -- -- -- (2,909,980) -- -- -- (2,909,980)
---------- -------- ----------- -------------- ---------- ------------ ----------- -------------
Balance at March 31,
1996.............. 60,900,000 609,000 (606,400) (2,909,980) -- -- -- (2,907,380)
Issuance of common
stock (note 8).... 9,100,000 91,000 7,209,013 -- -- -- -- 7,300,013
Purchase of treasury
stock............. -- -- -- -- 25,052,632 (15,000,000) -- (15,000,000)
Net loss............ -- -- -- (8,120,058) -- -- -- (8,120,058)
---------- -------- ----------- -------------- ---------- ------------ ----------- -------------
Balance at March 31,
1997.............. 70,000,000 700,000 6,602,613 (11,030,038) 25,052,632 (15,000,000) -- (18,727,425)
Compensation expense
related to stock
options........... -- -- 1,661,166 -- -- -- -- 1,661,166
Issuance of common
stock (note 8).... 483,980 4,840 3,383,020 -- -- -- -- 3,387,860
Exercise of stock
options (notes 5
and 8)............ 2,975,200 29,752 4,137,815 -- -- -- (3,290,531) 877,036
Net income.......... -- -- -- 11,580,395 -- -- -- 11,580,395
---------- -------- ----------- -------------- ---------- ------------ ----------- -------------
Balance at March 31,
1998.............. 73,459,180 734,592 15,784,614 550,357 25,052,632 (15,000,000) (3,290,531) (1,220,968)
Compensation expense
related to stock
options........... 381,664 381,664
Imputed interest.... (134,142) (3,424,673)
Net income
(unaudited)....... 1,368,880 1,368,880
---------- -------- ----------- -------------- ---------- ------------ ----------- -------------
Balance at September
30, 1998
(unaudited)....... 73,459,180 $734,592 $16,166,278 $ 1,919,237 25,052,632 $(15,000,000) $ 3,424,673 $ 395,434
---------- -------- ----------- -------------- ---------- ------------ ----------- -------------
---------- -------- ----------- -------------- ---------- ------------ ----------- -------------
</TABLE>
See accompanying notes to consolidated financial statements.
F-40
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996
AND FOR THE YEARS ENDED MARCH 31, 1997 AND 1998
(INFORMATION AS OF SEPTEMBER 30, 1998 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997 IS UNAUDITED)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(A) DESCRIPTION OF BUSINESS
The consolidated financial statements include the accounts of PT-1
Communications, Inc. and PT-1 Technologies, Inc., a wholly owned subsidiary.
PT-1 Communications, Inc., formerly PhoneTime, Inc., was incorporated on April
21, 1995. All intercompany balances and transactions have been eliminated in
consolidation. PT-1 Communications, Inc. and Subsidiary ("PT-1" or the
"Company") are engaged in the sale of international and domestic long-distance
and local telecommunications services primarily through the marketing of prepaid
phone cards, which it manufactures and distributes on a wholesale basis. PT-1
provides card users access to long-distance and international service through
contractual arrangements with carriers, which comprise the Company's least-cost
routing network. In addition, PT-1 provides international and domestic
long-distance services to other telecommunications carriers on a wholesale
basis.
(B) REVENUE RECOGNITION AND DEFERRED REVENUE
Revenue from telecommunications services is recognized when the services are
provided.
Sales of prepaid phone cards are made to distributors with no contractual
right of return. At the time of sale, the Company becomes legally obligated to
provide such service. Such sales are initially recorded as deferred revenue upon
shipment and revenue is recognized in accordance with the terms of the card as
the ultimate card users utilize calling time and service fees for all prepaid
cards. The terms of the card refer to the rates, fees and expiration dates of
the card as well as any other provisions which govern their use. Effective April
1, 1996, the Company began to assess a monthly service fee per card, commencing
30 days after the date a prepaid phone card is first used to make a telephone
call by reducing the unused card balance available for calls. All prepaid phone
cards sold by the Company since October 1, 1996 expire upon the earlier to occur
of (i) an expiration date printed on the prepaid phone card or (ii) six months
after the prepaid phone card is first used. Upon expiration and cancellation of
the prepaid phone card, the Company recognizes the related deferred revenue as
revenue. Prepaid phone cards sold prior to October 1, 1996 did not carry an
expiration date. The Company did not recognize any revenue related to the
expiration of the cards for the period from April 21, 1995 (inception) through
March 31, 1996 and for the year ended March 31, 1997. For the year ended March
31, 1998 the Company recognized approximately $2.5 million of revenue related to
the expiration of cards which were sold since October 1, 1996. The Company
recognized $0 and $6.7 million of revenue related to the expiration of cards for
the six months ended September 30, 1997 and 1998, respectively. The primary card
costs associated with the provision of telecommunications services are carrier
costs for transport of traffic and switch administration fees.
For the period from April 21, 1995 (inception) through March 31, 1996 and
for the years ended March 31, 1997 and 1998, approximately $-0-, $7,084,000 and
$75,188,000, respectively, of wholesale revenue was included in revenues. For
the six months ended September 30, 1997 and 1998, $23,557,000 and $73,630,000
respectively of wholesale revenues was included in telecommunications services
revenues.
F-41
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996
AND FOR THE YEARS ENDED MARCH 31, 1997 AND 1998
(INFORMATION AS OF SEPTEMBER 30, 1998 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997 IS UNAUDITED)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
(C) CASH EQUIVALENTS
For purposes of the consolidated statements of cash flows, the Company
considers all highly liquid investments with original maturities of three months
or less to be cash equivalents.
(D) MARKETABLE SECURITIES
Management determines the appropriate classification of its marketable
securities at the time of purchase and classifies them as trading, held to
maturity or available for sale, in accordance with the provisions of Statement
of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain
Investments in Debt and Equity Securities."
(E) PROPERTY AND EQUIPMENT AND SOFTWARE
Property and equipment consist principally of telecommunications equipment,
office equipment, packaging machinery and equipment, furniture and fixtures and
leasehold improvements. Property and equipment are stated at cost with
depreciation provided using the straight-line method over the estimated useful
lives of the related assets. Leasehold improvements are amortized over the life
of the lease or the useful life of the improvement, whichever is shorter. The
estimated useful lives are as follows:
<TABLE>
<S> <C>
7-10
Telecommunications equipment..................................... years
Telecommunication networks....................................... 20 years
Office equipment................................................. 5 years
Machinery and equipment.......................................... 15 years
Furniture and fixtures........................................... 10 years
Leasehold improvements........................................... 5 years
Computer software................................................ 3-4 years
</TABLE>
Telecommunications equipment is comprised of telephone switches and
communications equipment utilized to route and connect calls. Telecommunications
network includes two Indefeasible Rights of Use (IRU) in fiber optic telephone
cable systems which have been accounted for as capital leases. These assets are
amortized over the life of the agreements not to exceed 20 years (see Notes 2
and 12).
The Company's telecommunications equipment is subject to technological risks
and rapid market changes due to new products and services and changing customer
demand. These changes may result in future adjustments to the estimated useful
lives of these assets.
(F) INVENTORY
Inventory consists of costs of production and packaging of unsold phone
cards, is valued using the average-cost method and is charged to cost of
services when the cards are sold.
F-42
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996
AND FOR THE YEARS ENDED MARCH 31, 1997 AND 1998
(INFORMATION AS OF SEPTEMBER 30, 1998 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997 IS UNAUDITED)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
(G) CAPITALIZED SOFTWARE
The Company capitalizes certain computer software license acquisition costs
which are amortized utilizing the straight-line method over three years, the
period for which the Company maintains exclusive rights to such license.
On April 1, 1997, the Company adopted the provisions of Statement of
Position (SOP) 98-1, "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use." The SOP requires that certain costs related to the
development or purchase of internal-use software be capitalized and amortized
over the estimated useful life of the software. The SOP also requires that costs
related to the preliminary project stage and the post-implementation/operations
stage of an internal-use computer software development project be expensed as
incurred. There was no cumulative effect of adopting this SOP and subsequent to
its adoption there were no material amounts capitalized under its provisions.
(H) INCOME TAXES
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases and operating loss carryforwards. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be realized or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date.
Valuation allowances are established when necessary to reduce deferred tax
assets to the amounts expected to be realized.
(I) FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107, "Disclosures about Fair Value of Financial Instruments,"
requires the determination of fair value for certain of the Company's assets and
liabilities. The Company estimates that the carrying value of its financial
instruments approximates fair value.
(J) IMPAIRMENT OF LONG-LIVED ASSETS AND LONG-LIVED ASSETS TO BE DISPOSED OF
In accordance with SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," the Company
reviews for the impairment of long-lived assets and certain identifiable
intangibles to be held and used by the Company whenever events and changes in
circumstances indicate that the carrying value of an asset may not be
recoverable.
The Company assesses the recoverability of an asset by determining whether
the amortization of the asset balance over its remaining life can be recovered
through projections of undiscounted future cash flows of the related asset. The
amount of asset impairment, if any, is measured based on projected discounted
future cash flows using a discount rate reflecting the Company's average cost of
funds.
F-43
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996
AND FOR THE YEARS ENDED MARCH 31, 1997 AND 1998
(INFORMATION AS OF SEPTEMBER 30, 1998 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997 IS UNAUDITED)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
(K) RISKS AND UNCERTAINTIES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expense during the reporting
period. Estimates are used in determining the allowance for doubtful accounts,
depreciation and amortization, carrier cost liabilities and the realization of
deferred tax assets. The accompanying consolidated balance sheets include
liabilities with respect to carrier line costs and related disputes which are
determined based upon various assumptions (see Note 9(b)). It is reasonably
possible that the final resolution of some of these disputes may require
expenditure by the Company in excess of estimates and in a range of amounts that
cannot be reasonably estimated. Actual results could differ from those
estimates.
The taxation of prepaid phone cards is evolving and is not specifically
addressed by many of the states in which the Company does business. While the
Company believes it has adequately provided for any such taxes it may ultimately
be required to pay, certain states may enact legislation which specifically
provides for taxation of such cards or may interpret current laws in a manner
resulting in additional tax liabilities.
(L) STOCK-BASED COMPENSATION
The Company accounts for stock-based compensation in accordance with SFAS
No. 123, "Accounting for Stock-Based Compensation," which permits entities to
recognize as expense over the vesting period the fair value of all stock-based
awards on the date of grant. Alternatively, SFAS No. 123 also allows entities to
continue to apply the provisions of the Accounting Principles Board (APB)
Opinion No. 25 and provide pro forma net income and pro forma earnings per share
disclosures for employee stock option grants as if the fair value-based method,
as defined in SFAS No. 123, had been applied. The Company has elected to
continue to apply the provisions of APB Opinion No. 25 and provide the pro forma
disclosure required by SFAS No. 123. As such, compensation expense is generally
recorded on the date of grant only if the current market price of the underlying
stock exceeded the exercise price.
(M) ADVERTISING COSTS
Advertising costs are expensed as incurred. Advertising costs period from
April 21, 1995 (inception) through March 31, 1996 and for the years ended March
31, 1997 and 1998 amounted to approximately $108,000, $202,000 and $760,000,
respectively. Advertising costs amounted to approximately $207,000 and
$1,178,000 for the six months ended September 30, 1997 and 1998, respectively.
(N) INTANGIBLE ASSETS
Intangible assets consist of a noncompetition agreement which is being
amortized by use of the straight-line method over the estimated life of the
agreement (see note 8).
F-44
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996
AND FOR THE YEARS ENDED MARCH 31, 1997 AND 1998
(INFORMATION AS OF SEPTEMBER 30, 1998 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997 IS UNAUDITED)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
(O) NET EARNINGS (LOSS) PER SHARE
The Company adopted the provisions of SFAS 128, "Earnings Per Share" for the
year ended March 31, 1998. SFAS 128, which supercedes APB Opinion No. 15,
"Earnings Per Share" was issued in February 1997. SFAS 128 requires dual
presentation of basic and diluted earnings per share ("EPS") for complex capital
structures on the face of the statement of operations. Basic EPS is computed by
dividing net income or loss by the weighted average number of common shares
outstanding for the period. Diluted EPS reflects the potential dilution from the
exercise or conversion of securities into common stock. Net earnings (loss) and
weighted average shares outstanding used for computing diluted loss per common
share were the same as that used for computing net earnings (loss) per common
share for all periods presented.
Potentially dilutive instruments totalling 9,000,000 for the year ended
March 31, 1997 have not been included in the computation of diluted net income
(loss) per common share because they were antidilutive for those periods.
(P) TAXES ON PREPAID CARDS
Various jurisdictions levy taxes on telecommunications services whether
provided through prepaid cards or some other means utilizing different methods
and rates. The Company accrues for excise, sales and other usage based taxes on
telecommunication services based on the enacted method and rate for each
jurisdiction in the period usage occurs and revenue is recognized.
(2) PROPERTY AND EQUIPMENT
Property and equipment consist of the following as of March 31, 1997 and
1998 and September 30, 1998:
<TABLE>
<CAPTION>
MARCH 31,
-------------------------- SEPTEMBER 30,
1997 1998 1998
------------ ------------ -------------
UNAUDITED
<S> <C> <C> <C>
Telecommunications equipment....................... $ 1,174,032 19,885,282 30,639,820
Telecommunication networks......................... -- -- 8,600,000
Office equipment................................... 141,920 931,374 1,896,582
Packaging machinery and equipment.................. 120,396 412,638 412,638
Furniture and fixtures............................. 96,793 273,055 368,273
Leasehold improvements............................. 30,642 1,222,099 2,704,803
Software........................................... -- 1,142,876 1,331,412
------------ ------------ -------------
1,563,783 23,867,324 45,953,528
Less accumulated depreciation...................... 79,960 1,257,870 2,473,042
------------ ------------ -------------
$ 1,483,823 22,609,454 43,480,486
------------ ------------ -------------
------------ ------------ -------------
</TABLE>
F-45
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996
AND FOR THE YEARS ENDED MARCH 31, 1997 AND 1998
(INFORMATION AS OF SEPTEMBER 30, 1998 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997 IS UNAUDITED)
(2) PROPERTY AND EQUIPMENT (CONTINUED)
In March 1998, the Company acquired telecommunications equipment for $10
million under a lease with a financing company. The Company has accounted for
the lease as a capital lease and included the $10 million of equipment in
telecommunications equipment. The lease requires monthly payments of $206,420,
including interest at 8.76%, until April 2003 and is secured by the Company's
equipment and accounts receivable. At March 31, 1998, the Company was in
compliance with the covenants contained in the lease.
(3) MARKETABLE SECURITIES AND INVESTMENTS
Marketable securities are composed of common stock investments in public
corporations and are classified as trading securities, which are carried at
their fair value based upon the quoted market prices of those investments.
Accordingly, net realized and unrealized gains and losses on trading securities
are included in the consolidated statements of operations. Net realized gains
and losses are determined on the first-in first-out basis.
Net gains on trading securities of $507,170 for the year ended March 31,
1998 is composed of a net realized gain of $302,825 and unrealized holding gains
of $204,345. Net losses on trading securities of ($50,542) for the six months
ended September 30, 1998 is composed of a net unrealized holding gain of $11,208
and a net unrealized holding loss of ($61,750).
Investments in the accompanying balance sheet represent certificates of
deposit which mature at varying dates through January 1999 and bear interest at
rates which range from 4.1% to 5.3% These investments are stated at cost plus
accrued interest which approximates fair value. At March 31, 1997 and 1998 and
September 30, 1998, certificates of deposit with a carrying value of $1,472,000,
$2,406,000, and $0, respectively, collateralize standby letters of credit to
certain of the Company's service providers and are classified as long-term
investments. These letters of credit expire at various dates through March 20,
1999, have been issued as security against services provided to the Company and
are expected to be renewed.
(4) BUSINESS CONCENTRATIONS
SALES
For the period from April 21, 1995 (inception) through March 31, 1996 no one
distributor represented 10% or more of prepaid phone card revenue. For the years
ended March 31, 1997 and 1998 and the six month periods ended September 30, 1997
and 1998, prepaid phone card sales to five individual distributors represented
approximately 5%, 13%, 6%, 11% and 10%, 18%, 17%, 12%, 4% and 5%, 15%, 17%, 9%,
7% and 8%, and 21%, 16%, 11%, 0% and 0%, of prepaid phone card revenue for each
respective period.
ACCOUNTS RECEIVABLE
The Company's accounts receivable are primarily due from distributors. Two
distributors individually represented approximately 35% and 15% of the net
accounts receivable balance at March 31, 1997 and one distributor represents
approximately 30% of the net accounts receivable balance at March 31, 1998.
F-46
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996
AND FOR THE YEARS ENDED MARCH 31, 1997 AND 1998
(INFORMATION AS OF SEPTEMBER 30, 1998 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997 IS UNAUDITED)
(4) BUSINESS CONCENTRATIONS (CONTINUED)
At March 31, 1997, accounts receivable of approximately $585,000 relate to
PT-1 California, an unrelated exclusive sales distribution center. At March 31,
1998, accounts receivable of approximately $2,953,000 and $71,000, respectively,
relate to PT-1 California and PT-1 Ohio, unrelated exclusive sales distribution
centers. These exclusive sales distribution centers are sites where PT-1's
prepaid cards are exclusively distributed by those PT-1 distributors who are
authorized to use the PT-1 name for promotional purposes.
COST OF SERVICES
For the year ended March 31, 1998, one telecommunications service provider
represented approximately 35% of cost of services.
(5) ASSET PURCHASE AND SOFTWARE-LICENSING AGREEMENT
On May 9, 1997, PT-1 entered into an asset purchase agreement with
Interactive Telephone Company ("Interactive") and Joseph Pannullo ("Pannullo"),
the sole director and stockholder of Interactive, for $600,000 for computer
hardware and other assets. Interactive is in the business of providing
long-distance telecommunications services to issuers of prepaid debit phone
cards.
On May 9, 1997, PT-1 entered into a three-year employment agreement with
Panullo. In connection with this agreement, the Company granted Panullo an
option to purchase 1,048,600 shares of stock at an aggregate option price of
$0.01. The Company has recorded compensation expense of $1 million, the
intrinsic value of the option representing the difference between the fair value
of the stock and the exercise price, on the grant date in accordance with APB
25. The entire $1 million was recognized as compensation expense on May 9, 1997,
since the option immediately vested. Because the option was exercisable for a
nominal amount, the fair value of the option approximated the amount recognized
as compensation. The fair value of the stock was determined by the Company's
board of directors utilizing a recent arms length transaction adjusted for other
considerations including growth of the business. The fair value was supported by
an independent valuation report.
On May 9, 1997, PT-1 entered into a software license agreement with Godot
Soft, LLC ("Godot"), which is owned by Pannullo, and Pannullo for a license fee
of $1,000,000. The license fee was paid with $350,000 in cash and the delivery
of a $650,000 noninterest-bearing promissory note payable in ten equal monthly
installments commencing 90 days following the effective date. The license fee
has been capitalized as software and is being amortized over a period of 4
years, the term of PT-1s' exclusivity. In addition, the software license
agreement provides that if (i) the Company engages in a specified transfer of
control transaction and (ii) Sam Tawfik ("Tawfik"), the Company's Chief
Executive Officer, and his affiliates and family members receive at least $100
million in cash or publicly held securities as a result of such transaction, the
Company must pay a fee of $2.0 million to Godot. Such amount would become
payable if the merger transaction described in note 12 closes.
F-47
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996
AND FOR THE YEARS ENDED MARCH 31, 1997 AND 1998
(INFORMATION AS OF SEPTEMBER 30, 1998 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997 IS UNAUDITED)
(6) RELATED PARTY TRANSACTIONS
During the year ended March 31, 1997, the Company made loans to two of its
officers and a former employee aggregating $591,542, of which $202,820 remains
outstanding at March 31, 1998. These loans bear interest at rates which range
from 8% to 8.5% and have no specified repayment terms. During the six months
ended September 30, 1998. PT-1 made an additional $350,000 loan to an officer.
The note is secured by 70,000 shares of PT-1 common stock.
Through March 31, 1996, PT-1 sold phone cards to Tempus International, a
corporation controlled by the Company's then President and a director, on terms
identical to those extended to the company's customers. For the period from
April 21, 1995 (inception) to March 31, 1996, these purchases aggregated
approximately $1,050,000.
(7) TAXES
The components of income tax expense (benefit) for the year ended March 31,
1998 are presented in the following table:
<TABLE>
<S> <C>
Current:
Federal............................... $ 6,283,840
State................................. 921,939
-------------
Total current....................... 7,205,779
Deferred:
Federal............................... (1,787,050)
State................................. (268,729)
-------------
Total deferred...................... (2,055,779)
-------------
Total............................... $ 5,150,000
-------------
-------------
</TABLE>
The statutory Federal income tax rate for the period ended March 31, 1996
and years ended March 31, 1997 and 1998 was 35% and the effective income tax
rate was 0%, 0% and 30.78%, respectively.
F-48
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996
AND FOR THE YEARS ENDED MARCH 31, 1997 AND 1998
(INFORMATION AS OF SEPTEMBER 30, 1998 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997 IS UNAUDITED)
(7) TAXES (CONTINUED)
The following table shows the principal reasons for the difference between
the effective tax rate and the statutory federal income tax rate for the year
ended March 31,:
<TABLE>
<CAPTION>
1996 1997 1998
--------------------- --------------------- ---------------------
AMOUNT % AMOUNT % AMOUNT %
----------- -------- ----------- -------- ----------- --------
<S> <C> <C> <C> <C> <C> <C>
Expected federal income (benefit) tax at
statutory rate........................ $(1,018,493) 35.00% $(2,842,020) 35.00% $ 5,855,838 35.00%
State income taxes, net of federal
benefit............................... -- -- -- -- 424,587 2.54%
Change in valuation allowance........... 1,011,500 (34.76%) 278,500 (3.43%) (1,290,000) (7.71%)
Stock based compensation not deductible
for tax purposes...................... -- -- 2,555,000 (31.47%) -- --
Other................................... 6,993 (0.24%) 8,520 (0.10%) 159,575 0.95%
----------- -------- ----------- -------- ----------- --------
$ 0 0.00% $ 0 0.00% $ 5,150,000 30.78%
----------- -------- ----------- -------- ----------- --------
----------- -------- ----------- -------- ----------- --------
</TABLE>
The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets at March 31, 1997 and 1998 are described
below:
<TABLE>
<CAPTION>
1997 1998
-------------------------- -----------------------
CURRENT NONCURRENT CURRENT NONCURRENT
------------- ----------- ---------- -----------
<S> <C> <C> <C> <C>
Net operating loss carryforwards............................ $ 1,032,000 -- -- --
Stock-based compensation expense............................ -- -- 605,739 --
Accounts receivable primarily due to allowance for doubtful
accounts.................................................. 136,000 -- 182,744 --
Accrued expenses............................................ 183,000 -- 1,794,896 --
Net unrealized gain on marketable securities................ -- -- (78,162) --
Depreciation................................................ -- (61,000) -- (450,000)
------------- ----------- ---------- -----------
Total deferred tax asset (liability)...................... 1,351,000 (61,000) 2,505,217 (450,000)
Less valuation allowance.................................... (1,290,000) -- -- --
------------- ----------- ---------- -----------
Net deferred tax assets (liabilities)..................... $ 61,000 (61,000) 2,505,217 (450,000)
------------- ----------- ---------- -----------
------------- ----------- ---------- -----------
</TABLE>
In assessing the realizability of deferred tax assets, management considers
whether it is more likely than not that some portion or all of the deferred tax
assets will not be realized. The ultimate realization of deferred tax assets is
dependent upon the generation of future taxable income during the periods in
which those temporary differences become deductible. Management considers
projected future taxable income and tax planning in making these assessments.
During the years ended March 31, 1997 and 1998, the valuation allowance
increased by $278,500 and decreased by $1,290,000, respectively.
F-49
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996
AND FOR THE YEARS ENDED MARCH 31, 1997 AND 1998
(INFORMATION AS OF SEPTEMBER 30, 1998 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997 IS UNAUDITED)
(7) TAXES (CONTINUED)
The Company currently believes that the realization of its deferred tax
assets is more likely than not based on the generation of net income during the
period and the Company's projection of future taxable income. For the year ended
March 31, 1998, the Company utilized the prior period net operating loss
carryforwards of $2,950,000, providing a tax benefit of $1.1 million to the
Company's consolidated statements of operations.
(8) CAPITAL TRANSACTIONS
The Company was initially capitalized with the issuance of 20 shares of
common stock for a capital contribution of $2,600. As of April 6, 1996 and
December 30, 1997, PT-1's Board of Directors declared stock splits of
4.35-for-one and 700,000-for-one, respectively (collectively, the "Stock
Split"). Retroactive treatment has been made in the consolidated financial
statements to reflect the stock split.
TRANSACTION WITH THOMAS HICKEY
On February 25, 1997, litigation related to disputed ownership interests and
control of the Company was commenced against the Company, Thomas Hickey
(Hickey), a former director and executive officer of the Company, and Sam Tawfik
(Tawfik), the Company's Chief Executive Officer. On March 20, 1997, a second
action was commenced asserting similar claims against the same defendants. Such
litigation involved disputed equity issuance commitments in connection with the
establishment of the Company and employment of key executives. On March 26,
1997, a settlement agreement among the parties was reached which included the
dismissal of litigation, execution of equity issuance commitments (as described
below), release of claims, the resignation of Hickey as a director, executive
officer and employee of the Company and the redemption of 25,052,632 shares of
common stock of the Company for $15 million which was satisfied by a cash
payment of $5 million and the issuance of a note in the principal amount of $10
million (the Note).
In connection with the March 27, 1997 settlement agreement described above,
two officers received 12.25 million shares of the Company for nominal
consideration in accordance with commitments made in July 1995 and March 1996,
the dates they joined the Company. Certain of the shares were newly issued
shares and certain shares were transferred from Hickey to the two officers. In
accordance with the provisions of APB Opinion No. 25, the Company has recognized
non-cash compensation expense for the year ended March 31, 1997, of
approximately $7.3 million related to all of the shares provided to the two
officers. Such value was determined based upon the value ascribed to the shares
redeemed from Hickey on March 27, 1997.
On November 7, 1997, in connection with the Company's then pending initial
public offering, the Company, Hickey and certain executive officers of the
Company entered into additional agreements pursuant to which Hickey affirmed the
validity of agreements entered into on March 26, 1997, and agreed to an extended
noncompetition agreement for consideration of 483,980 shares of common stock
valued at approximately $3.4 million. The Company determined the fair market
value of the common stock as of November 7, 1997 based upon consultations with
its investment advisors in connection with its then
F-50
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996
AND FOR THE YEARS ENDED MARCH 31, 1997 AND 1998
(INFORMATION AS OF SEPTEMBER 30, 1998 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997 IS UNAUDITED)
(8) CAPITAL TRANSACTIONS (CONTINUED)
proposed initial public offering and as a result of arms length negotiations
with Mr. Hickey. Additional releases were obtained for claims relating to
Hickey's interest in the Company and the pending initial public offering. The
fair value of the common stock issued in consideration for the extended
noncompetition agreement was recorded as an intangible asset and is being
amortized by use of the straight-line method over the 41 month life of the
agreement. Amortization expense of approximately $396,000 was recorded in
connection with this agreement.
The Note accrued interest at a rate of 8% per annum. The Company paid $5
million of the Note on March 25, 1998 in accordance with its terms and must
repay the remaining outstanding principal and all accrued interest on or prior
to March 25, 1999. The Company pledged two-thirds of the shares of common stock
if redeemed from Hickey as collateral for the Note.
STOCK OPTIONS AND WARRANTS
On May 12, 1997 and during June 1997, the Company granted incentive
stock/stock options compensation awards in connection with three employment
agreements. The incentive awards, which vest at specified future dates ranging
from 18 to 36 months from the effective dates of the agreements, are not
dependent upon performance targets and provide for a maximum value of $850,000
in the aggregate payable in stock or stock options of equivalent value. The
Company has recorded compensation expense of $384,269 for the year ended March
31, 1998 in connection with such incentive awards.
On May 26, 1997, the Company granted an option to purchase 1,916,600 shares
of common stock in connection with an employment agreement. The option is
exercisable for $3.57 million, the fair market value at the date of grant. On
October 15, 1997, the optionee exercised the option and obtained a loan for the
exercise price from the Company. The loan is with recourse to the optionee,
noninterest bearing for a period of up to 18 months, bears interest at a market
rate thereafter and matures on the earlier of (i) two years from the date of the
loan, (ii) one year after the closing of the Offering or (iii) upon a sale of
control of the Company. The acceleration provision due to a change in control
has been waived by STAR in connection with the proposed merger.
On June 29, 1997, the Company entered into a service agreement with
Interexchange, Inc. (Interexchange), a debit card service provider. In
connection with the execution of the Interexchange Agreement, the Company
granted warrants from the purchase of shares of Common Stock to certain
principals of Interexchange (collectively, the "Interexchange Warrants"). The
Interexchange Warrants are exercisable for shares of Common Stock with an
aggregate fair market value equal to (i) $1,000,000, at a total exercise price
of $.15 and (ii) $2.0 million, at an aggregate exercise price equal to
$1,000,000 (collectively, the "Warrant Shares"). Interexchange Warrants with
respect to one-third of the Warrant Shares vest and become exercisable upon each
of: (i) the earlier to occur of the closing of the Offering or March 31, 1998,
(ii) January 1, 1999 and (iii) December 1, 1999, in each case if and only if the
Interexchange Agreement has not been terminated on or before such date (other
than as a result of a breach by the Company). The Interexchange Warrants expire
upon the fifth anniversary of their respective vesting dates. In the event of a
change of control, any unvested Interexchange Warrants at such time shall
immediately vest and become
F-51
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996
AND FOR THE YEARS ENDED MARCH 31, 1997 AND 1998
(INFORMATION AS OF SEPTEMBER 30, 1998 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997 IS UNAUDITED)
(8) CAPITAL TRANSACTIONS (CONTINUED)
exercisable and the fair market value shall be fixed as of the date of such
change of control. In connection with the warrants, the Company will record
compensation expense of approximately $2.0 million, the difference between the
exercise price and market value, over the vesting period applicable to each
portion of the grant. The Company has recorded compensation expense of
approximately $1,200,000 for the year ended March 31, 1998, in connection with
the warrants.
On September 30, 1997, the Board of Directors adopted, and the shareholders
of the Company approved, the 1997 Stock Incentive Plan (the "Stock Incentive
Plan"), which provides for the grant to officers, key employees and directors of
the Company and its subsidiaries of both "incentive stock options" within the
meaning of the Internal Revenue Code, and stock options that are nonqualified
for federal income tax purposes. The total number of shares for which options
may be granted pursuant to the Stock Incentive Plan and the maximum number of
shares for which options may be granted pursuant to the Stock Incentive Plan and
the maximum number of shares for which options may be granted to any person is
3,500,000 shares, subject to certain adjustments to reflect changes in the
Company's capitalization.
As of March 31, 1998, options to purchase an aggregate 628,000 shares of
Common Stock were granted under the Stock Incentive Plan and a total of
2,872,000 shares of Common Stock remained available for future grants. The
outstanding options were held by 30 individuals. The Company has recorded
compensation expense of $70,000 for the year ended March 31, 1998 in connection
with such options. Shares subject to options granted under the plan that have
lapsed or terminated may again be subject to options granted under the plan.
The following table summarizes the transactions of the Company's Stock
Incentive Plan for the year ended March 31, 1998:
<TABLE>
<CAPTION>
WEIGHTED
SHARES AVERAGE
SUBJECT TO OPTION PRICE
OPTION PER SHARE
----------- -------------
<S> <C> <C>
Balance at April 1, 1997.......................................... -- $ --
Options granted................................................. 3,720,700 3.14
Options exercised............................................... (2,975,200) 1.20
Options canceled................................................ (117,500) 10.53
----------- ------
Balance at March 31, 1998......................................... 628,000 $ 10.97
----------- ------
Options granted................................................. -- --
Options exercised............................................... -- --
Options canceled................................................ (61,000) 10.75
----------- ------
Balance at September 30, 1998 (unaudited)......................... 567,000 $ 10.98
----------- ------
----------- ------
</TABLE>
The Company did not grant any stock options for the year ended March 31,
1997.
F-52
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996
AND FOR THE YEARS ENDED MARCH 31, 1997 AND 1998
(INFORMATION AS OF SEPTEMBER 30, 1998 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997 IS UNAUDITED)
(8) CAPITAL TRANSACTIONS (CONTINUED)
The following table summarizes information about shares subject to options
under the Company's Stock Incentive Plan at September 30, 1998:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
- -------------------------------------------------------------- --------------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
NUMBER RANGE OF EXERCISE EXERCISE REMAINING LIFE NUMBER EXERCISE
OUTSTANDING PRICE PRICE IN YEARS EXERCISABLE PRICE
- ----------- ----------------- ------------- --------------- ----------- -------------
<S> <C> <C> <C> <C> <C>
547,000 $ 10.00 - $11.00 $ 10.86 0.31 399,659 $ 10.87
20,000 $ 13.20 - $15.40 $ 14.30 0.50 10,000 $ 13.20
- ----------- -----------
567,000 $ 10.00 - $15.40 $ 10.98 0.32 409,659 $ 10.87
- ----------- -----------
- ----------- -----------
</TABLE>
(9) COMMITMENTS AND CONTINGENCIES
(A) LEASE
At March 31, 1998, the Company was committed under a noncancelable operating
lease for the rental of office space for which it is also obligated to pay a pro
rata portion of increases in real property taxes as additional rent.
The Company's future lease payments are as follows:
<TABLE>
<CAPTION>
OPERATING CAPITAL
YEAR ENDING MARCH 31, LEASES LEASES
- ---------------------------------------------------------------- ------------ --------------
<S> <C> <C>
1999............................................................ $ 1,331,000 $ 2,270,620
2000............................................................ 1,275,000 2,477,040
2001............................................................ 1,260,000 2,477,040
2002............................................................ 1,214,000 2,477,040
2003............................................................ 376,000 2,477,040
Remainder....................................................... 2,050,000 206,420
------------ --------------
$ 7,506,000 12,385,200
------------
------------
Less Amount Representing Interest............................... (2,385,200)
--------------
Capital Lease Obligation........................................ 10,000,000
--------------
--------------
</TABLE>
Total rent expense for the years ended March 31, 1997 and 1998 was
approximately $76,000 and $788,000, respectively.
F-53
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996
AND FOR THE YEARS ENDED MARCH 31, 1997 AND 1998
(INFORMATION AS OF SEPTEMBER 30, 1998 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997 IS UNAUDITED)
(9) COMMITMENTS AND CONTINGENCIES (CONTINUED)
(B) TELECOMMUNICATIONS SERVICE AGREEMENTS
The Company has an agreement with a telecommunications company with an
annual usage commitment of $1,500,000. The Company has exceeded the annual usage
commitment since the inception of this agreement.
The Company has minimum volume commitments of approximately 940,000 minutes
per month with eight of its service providers which, if not met, may require the
Company to make payments to these providers. As of March 31, 1998, the Company
anticipates that it will fulfill these commitments.
The Company is committed to paying a minimum monthly service charge of
$500,000 through January 1, 2001 for use of a debit platform switching network.
The Company has been billed $3.2 million by a carrier for completed and
uncompleted calls. Under FCC regulation, the Company is only required to pay for
completed calls and has disputed the billed amount. The Company has accrued $1.6
million at March 31, 1998, its estimate of charges for completed calls.
(C) EMPLOYMENT CONTRACTS
The Company has employment agreements with certain executive officers and
key management personnel, the terms of which expire at various times through
June 2000. Such agreements provide for minimum salary levels, as well as for
incentive bonuses that are payable if specified management goals are attained.
The aggregate commitment for future salaries at March 31, 1998, excluding
bonuses, was approximately $3,047,000. All agreements contain covenants not to
compete.
(D) LETTERS OF CREDIT
At March 31, 1997 and 1998 and September 30, 1998, certificates of deposit
with carrying values of $1,472,000 and $2,406,000 and $0, respectively,
collateralize standby letters of credit to the Company's major service provider.
These letters of credit have been issued as security against services advanced.
(E) REGULATORY
The Company is subject to regulation by various government agencies and
jurisdictions and believes it is in compliance with all applicable laws and
regulations. However, implementation and interpretation of the Telecom Act of
1996 (the Act) is ongoing and subject to litigation by various Federal and state
agencies and courts. As a result, the impact of the Act on the Company is not
yet completely determinable and future interpretations and rulings may impact
the financial position and results of operations of the Company.
The Telecommunications Act (Section 276) mandated that the FCC promulgate
rules to establish a per call compensation plan to ensure that all payphone
providers are fairly compensated for each completed intrastate and interstate
payphone initialed call, including calls on which payphone providers
F-54
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996
AND FOR THE YEARS ENDED MARCH 31, 1997 AND 1998
(INFORMATION AS OF SEPTEMBER 30, 1998 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997 IS UNAUDITED)
(9) COMMITMENTS AND CONTINGENCIES (CONTINUED)
had not heretofore received compensation. Such calls included those placed to
toll free numbers (800/888) such as operator assisted and prepaid calling card
calls, and calls placed through network access codes. In September 1996, the FCC
promulgated rules to implement Section 276 of the Telecommunications Act which
established a three-phase compensation plan for payphone providers. On July 1,
1997, the D.C. Circuit Court of Appeals vacated significant portions of the
FCC's rules including the per call rate which was found to be arbitrary and
capricious, and remanded the matter to the FCC for reconsideration. On remand,
the FCC in September 1997, established a two-year "default" compensation rate of
$0.284 per payphone-originated toll free or access code call. At the end of the
two year interim period, the per call payphone compensation rate will be the
deregulated market-based local coin rate less $0.066. This amount is payable by
all "switched-based" interexchange carriers (but again may be passed through to
non-facilities-based resellers). The revised FCC's rules became effective on
October 7, 1997, but continue to be subject to regulatory and legal challenges.
The Company accrues $0.284 for each terminated toll free call which originates
from a payphone, in the period the call is made, in accordance with the FCC's
rules.
In 1998, the Company began incurring certain universal service support
obligation costs resulting from the Federal Communications Commission Universal
Service Order. The Universal Service Order created new universal service support
obligations for telecommunications services for schools and libraries and rural
health care facilities. The Universal Service Order is currently being
challenged.
PT-1 believes that these regulations or other potential changes in the
regulatory environment will not have a material effect on the Company.
(F) LEGAL
On July 31, 1997, the Company was notified by the Federal Trade Commission
(FTC) and the New York Attorney General Office (NYAG) that it was the subject of
an investigation alleging deceptive advertising practices in connection with the
sale of its prepaid telephone cards. The Company has recently been informed that
the NYAG office is no longer pursuing this matter. The Company does not believe
its advertising practices are deceptive and it is currently in discussions with
the FTC offices regarding resolution. Management does not believe that the
outcome, if unfavorable, will have a material adverse effect on the Company's
business, financial condition or results of operations. The Company estimates
that the range it would be obligated to pay is approximately $250,000 to
$300,000. The Company has accrued $250,000 at March 31, 1998 relating to this
claim.
(10) SHORT-TERM DEBT
On October 8, 1997, the Company entered into a $5.0 million revolving credit
facility and a $5.0 million letter of credit facility with Chase Manhattan Bank,
N.A. (the "Credit Facility"). Borrowings under the Credit Facility bear interest
at a rate equal to either the adjusted London Interbank Offer Rate plus 2.25%,
the prime rate or a fixed rate to be determined pursuant to the Credit Facility.
Borrowings under the Credit Facility are secured by the Company's equipment and
accounts receivable. The Company may borrow up to 75% of eligible equipment and
accounts receivable. The Credit Agreement expires on
F-55
<PAGE>
PT-1 COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE PERIOD FROM APRIL 21, 1995 (INCEPTION) TO MARCH 31, 1996
AND FOR THE YEARS ENDED MARCH 31, 1997 AND 1998
(INFORMATION AS OF SEPTEMBER 30, 1998 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997 IS UNAUDITED)
(10) SHORT-TERM DEBT (CONTINUED)
September 30, 1998. The amount borrowed on the line of credit was $2,760,000 at
March 31, 1998 and $5,000,000 at September 30, 1998.
(11) DEFERRED OFFERING COSTS
The Company has deferred offering costs of $485,790 relating to its proposed
initial public offering. In connection with the merger transaction described in
note 12 the Company is not pursuing the initial public offering and such costs
will be expensed in the first quarter of fiscal 1999.
(12) TRANSACTIONS WITH STAR TELECOMMUNICATIONS, INC.
In June and September 1998, PT-1 entered into two Capacity Purchase and
Assignment Agreements with STAR Telecommunications, Inc. (STAR) for $4.5 million
and $4.1 million respectively. Pursuant to these agreements PT-1 acquired two
indefeasible rights of use (IRU) from STAR which have been accounted for as
capital leases and are included in telecommunications network.
On August 17, 1998 PT-1 obtained a loan from STAR for $10 million with a
maturity date of August 17, 1999. The loan accrues interest monthly at 6 3/4%
and PT-1 may defer payment of all interest until the maturity date.
On August 20, 1998, PT-1 entered into an amended and restated agreement and
plan of merger with STAR. The acquisition will be completed through the issuance
of 15 million shares of STAR common stock and the payment of $19.5 million to
PT-1 stockholders. Effective as of September 1, 1998, the merger agreement was
amended by the parties to modify the consideration to be paid to the
stockholders of PT-1 and to provide Star with managerial and operational
authority over PT-1 as of that date.
F-56
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
---------
<S> <C>
Report of Independent Accountants for the years ended April 30, 1996 and 1997 and for the eight months
ended December 31, 1997.................................................................................. F-58
Independent Auditor's Report for the year ended April 30, 1995............................................. F-59
Consolidated Financial Statements:
Consolidated Balance Sheets as of April 30, 1996 and 1997 and as of December 31, 1997...................... F-60
Consolidated Statements of Operations for the years ended April 30, 1995, 1996 and 1997 and for the eight
months ended December 31, 1997........................................................................... F-61
Consolidated Statements of Shareholders' Equity (Deficit) for the years ended April 30, 1995, 1996 and 1997
and for the eight months ended December 31, 1997......................................................... F-62
Consolidated Statements of Cash Flows for the years ended April 30, 1995, 1996 and 1997 and for the eight
months ended December 31, 1997........................................................................... F-63
Notes to Consolidated Financial Statements................................................................. F-64
</TABLE>
F-57
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders of
United Digital Network, Inc. and Subsidiaries
(formerly Unidex Communications Corp.)
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, shareholders' equity (deficit) and of
cash flows present fairly, in all material respects, the financial position of
United Digital Network, Inc. and its Subsidiaries (formerly Unidex
Communications Corp.) at April 30, 1996 and 1997 and at December 31, 1997, and
the results of their operations and their cash flows for the years ended April
30, 1996 and 1997 and for the eight months ended December 31, 1997, in
conformity with generally accepted accounting principles. These financial
statements are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these financial statements in accordance
with generally accepted auditing standards which require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for the opinion expressed
above.
The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. As described in Note
14 to the consolidated financial statements, the Company has a significant
working capital deficiency and its current cash flow from operations is not
sufficient to permit the Company to repay debts on the scheduled due dates.
These conditions raise substantial doubt about the Company's ability to continue
as a going concern. Management's plans in regard to this matter are also
described in Note 14. The financial statements do not include any adjustment
that might result from the outcome of this uncertainty.
/s/ PRICEWATERHOUSECOOPERS LLP
Dallas, Texas
May 31, 1998
F-58
<PAGE>
INDEPENDENT AUDITOR'S REPORT
To the Shareholders
UNIDEX COMMUNICATIONS CORP.
We have audited the consolidated balance sheet of Unidex Communications
Corp. and Subsidiaries as of April 30, 1995, and the consolidated statements of
operations, shareholders' equity and cash flows for the year then ended. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our previously issued report dated July 21, 1995, we expressed an opinion
that the 1995 consolidated financial statements presented fairly the financial
position of Unidex Communications Corp. and Subsidiaries as of April 30, 1995,
and the results of operation and cash flows for the year then ended in
conformity with generally accepted accounting principles, except for the
omission of the disclosure of proforma results of operations relating to a
business acquisition on April 27, 1996. The Company has included the omitted
proforma information in Note 6. Accordingly, our present opinion on the 1995
financial statements is different from that presented in our previous report.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of the Unidex
Communications Corp. and Subsidiaries as of April 30, 1995 and the results of
its operations and its cash flows for the year then ended in accordance with
generally accepted accounting principles.
/s/ WEAVER AND TIDWELL, L.L.P.
Dallas, Texas
July 21, 1995, except for the
proforma information relating to
the business acquisition, as to which
the date is May 20, 1997.
F-59
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
CONSOLIDATED BALANCE SHEETS
ASSETS
<TABLE>
<CAPTION>
AS OF APRIL 30, AS OF
---------------------------- DECEMBER 31,
1996 1997 1997
------------- ------------- -------------
<S> <C> <C> <C>
Current assets:
Cash and cash equivalents......................................... $ 1,073,649 $ 556,366 $ 45,317
Accounts and notes receivable, net (Note 5)....................... 2,452,336 3,918,905 3,787,173
Receivable from employee.......................................... 12,010 -- --
Prepaid expenses and other........................................ 140,991 453,247 383,369
------------- ------------- -------------
Total current assets............................................ 3,678,986 4,928,518 4,215,859
Property and equipment, net (Note 6)................................ 1,369,576 1,947,234 2,038,308
Intangible assets, net (Note 7)..................................... 5,367,809 6,158,354 6,012,110
Other assets........................................................ 170,791 162,067 262,376
------------- ------------- -------------
Total assets.................................................... $ 10,587,162 $ 13,196,173 $ 12,528,653
------------- ------------- -------------
------------- ------------- -------------
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Trade accounts payable............................................ $ 3,407,351 $ 5,628,664 $ 8,121,197
Other accrued liabilities......................................... 220,834 330,640 374,178
Notes and accounts payable to related parties, net (Note 12)...... 1,143,650 896,470 3,634,333
Current maturities of long-term obligations (Note 8).............. 559,596 689,712 1,306,825
Accrued taxes, other than income taxes............................ 388,881 567,352 634,242
------------- ------------- -------------
Total current liabilities....................................... 5,720,312 8,112,838 14,070,775
------------- ------------- -------------
Long-term obligations (Note 8)...................................... 436,700 1,309,792 1,043,803
Long-term obligations to related parties, net (Note 12)............. 1,624,586 684,990 --
Commitments and contingencies (Note 13)
Shareholders' equity (deficit):
Common stock, $.01 par value, 100,000,000 shares authorized;
5,250,340, 6,378,442, and 6,808,594 issued at April 30, 1996 and
1997, and December 31, 1997, respectively (Notes 2 and 9)....... 52,503 63,784 68,086
Additional paid-in capital........................................ 9,913,694 11,863,723 12,617,072
Retained deficit.................................................. (7,160,633) (8,838,954) (15,271,083)
------------- ------------- -------------
Total shareholders' equity (deficit)............................ 2,805,564 3,088,553 (2,585,925)
------------- ------------- -------------
Total liabilities and shareholders' equity (deficit)............ $ 10,587,162 $ 13,196,173 $ 12,528,653
------------- ------------- -------------
------------- ------------- -------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-60
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
FOR THE
EIGHT MONTHS
FOR THE YEARS ENDED APRIL 30, ENDED
------------------------------------------- DECEMBER 31,
1995 1996 1997 1997
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
Telecommunications revenues.......................... $ 2,338,467 $ 8,026,587 $ 24,012,368 $ 21,078,166
Operating expenses:
Costs of services.................................. 1,917,734 6,029,796 18,455,095 16,888,577
Selling, general and administrative................ 1,941,624 2,675,265 5,154,901 6,161,937
Provision for doubtful accounts.................... 74,662 228,827 693,164 3,144,128
Depreciation and amortization...................... 273,053 583,530 900,545 698,106
------------- ------------- ------------- -------------
Total operating expenses......................... 4,207,073 9,517,418 25,203,705 26,892,748
------------- ------------- ------------- -------------
Loss from operations before other expenses........... (1,868,606) (1,490,831) (1,191,337) (5,814,582)
Other expenses:
Interest expense, net.............................. (85,431) (107,474) (634,103) (617,547)
Loss on sale of assets............................. (118,680) -- -- --
Loss on impairment of assets....................... -- (63,997) -- --
------------- ------------- ------------- -------------
Total other expenses............................. (204,111) (171,471) (634,103) (617,547)
------------- ------------- ------------- -------------
Loss before income tax benefit and extraordinary
gain............................................... (2,072,717) (1,662,302) (1,825,440) (6,432,129)
------------- ------------- ------------- -------------
Income tax benefit (Note 10)......................... -- -- 50,000 --
------------- ------------- ------------- -------------
Loss before extraordinary gain....................... (2,072,717) (1,662,302) (1,775,440) (6,432,129)
------------- ------------- ------------- -------------
Extraordinary gain on debt restructuring (net of
income taxes of $50,000)........................... -- -- 97,119 --
------------- ------------- ------------- -------------
Net loss............................................. $ (2,072,717) $ (1,662,302) $ (1,678,321) $ (6,432,129)
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
Loss per weighted average common shares outstanding
(basic and diluted):
Loss before extraordinary gain on debt
restructuring.................................... $ (0.92) $ (0.45) $ (0.33) $ (0.98)
Extraordinary gain................................. -- -- 0.02 --
------------- ------------- ------------- -------------
Net loss per share................................. $ (0.92) $ (0.45) $ (0.31) $ (0.98)
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
Weighted average number of common shares
outstanding (basic and diluted).................. 2,252,953 3,706,993 5,359,156 6,546,499
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-61
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT)
<TABLE>
<CAPTION>
FOR THE YEARS ENDED APRIL 30, 1995, 1996 AND 1997
AND FOR THE EIGHT MONTHS ENDED DECEMBER 31, 1997
----------------------------------------------------------
COMMON STOCK ADDITIONAL
------------------ PAID-IN RETAINED
SHARES AMOUNT CAPITAL DEFICIT TOTAL
--------- ------- ----------- ------------ -----------
<S> <C> <C> <C> <C> <C>
Balance at April 30, 1994............... 1,854,002 $ -- $ 4,074,620 $ (3,425,614) $ 649,006
Net loss................................ -- -- -- (2,072,717) (2,072,717)
Issuance of common stock for:
Private placements.................... 1,205,625 -- 2,015,722 -- 2,015,722
Exercise of warrants.................. 43,405 -- 167,113 -- 167,113
Acquisition of DNI.................... 250,000 -- 407,006 -- 407,006
Consideration for finder's fees....... 1,984 -- -- -- --
Issuance costs.......................... -- -- (49,915) -- (49,915)
--------- ------- ----------- ------------ -----------
Balance at April 30, 1995............... 3,355,016 -- 6,614,546 (5,498,331) 1,116,215
--------- ------- ----------- ------------ -----------
Net loss................................ -- -- -- (1,662,302) (1,662,302)
Increase in par value to $.01/share..... -- 33,550 (33,550) -- --
Issuance of common stock for:
Private placements.................... 1,444,432 14,444 2,674,593 -- 2,689,037
Exercise of warrants.................. 450,892 4,509 714,644 -- 719,153
Compensation expense.................... -- -- 47,000 -- 47,000
Issuance costs.......................... -- -- (103,539) -- (103,539)
--------- ------- ----------- ------------ -----------
Balance at April 30, 1996............... 5,250,340 52,503 9,913,694 (7,160,633) 2,805,564
--------- ------- ----------- ------------ -----------
Net loss................................ -- -- -- (1,678,321) (1,678,321)
Issuance of common stock for:
Private placements.................... 722,250 7,222 1,143,272 -- 1,150,494
Exercise of warrants.................. 155,852 1,559 264,259 -- 265,818
Conversion of 11% debentures.......... 250,000 2,500 497,498 -- 499,998
Compensation expense.................... -- -- 45,000 -- 45,000
--------- ------- ----------- ------------ -----------
Balance at April 30, 1997............... 6,378,442 63,784 11,863,723 (8,838,954) $ 3,088,553
--------- ------- ----------- ------------ -----------
Net loss................................ -- -- -- (6,432,129) (6,432,129)
Issuance of common stock for:
Private placements.................... 337,152 3,372 586,644 -- 590,016
Exercise of warrants.................. 68,000 680 117,955 -- 118,635
Exercise of stock options............. 25,000 250 48,750 -- 49,000
--------- ------- ----------- ------------ -----------
Balance at December 31, 1997............ 6,808,594 $68,086 $12,617,072 $(15,271,083) $(2,585,925)
--------- ------- ----------- ------------ -----------
--------- ------- ----------- ------------ -----------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-62
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
FOR THE EIGHT
MONTHS
FOR THE YEARS ENDED APRIL 30, ENDED
------------------------------------------- DECEMBER 31,
1995 1996 1997 1997
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
Cash flows from operating activities:
Net loss............................................ $ (2,072,717) $ (1,662,302) $ (1,678,321) $ (6,432,129)
Adjustments to reconcile net loss to net cash used
by operating activities:
Depreciation and amortization..................... 276,026 583,530 900,545 698,106
Gain on debt restructuring........................ -- -- (147,119) --
Loss on disposal of assets........................ 118,680 -- -- --
Loss on impairment................................ -- 63,997 -- --
Compensation recognized for stock options......... -- 47,000 45,000 --
Interest amortization of notes discount........... -- -- 263,307 137,468
Proceeds from factoring of trade receivables,
net............................................. -- -- 3,562,230 2,091,772
Other............................................. (14,914) (3,494) 7,990 --
(Increase) decrease, net of effect of acquisition:
Unfactored accounts and notes receivable........ (203,307) 179,016 (3,750,778) (2,015,660)
Prepaid expenses and other assets............... 47,751 152,385 (631,734) 27,529
Increase (decrease), net of effect of acquisition:
Accounts and notes payable and accrued
expenses...................................... 29,143 (705,416) 1,666,637 3,146,311
------------- ------------- ------------- -------------
Net cash used in operating activities......... (1,819,338) (1,345,284) 237,757 (2,346,603)
------------- ------------- ------------- -------------
Cash flows from investing activities:
Additions to property and equipment................. (193,745) (186,439) (673,714) (472,802)
Purchase of CTN, net of cash acquired............... -- -- (350,000) --
Purchase of AMS, net of cash acquired............... -- (542,980) -- --
Purchase of DNI, net of cash acquired............... (200,000) -- -- --
Sale of assets...................................... 150,000 -- -- --
Receipts on notes................................... 5,128 71,375 75,752 52,717
------------- ------------- ------------- -------------
Net cash used in investing activities......... (238,617) (658,044) (947,962) (420,085)
------------- ------------- ------------- -------------
Cash flows from financing activities:
Proceeds from issuance of common stock.............. 2,132,920 3,236,725 1,350,309 757,652
Proceeds from short-term loan....................... -- -- -- 2,500,000
Principal payments on obligations................... (303,080) (280,825) (1,157,387) (1,002,013)
Advances from shareholders.......................... 233,329 -- -- --
------------- ------------- ------------- -------------
Net cash provided by financing activities..... 2,063,169 2,955,900 192,922 2,255,639
------------- ------------- ------------- -------------
Increase (decrease) in cash and cash equivalents...... 5,214 952,572 (517,283) (511,049)
Cash and cash equivalents at beginning of period...... 115,863 121,077 1,073,649 556,366
------------- ------------- ------------- -------------
Cash and cash equivalents at end of period............ $ 121,077 $ 1,073,649 $ 556,366 $ 45,317
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
Supplemental disclosure of cash flow information:
Interest paid....................................... $ 93,105 $ 113,815 $ 719,758 $ 581,252
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-63
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) DESCRIPTION OF BUSINESS
United Digital Network, Inc. (the "Company"), formerly Unidex Communications
Corp., was incorporated in 1980 under the British Columbia Company Act in
British Columbia, Canada, and its shares are publicly traded on the Vancouver
Stock Exchange. In April 1995, the Company's continuance was authorized to the
jurisdiction of Wyoming under the Wyoming Business Corporation Act from the
Registrar of Companies for the Province of British Columbia. The Company then
merged with a wholly-owned subsidiary domiciled in the state of Delaware,
thereafter becoming a Delaware Corporation. The Company operates through its
principal subsidiaries, United Digital Network of Texas, Inc. (UDN), Advanced
Management Services, Inc. (AMS) and CTN-Custom Telecommunications Network of
Arizona, Inc. (CTN). In September 1997, the Company formed UDN with the merger
of Answer-Net, Inc. (ANI) and Digital Network, Inc. (DNI).
The Company's principal business activity is providing basic long distance
services, travelcard services, prepaid calling card services, and various other
telecommunication services to residential and small to medium sized commercial
customers. The majority of the Company's customers are located in the states of
Texas, Oklahoma, Arizona, New Mexico and California, as well as customers
located nationwide in the motor freight industry.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
FISCAL YEAR
Effective January 1, 1998, the Company changed its fiscal year ended April
30 to a fiscal year ended December 31.
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries UDN, AMS and CTN. The financial statements and
related footnotes are presented in U.S. dollars, unless otherwise indicated, and
all significant intercompany accounts and transactions are eliminated in
consolidation. Certain previously reported amounts have been reclassified to
conform to the current year presentation.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents represent cash and short-term, highly liquid
investments with original maturities three months or less.
FINANCIAL INSTRUMENTS
The fair market value of financial instruments is determined by reference to
various market data and other valuation techniques as appropriate. The Company
believes that the fair values of financial instruments approximate their
recorded values.
F-64
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BUSINESS AND CREDIT CONCENTRATIONS
In the normal course of business, the Company extends unsecured credit to
its customers. Management has provided an allowance for doubtful accounts to
provide for amounts which may eventually become uncollectible and to provide for
any disputed charges.
REVENUE RECOGNITION
The Company recognizes revenue from its direct dial, prepaid calling card,
and travel card long distance services as such services are performed.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Depreciation for financial
statement purposes, which includes amortization of assets under capital leases,
is provided utilizing the straight-line method over the estimated useful lives
of the depreciable assets or the lease terms.
Expenditures for major renewals and betterments, which significantly extend
the useful lives of existing property and equipment, are capitalized and
depreciated. Upon retirement or disposition of property and equipment, the cost
and related accumulated depreciation are removed from the accounts and any
resulting gain or loss is recognized in income. Expenditures for repair and
maintenance are charged to expense as incurred.
In March 1995, the FASB issued Statement of Financial Accounting Standards
No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of" ("SFAS 121"), which requires that an entity review
long-lived assets for impairment, and any impairment loss for assets to be held
and used shall be reported as a component of income from continuing operations
before income taxes. The impairment loss recognized shall be measured as the
amount by which the carrying amount of the asset exceeds the fair value of the
asset.
In November 1995, the Company adopted SFAS 121. The application of SFAS 121
resulted in a charge to income for the 1996 fiscal year and a decrease in the
value of two long-lived assets.
FOREIGN CURRENCY TRANSACTIONS
Foreign currency transaction gains and losses are included in determining
net income and are not significant.
INTANGIBLE ASSETS
Intangible assets consist of the acquired cost of goodwill and customer
lists. These intangibles are amortized utilizing the straight-line method over
their estimated useful lives. The realizability of goodwill and customer lists
is evaluated periodically as events or circumstances indicate a possible
inability to recover their carrying amount. Such evaluation is based on various
analyses, including cash flow and profitability projections that incorporate, as
applicable, the impact on existing company businesses. The analyses necessarily
involve significant management judgment to evaluate the capacity of an acquired
business to perform within projections. Historically, the Company has generated
sufficient returns from acquired businesses to recover the cost of their
intangible assets.
F-65
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires the Company to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent liabilities at the date of the financial statements and
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.
SHAREHOLDERS' EQUITY (DEFICIT)
Loss per share is computed by dividing the net loss by the weighted average
number of shares of common stock outstanding during the periods. The effect of
outstanding options and warrants on the computation of net loss per share is
antidilutive and, therefore, is not included in the computation for the years
ended April 30, 1995, 1996 and 1997 and for the eight months ended December 31,
1997.
On June 5, 1996, the Company's board of directors declared a four-for-one
reverse common stock split. As a result, effective August 9, 1996, all of the
Company's 50,000,000 shares of common stock, both issued and unissued, were
consolidated into 12,500,000 shares. The Company's par value of $.01 per share
remained unchanged. All share and per share amounts appearing in the
consolidated financial statements and notes thereto have been retroactively
adjusted for the stock split.
On June 5, 1996, the Company's board of directors also approved an increase
in the authorized shares of the Company from 12,500,000 to 100,000,000 shares
effective August 9, 1996. Concurrent with this change, the Company's name was
changed to United Digital Network, Inc.
INCOME TAXES
Deferred income taxes are calculated utilizing an asset and liability
approach, whereby deferred taxes are provided for tax effects of basis
differences for assets and liabilities arising from differing treatments for
financial and income tax reporting purposes. Valuation allowances against
deferred tax assets are provided where appropriate.
NEW ACCOUNTING STANDARDS
In February 1997, the FASB issued Financial Statement of Accounting
Standards No. 128, "Earnings per Share" ("SFAS 128"). SFAS 128 specifies the
computation, presentation and disclosure requirements for earnings per share
("EPS") for entities with publicly held common stock or potential common stock.
Effective January 1, 1998, Company adopted SFAS 128 and has restated all prior
period EPS amounts pursuant to SFAS 128. SFAS 128 simplifies the standards for
computing EPS previously found in Accounting Principles Board Opinion No. 15,
"Earnings per Share" and makes them comparable to international EPS standards.
It replaces the presentation of primary EPS with a presentation of basic EPS. It
also requires dual presentation of basic and diluted EPS on the face of the
statement of operations for all entities with complex capital structures and
requires a reconciliation of the numerator and denominator of the basic EPS
computation to the numerator and denominator of the diluted EPS computation.
Basic EPS excludes the effect of potentially dilutive securities while
diluted EPS reflects the potential dilution that would occur if securities or
other contracts to issue common stock were exercised, converted
F-66
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
into or resulted in the issuance of common stock. Common stock equivalents
consist of common stock issuable under the assumed exercise of stock options and
warrants, computed based on the treasury stock method and the assumed conversion
of the Company's issued and outstanding preferred stock. Common stock
equivalents are not included in diluted EPS calculations to the extent their
inclusion would have an anti-dilutive effect.
In June 1997, the FASB issued Financial Statement of Accounting Standards
No. 130, "Reporting Comprehensive Income." This statement establishes standards
for reporting and display of comprehensive income and its components (revenues,
expenses, gains and losses) in a full set of general-purpose financial
statements.
This statement is effective for fiscal years beginning after December 15,
1997. The Company believes that the adoption of this standard will not have a
material effect on the Company's consolidated results of operations or financial
position.
On June 15, 1998, FASB issued Statement of Financial Accounting Standards
No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS
133"). SFAS 133 is effective for all fiscal quarters of all fiscal years
beginning after June 15, 1999. SFAS 133 requires that all derivative instruments
be recorded on the balance sheet at their fair value. Changes in the fair value
of derivatives are recorded each period in current earnings or other
comprehensive income, depending on whether a derivative is designated as part of
a hedge transaction and, if it is, the type of hedge transaction. Management of
the Company anticipates that, due to its limited use of derivative instruments,
the adoption of SFAS 133 will not have a significant effect on the Company's
results of operations or its financial position.
(3) ACQUISITIONS
DIGITAL NETWORK, INC.
Effective April 27, 1995, the Company acquired all of the outstanding shares
of Digital Network, Inc. (DNI). DNI provides telecommunication services to
customers in Texas and southern Oklahoma.
The acquisition was accounted for using the purchase method of accounting,
and accordingly, the purchase price was allocated to the assets purchased and
the liabilities assumed based upon fair values at the date of acquisition. The
excess of the purchase price over the fair values of the net assets acquired was
$679,241, and was reflected as goodwill.
A summary of the DNI excess of cost over the net assets acquired is as
follows:
<TABLE>
<S> <C>
Assets, including identified intangible
assets of $360,000.................... $ 1,331,363
Property and equipment.................. 1,261,674
Current liabilities..................... (1,906,894)
Long-term debt, net..................... (537,719)
--------------
Net assets acquired..................... 148,424
Goodwill................................ 679,241
--------------
Purchase price.......................... $ 827,665
--------------
--------------
</TABLE>
F-67
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(3) ACQUISITIONS (CONTINUED)
ADVANCED MANAGEMENT SERVICES, INC.
Effective March 26, 1996, the Company acquired all of the outstanding common
stock of AMS, a long distance carrier based in Phoenix, Arizona. The acquisition
was accomplished through the payment of $1,100,000 in cash and the issuance of a
series of convertible debentures and a note payable totaling $2,381,947, net of
discount. The Company has recorded adjustments to the purchase price and
reductions to the notes and debentures payable to the sellers based on
management's best estimate of allowable adjustments defined in the stock
purchase agreement.
The present value of the notes and debentures was imputed using an interest
rate of 11%. Future payments are contingent upon, and may be reduced, if various
revenue and equity targets through March 1998 as outlined in the purchase
agreement are not met.
The acquisition was accounted for using the purchase method of accounting,
and accordingly, the purchase price was allocated to the assets purchased and
the liabilities assumed based upon fair values at the date of acquisition. The
excess of the purchase price over the fair values of the net liabilities
acquired was $3,541,050 and was reflected as goodwill.
A summary of the AMS excess of cost over net liabilities acquired is as
follows:
<TABLE>
<S> <C>
Assets, including identified intangible
assets of $820,000.................... $ 2,994,730
Property and equipment.................. 24,295
Liabilities............................. (3,078,128)
--------------
Net liabilities acquired................ (59,103)
Goodwill................................ 3,541,050
--------------
Purchase price.......................... $ 3,481,947
--------------
--------------
</TABLE>
The Company's consolidated statement of operations includes the results of
operations of AMS since March 26, 1996.
CTN-CUSTOM TELECOMMUNICATIONS NETWORK OF ARIZONA, INC.
Effective January 1, 1997, the Company acquired all of the outstanding
common stock of CTN, a long distance carrier based in Phoenix, Arizona. The
acquisition was accomplished through the payment of $350,000 in cash and the
issuance of a convertible debenture and a note payable totaling $1,050,000,
accumulating interest at 7% per annum.
Future payments are contingent upon, and may be reduced, if various revenue
targets through November 1997, as outlined in the purchase agreement, are not
met.
The acquisition was accounted for using the purchase method of accounting,
and accordingly, the purchase price was allocated to the assets purchased and
the liabilities assumed based upon fair values at the date of acquisition. The
excess of the purchase price over the fair values of the net assets acquired was
F-68
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(3) ACQUISITIONS (CONTINUED)
$975,956 and was reflected as goodwill. A summary of the CTN excess of cost over
net assets acquired is as follows:
<TABLE>
<S> <C>
Assets, including identified intangible
assets of $290,000.................... $ 1,298,495
Property and equipment.................. 18,369
Liabilities............................. (842,950)
--------------
Net assets acquired..................... 473,914
Goodwill................................ 975,956
--------------
Purchase price.......................... $ 1,449,870
--------------
--------------
</TABLE>
The Company's consolidated statement of operations includes the results of
operations of CTN since January 1, 1997.
The following unaudited pro forma combined results of operations for the
Company assume that the acquisition of CTN was completed at May 1, 1995, the
acquisition of AMS was completed at May 1, 1994 and the acquisition of DNI was
completed at May 1, 1993. These pro forma amounts represent the historical
operating results of DNI combined with those of the Company with appropriate
adjustments which give effect to interest expense and amortization. These pro
forma amounts are not necessarily indicative of consolidated operating results
which would have occurred had AMS and DNI been included in the operations of the
Company during the periods presented, or which may result in the future, because
these amounts do not reflect full transmission and switched service cost
optimization, and the synergistic effect on operating, selling, and general and
administrative expenses.
<TABLE>
<CAPTION>
FOR THE YEARS ENDED APRIL 30,
-------------------------------------------
<S> <C> <C> <C>
1995 1996 1997
------------- ------------- -------------
Revenues.................................................. $ 17,429,712 $ 21,647,023 $ 26,966,853
Net loss.................................................. (3,190,433) (2,722,749) (2,104,696)
Net loss per share outstanding (basic and diluted)........ (1.42) (.73) (.39)
</TABLE>
(4) NONCASH INVESTING AND FINANCING ACTIVITIES
During the year ended April 30, 1996, the Company purchased all of the
capital stock of AMS for $1,100,000 in cash and the issuance of a series of
convertible debentures and a note payable totaling $2,381,947. During the year
ended April 30, 1995, the Company purchased all of the capital stock of DNI for
$200,000 in cash and the issuance of a $200,000 note payable and the issuance of
250,000 shares of common stock at $1.628 a share. Additionally, during fiscal
1995, the Company sold net assets with a carrying value of $578,876 in exchange
for $150,000 cash and a $295,000 note receivable.
The Company recorded capital lease obligations of $87,465, $19,949,
$489,802, and $225,108 during the years ended April 30, 1995, 1996 and 1997, and
the eight months ended December 31, 1997, respectively.
During the year ended April 30, 1996, accounts payable to shareholders of
$17,926 and notes payable of $50,000 were relieved through the exercise of
warrants.
F-69
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(4) NONCASH INVESTING AND FINANCING ACTIVITIES (CONTINUED)
During the year ended April 30, 1997, an accrued liability of $66,000 was
relieved through the issuance of common stock.
During the year ended April 30, 1997 the Company purchased all of the
capital stock of CTN for $350,000 in cash and the issuance of a convertible
debenture and a note payable totaling $1,050,000.
(5) ACCOUNTS AND NOTES RECEIVABLE
Accounts and notes receivable consist of the following:
<TABLE>
<CAPTION>
FOR THE EIGHT
FOR THE YEARS ENDED APRIL MONTHS
30, ENDED
--------------------------- DECEMBER 31,
1996 1997 1997
------------ ------------- -------------
<S> <C> <C> <C>
Trade receivables:
Billed.................................................... $ 1,262,617 $ 3,420,941 $ 6,018,752
Unbilled.................................................. 1,337,640 3,213,712 1,613,583
Receivable from Freshstart Communications................... -- 614,858 430,608
Credit reserve due from factor.............................. -- 330,695 293,297
Other....................................................... 74,790 332,468 117,448
------------ ------------- -------------
Total notes and unfactored accounts receivable.............. 2,675,047 7,912,674 8,473,688
Total receivables assigned to factor........................ -- (3,562,230) (2,079,193)
------------ ------------- -------------
Total notes and accounts receivables........................ 2,675,047 4,350,444 6,394,495
Allowance for doubtful accounts............................. (222,711) (431,539) (2,607,322)
------------ ------------- -------------
Total accounts and notes receivable, net.................... $ 2,452,336 $ 3,918,905 $ 3,787,173
------------ ------------- -------------
------------ ------------- -------------
</TABLE>
The Company's monthly billing cycle is such that certain services performed
in the last month of one fiscal year will not be billed until the first month of
the subsequent fiscal year. These services are recognized as revenue and
recorded as unbilled receivables when earned.
In May 1996, the Company entered into a receivables purchase facility with
Receivables Funding Corporation (RFC). Under this facility, the Company
transfers receivables with recourse to RFC subject to the conditions of the
facility. The transfers are recorded in the period in which they occur. DNI and
AMS began transferring approximately 90% of eligible receivables to RFC
beginning in July and September, 1996, respectively.
In June 1996, the FASB issued Statement of Financial Accounting Standards
No. 125, "Accounting for Transfer and Servicing of Financial Assets and
Extinguishment of Liabilities" ("SFAS 125"). SFAS 125 requires that a transfer
of financial assets be accounted for as either a sale of these assets or as a
secured borrowing with a pledge of collateral. There are certain criteria which
must be met to classify the transfer as a sale. The Company adopted SFAS 125 for
the 1997 fiscal year. Under the provisions of SFAS 125, the Company's transfers
of receivables to RFC meet the criteria for classification as sales.
In the eight month period ended December 31, 1997, the Company received
$16,058,301 in proceeds from the factoring of trade receivables.
F-70
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(5) ACCOUNTS AND NOTES RECEIVABLE (CONTINUED)
During the eight months ended December 31, 1997, bad debt expense of $3.0
million was recorded by the Company. Included in this amount was the write-off
of receivables from two major wholesale customers as a result of the customers'
bankruptcies and the write-off of a $1.3 million receivable resulting from
customer fraud.
(6) PROPERTY AND EQUIPMENT
Property and equipment consist of:
<TABLE>
<CAPTION>
APRIL 30,
---------------------------- DECEMBER 31,
1996 1997 1997 LIFE
------------- ------------- ------------- ----------
<S> <C> <C> <C> <C>
Communications equipment...................... $ 3,281,643 $ 4,153,300 $ 4,353,018 2-8 years
Office equipment.............................. 321,250 569,705 790,897 5 years
Leasehold improvements........................ 20,053 43,894 56,988 5 years
------------- ------------- -------------
3,622,946 4,766,899 5,200,903
Accumulated depreciation...................... (2,253,370) (2,819,665) (3,162,595)
------------- ------------- -------------
Total property and equipment, net............. $ 1,369,576 $ 1,947,234 $ 2,038,308
------------- ------------- -------------
------------- ------------- -------------
</TABLE>
Total depreciation expense, including amortization of equipment under
capital leases, charged to operations for the years ended April 30, 1995, 1996
and 1997 and for the eight months ended December 31, 1997, was $245,768,
$436,688, $498,701, and $401,750 respectively.
(7) INTANGIBLE ASSETS
Intangible assets consist of:
<TABLE>
<CAPTION>
APRIL 30,
-------------------------- DECEMBER 31,
1996 1997 1997 LIFE
------------ ------------ ------------ ---------
<S> <C> <C> <C> <C>
Goodwill......................................... $ 4,193,143 $ 5,094,387 $5,244,497 25 years
Customer lists................................... 1,316,832 1,606,832 1,579,307 7 years
------------ ------------ ------------
5,509,975 6,701,219 6,823,804
Accumulated amortization......................... (142,166) (542,865) (811,694)
------------ ------------ ------------
Total intangible assets, net..................... $ 5,367,809 $ 6,158,354 $6,012,110
------------ ------------ ------------
------------ ------------ ------------
</TABLE>
Additions to goodwill and customer lists were recorded during fiscal years
1995, 1996 and 1997 as a result of the Company's acquisitions (Note 3).
F-71
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(8) LONG-TERM OBLIGATIONS
Long-term obligations consist of:
<TABLE>
<CAPTION>
APRIL 30,
----------------------- DECEMBER 31,
1996 1997 1997
---------- ----------- ------------
<S> <C> <C> <C>
Convertible debenture with interest of 7% per annum due January
1999. Amounts contingent on certain factors discussed in Note
3............................................................. $ -- $ 500,000 $ 500,000
Notes payable
Repayable in monthly installment amounts of $24,625 including
interest at 7% per annum, commencing in February 1997, due
January 1999................................................ -- 463,581 307,553
Repayable in monthly installments of $7,395 including interest
at 16.9% per annum. Final payment due November 1998......... -- 116,828 68,520
Repayable to a bank in monthly installments of $2,042
including interest at the Prime Rate plus 2% per annum,
fully retired............................................... 50,117 -- --
Repayable in monthly installment amounts of $3,678 plus
interest at 8%, final payment due June 1995. This note is
currently in default........................................ 41,098 41,098 41,098
Repayable to a bank in monthly installments of $1,825
including interest at the Prime Rate plus 2% per annum,
fully retired............................................... 63,743 -- --
Repayable in monthly installments of $4,894 including interest
at 8%, fully retired........................................ 36,800 -- --
Repayable monthly in amounts of $72,728 plus interest at 9.5%
per annum. Final payment due July 1998...................... -- -- 543,351
Capital lease obligations..................................... 804,538 877,997 890,106
---------- ----------- ------------
Total long-term obligations..................................... 996,296 1,999,504 2,350,628
Less current maturities:
Debt.......................................................... 191,758 387,322 935,911
Capital lease obligations..................................... 367,838 302,390 370,914
---------- ----------- ------------
Long-term portion............................................... $ 436,700 $ 1,309,792 $1,043,803
---------- ----------- ------------
---------- ----------- ------------
</TABLE>
Principal repayments of long-term obligations are due approximately as
follows:
<TABLE>
<CAPTION>
YEARS ENDING
DECEMBER 31,
------------
<S> <C>
1998............................................................................ $1,306,825
1999............................................................................ 903,251
2000............................................................................ 92,585
2001............................................................................ 46,104
2002............................................................................ 1,863
------------
Total long-term obligations..................................................... $2,350,628
------------
------------
</TABLE>
F-72
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(8) LONG-TERM OBLIGATIONS (CONTINUED)
In September 1996, the Company recorded an extraordinary gain of $68,258
from the restructuring of a capital lease to a note payable.
In February 1997, the Company recorded an extraordinary gain of $78,861 from
the full settlement of two notes payable.
(9) STOCK OPTIONS, WARRANTS, AND OTHER ACCOUNTING FOR STOCK-BASED COMPENSATION
In October 1995, Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-based Compensation" ("SFAS 123"), was issued by the
Financial Accounting Standards Board. The statement requires the fair value of
stock options and other stock-based compensation issued to employees to either
be included as compensation expense in the income statements of companies or the
pro forma effect on net income and earnings per share of such compensation
expense to be disclosed in the footnotes to the Company's financial statements
beginning in 1996. The Company has elected to adopt SFAS 123 on a disclosure
basis only. Accordingly, the Company does not recognize compensation cost for
options issued except for option grants with exercise prices below the fair
value of the stock on the date of grant. Had compensation cost for the Company's
stock option issuances been determined based on the fair market value at the
grant dates for awards consistent with the method provided by SFAS 123, the
Company's net loss and net loss per share would have been reflected by the
following pro forma amounts for the years ended April 30, 1995, 1996, and 1997
and for the eight months ended December 31, 1997.
<TABLE>
<CAPTION>
EIGHT
MONTHS
YEARS ENDED APRIL 30, ENDED
------------------------------------------- DECEMBER 31,
1995 1996 1997 1997
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
Net loss:
As reported............................... $ (2,072,717) $ (1,662,302) $ (1,678,321) $ (6,432,129)
Pro forma................................. $ (2,113,190) $ (2,150,441) $ (1,983,310) $ (6,520,477)
Net loss per share (basic and diluted)
As reported............................... $ (.92) $ (.45) $ (.31) $ (.98)
Pro forma................................. $ (.94) $ (.58) $ (.37) $ (1.00)
</TABLE>
The fair value of each grant is estimated on the date of grant using the
Black-Scholes Option Pricing Model with the following weighted-average
assumptions used for grants during the years ended April 30, 1995, 1996 and 1997
and for the eight months ended December 31, 1997.
<TABLE>
<CAPTION>
EIGHT
MONTHS
YEARS ENDED APRIL 30, ENDED
---------------------------------- DECEMBER 31,
1995 1996 1997 1997
---------- ---------- ---------- ------------
<S> <C> <C> <C> <C>
Dividend yield...................................... -- -- -- --
Expected volatility................................. 55.00% 53.54% 48.45% 50.00%
Risk free rate of return............................ 7.60% 5.91% 6.22% 6.23%
Expected life....................................... 2.5 years 3.5 years 3.5 years 3.5 years
</TABLE>
F-73
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(9) STOCK OPTIONS, WARRANTS, AND OTHER ACCOUNTING FOR STOCK-BASED COMPENSATION
(CONTINUED)
The Company has periodically granted nonqualified stock options to officers,
directors and key employees during the years ended April 30, 1995, 1996, and
1997 and for the eight months ended December 31, 1997. These options are subject
to varying vesting terms, the maximum of which is two years and expire after
various periods after the date of grant, the maximum of which is five years.
During the years ended April 30, 1996 and 1997, respectively, the Company
recorded compensation expense and an increase in additional paid-in-capital in
the amount of $47,000 and $45,000, respectively, for options granted to
outsiders. Vesting of these options is subject to the achievement of certain
performance targets. Outstanding stock options to officers, directors, key
employees, and others entitle the holders to purchase 403,000, 386,875, 438,125,
and 560,517 common shares at April 30, 1995, 1996, and 1997 and December 31,
1997, respectively. The weighted average exercise prices of these options are
$1.02, $2.79, $2.65, and $2.61 (Canadian), respectively.
Additional information regarding options granted and outstanding is
summarized below:
<TABLE>
<CAPTION>
WEIGHTED AVERAGE WEIGHTED AVERAGE
OPTION PRICE FAIR VALUE
SHARES (CANADIAN) (CANADIAN)
---------- ----------------- -----------------
<S> <C> <C> <C>
Outstanding at April 30, 1994........................... 153,250 $ 4.49
Granted............................................... 61,250 $ 2.73 $ 0.81
Canceled/Expired...................................... (71,250) $ 3.68
----------
Outstanding at April 30, 1995........................... 143,250 $ 4.14
Granted............................................... 386,250 $ 2.74 $ 1.26
Canceled/Expired...................................... (118,250) $ 4.34
----------
Outstanding at April 30, 1996........................... 411,250 $ 2.77
Granted............................................... 296,250 $ 2.49 $ 1.03
Canceled/Expired...................................... (101,875) $ 2.75
----------
Outstanding at April 30, 1997........................... 605,625 $ 2.64
Granted............................................... 76,250 $ 2.50 1.16
Canceled/Expired...................................... (25,000) $ 2.28
Exercised............................................. (25,000) $ 2.80
----------
Outstanding at December 31, 1997........................ 631,875 $ 2.59
</TABLE>
The following table summarizes information about the fixed-price stock
options outstanding at December 31, 1997.
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------------ ------------------------------
<C> <C> <S> <C> <C> <C>
RANGE OF WEIGHTED-AVERAGE WEIGHTED-AVERAGE SHARES WEIGHTED-AVERAGE
EXERCISE SHARES REMAINING EXERCISE EXERCISABLE EXERCISE
PRICES OUTSTANDING CONTRACTUAL PRICE AT PRICE
(CANADIAN) AT 12/31/97 LIFE (CANADIAN) 12/31/97 (CANADIAN)
- ------------- ----------- ---------------- ----------------- ----------- -----------------
$ 2.22-$2.92 631,875 3.08 years $ 2.59 560,517 $ 2.61
</TABLE>
F-74
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(9) STOCK OPTIONS, WARRANTS, AND OTHER ACCOUNTING FOR STOCK-BASED COMPENSATION
(CONTINUED)
WARRANTS
The Company issued warrants attached to certain shares issued for cash
entitling the holders to purchase an additional 1,205,625, 797,216, 361,125 and
112,394 common shares during the years ended April 30, 1995, 1996 and 1997 and
at December 31, 1997, respectively. Total outstanding warrants entitle the
holders to purchase up to 1,475,792, 1,551,949, 1,757,222 and 1,767,941 shares
as of April 30, 1995, 1996 and 1997 and as of December 31, 1997, respectively,
at prices ranging from $2.00 to $6.00, $2.00 to $4.40, $2.22 to $4.00 and $2.22
to $4.00 (Canadian) per share are exercisable at any time, and expire on various
dates through October 1999.
Pursuant to an agreement, the Company issued additional warrants to certain
warrant holders entitling them to purchase an additional 647,216 common shares
as the Company did not file with various securities regulatory authorities as
defined in the agreement by December 22, 1996. The additional warrants issued
expired in March 1998.
ESCROW SHARES
The Company issued 187,500 common shares to certain shareholders subject to
an escrow agreement dated May 19, 1988 and amended October 21, 1993, concurrent
with its initial public offering on the Vancouver Stock Exchange.
Under the terms of the escrow agreement, shares are to be released from
escrow on the basis of one share for each $1.52 (Canadian) of cumulative cash
flow, as defined by the agreement. Any shares released from escrow and issued to
employees will be treated as compensation. No shares had been released as of
December 31, 1997. In December 1998, any shares not released from escrow will be
canceled.
(10) INCOME TAXES
The components of the deferred taxes were as follows:
<TABLE>
<CAPTION>
APRIL 30,
---------------------------- DECEMBER 31,
1996 1997 1997
------------- ------------- -------------
<S> <C> <C> <C>
Deferred tax assets:
Allowance for doubtful accounts.......................... $ 76,000 $ 158,057 $ 886,489
Depreciation............................................. 23,000 92,943 63,338
Net operating loss carryforwards......................... 1,669,000 1,933,553 3,318,301
------------- ------------- -------------
Gross deferred tax asset................................. 1,768,000 2,184,553 4,268,128
Deferred tax liability:
Basis difference arising from purchase accounting........ 279,000 416,433 368,833
------------- ------------- -------------
Gross deferred tax liability............................. 279,000 416,433 368,833
------------- ------------- -------------
Valuation allowance........................................ (1,489,000) (1,768,120) (3,899,295)
------------- ------------- -------------
Net deferred tax asset..................................... $ -- $ -- $ --
------------- ------------- -------------
------------- ------------- -------------
</TABLE>
F-75
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(10) INCOME TAXES (CONTINUED)
The following is a reconciliation of the provision for income taxes at the
U.S. federal income tax rate to the income taxes reflected in the consolidated
statements of operations:
<TABLE>
<CAPTION>
FOR THE EIGHT
FOR THE YEARS ENDED APRIL 30, MONTHS ENDED
------------------------------------- DECEMBER 31,
1995 1996 1997 1997
----------- ----------- ----------- -------------
<S> <C> <C> <C> <C>
Income tax benefit at federal statutory rate..... $ (705,000) $ (565,000) $ (570,629) $ (2,186,958)
Operating losses not benefited................... 750,000 407,000 264,319 1,321,373
Nondeductible amortization arising from purchase
accounting..................................... -- 57,000 70,693 55,784
Change in valuation reserve and other............ (45,000) 101,000 235,617 809,801
----------- ----------- ----------- -------------
Income tax benefit provided...................... $ -- $ -- $ -- $ --
----------- ----------- ----------- -------------
----------- ----------- ----------- -------------
</TABLE>
The net deferred tax asset is fully reserved because of management's
uncertainty regarding the Company's ability to recognize the benefit of the
asset in future years. A portion of the deferred tax asset at April 30, 1997,
has been recognized as a tax benefit, the result of an extraordinary gain from
debt restructuring. At April 30, 1996 and 1997 and at December 31, 1997, the
Company had net operating loss carryforwards of approximately $4,909,511,
$5,686,922 and $9,759,709, respectively. Utilization of the net operating loss
carryforwards may be limited by the separate return loss year rules and by
ownership changes which have occurred or could occur in the future.
(11) LEASES
The Company leases certain office facilities and equipment under capital
leases and noncancellable operating leases expiring through January 2002. At the
end of the capital lease terms, the Company has the option to purchase the
leased equipment. Minimum annual rentals under these leases are as follows:
<TABLE>
<CAPTION>
CAPITAL OPERATING
YEARS ENDING DECEMBER 31, LEASES LEASES
- ------------------------------------------------------------------------------ ------------ ----------
<S> <C> <C>
1998.......................................................................... $ 445,225 $ 268,954
1999.......................................................................... 426,498 199,449
2000.......................................................................... 107,132 131,307
2001.......................................................................... 49,302 --
2002.......................................................................... 1,956 --
------------ ----------
Total minimum lease payments.................................................. 1,030,113 $ 599,710
----------
----------
Amounts representing interest................................................. (140,007) --
------------
Present value of net minimum lease payments................................... 890,106
Current portion............................................................... (370,914)
------------
Long-term capitalized lease obligations....................................... $ 519,192
------------
------------
</TABLE>
F-76
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(11) LEASES (CONTINUED)
Assets recorded under capital leases are included in property and equipment
as follows:
<TABLE>
<CAPTION>
APRIL 30,
-------------------------- DECEMBER 31,
1996 1997 1997
------------ ------------ ------------
<S> <C> <C> <C>
Communications equipment..................................... $ 948,733 $ 1,322,695 $1,382,314
Office equipment............................................. 64,106 53,432 218,920
------------ ------------ ------------
1,012,839 1,376,127 1,601,234
Accumulated amortization..................................... (202,852) (497,816) (616,497)
------------ ------------ ------------
$ 809,987 $ 878,311 $ 984,737
------------ ------------ ------------
------------ ------------ ------------
</TABLE>
The total rent expense incurred during the years ended April 30, 1995, 1996
and 1997 and for the eight months ended December 31, 1997 was $126,660,
$186,470, $300,662, and $212,206, respectively. In addition to minimum rentals,
one lease provides for the Company to pay contingent rentals based on usage.
Contingent rentals under this lease were not significant in the eight months
ended December 31, 1997.
The Company was in default on certain lease obligations totaling $211,110 at
April 30, 1996 due to nonpayment. The Company successfully restructured the
lease agreement and recorded an extraordinary gain during fiscal 1997.
F-77
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(12) RELATED PARTY TRANSACTIONS
The Company has the following obligations to related parties:
<TABLE>
<CAPTION>
APRIL 30,
------------------------ DECEMBER 31,
1996 1997 1997
----------- ----------- ------------
<S> <C> <C> <C>
Obligations to shareholders:
Convertible debenture with interest imputed at 11% per annum (Amounts
contingent on certain factors discussed in Note 3)
Due February 1997..................................................... $ 838,056 $ -- --
Due December 1997..................................................... 250,000 250,000 --
Due July 1998......................................................... 750,000 750,000 750,000
Notes payable
Repayable in four installments of $250,000 from June 1997 to June
1998, with interest imputed at 11% (Amount contingent on certain
factors discussed in Note 3)........................................ 1,000,000 725,341 439,667
Notes repayable in monthly installment amounts of $9,202 each
including interest at 6% per annum, refinanced in July 1996, due
June 1997........................................................... 200,000 36,532 --
Notes repayable in monthly installment amounts of $3,144 each
including interest at 12% per annum, refinanced in July 1996, due
June 1997........................................................... 150,000 12,388 --
Other................................................................. 36,289 -- --
----------- ----------- ------------
3,224,345 1,774,261 1,189,667
Obligation to STAR Telecommunications, Inc.:
Includes interest at Prime Rate plus 1%, paid quarterly beginning
February 1998, on outstanding principal. Principal repayment terms
contingent upon approval of Merger (Note 14)........................ -- -- 2,500,000
----------- ----------- ------------
-- -- 2,500,000
Less: Discount on convertible debentures and note payable imputed at
11%................................................................... (456,109) (192,801) (55,334)
----------- ----------- ------------
Total notes payable to related parties.................................. 2,768,236 1,581,460 3,634,333
Less current maturities:
Long-term debt, net of discount on convertible debenture imputed at
11% of $80,695, $51,144 and $55,334, respectively................... 1,143,650 896,470 3,634,333
----------- ----------- ------------
$ 1,624,586 $ 684,990 --
----------- ----------- ------------
----------- ----------- ------------
</TABLE>
In March 1996, in order to finance the acquisition of AMS, the Company
issued a series of convertible debentures with scheduled maturities through July
1998. The debentures are convertible at the option of the holder into a maximum
of 875,000 shares of the Company's common stock at a conversion rate of .5
shares for each $1 of outstanding debentures.
In February 1997, the holder of the convertible debentures converted
$500,000 of the outstanding debentures into 250,000 shares of the Company's
common stock.
F-78
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(12) RELATED PARTY TRANSACTIONS (CONTINUED)
In January 1997, as part of the financing of the acquisition of CTN, the
Company issued a convertible debenture with scheduled maturity in January 1999.
This debenture is convertible at the option of the holder into a maximum of
150,000 shares of the Company's common stock at a conversion rate of 3 shares
for each $10 of the outstanding debenture.
The Company is provided executive office space by another company of which a
Company executive is a director.
Interest of $1,587 and $12,706 was paid to directors of the Company for the
years ended April 30, 1996 and 1997, respectively.
(13) COMMITMENTS AND CONTINGENCIES
The Company has entered into various long-term commitments for the purchase
of network usage. Total payments under these agreements were $1,613,863,
$8,801,941 and $7,555,214 for the years ended April 30, 1996 and 1997 and the
eight months ended December 31, 1997. The aggregate amount of minimum purchases
of network usage under these various agreements are $7,700,000 and $3,000,000
for the years ended December 31, 1998 and 1999, respectively.
The Company is involved in various claims and legal actions arising in the
ordinary course of business. Management believes it is unlikely that the final
outcome of any of the claims or proceedings to which the Company is a party
would have a materially adverse effect on the Company's financial position or
results of operations.
(14) FINANCING OF OPERATIONS
At December 31, 1997, the Company's current liabilities exceeded its current
assets by $9,854,916 and the Company was experiencing losses and cash flow
deficits from operations. The financial stability of the Company depends on its
ability to raise additional capital until operations reach a profitable level.
On November 19, 1997, the Company entered into an Agreement and Plan of
Merger (the "Merger") whereby IIWII Corp., a wholly-owned subsidiary of STAR
Telecommunications, Inc. ("STAR"), will be merged with and into the Company.
Under the terms of amendments to the Merger dated January 30, 1998 and April 6,
1998 (the "Amendments"), UDN's stockholders will receive for each share of UDN
Common Stock a portion of a share (the "Exchange Ratio") of STAR Common Stock
determined by dividing $2.05 by the average closing price of STAR Common Stock
on the Nasdaq National Market for the five trading days prior to the Effective
Time (the "Average Price"), provided that if the Average Price is equal to or
greater than $27.50, the Exchange Ratio shall be determined by using $27.50 as
the Average Price. STAR will also assume all outstanding options, warrants, and
other rights to acquire the Company's stock. The Merger is subject to approval
by the stockholders of both companies and certain other conditions, including
the receipt of an opinion that the Merger may be accounted for as a pooling of
interests. In November 1997, in connection with the changes, STAR and the
Company executed a promissory note in the amount of $2.5 million to fund the
Company's working capital needs.
F-79
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(15) SUBSEQUENT EVENTS
In January 1998, STAR and the Company amended the Merger and executed an
additional promissory note in the amount of $2.0 million to fund the Company's
working capital needs.
In January 1998, the Company entered into an Agreement of Compromise,
Settlement and Release (the "Agreement") related to disputes arising under the
AMS stock purchase agreement dated March 5, 1996. Under the Agreement, the
convertible debenture in the amount of $750,000 due in July 1998 was reduced to
$550,000 as a result of allowable adjustments defined in the stock purchase
agreement.
F-80
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
---------
<S> <C>
Consolidated Financial Statements (Unaudited):
Consolidated Balance Sheet as of September 30, 1998...................................................... F-82
Consolidated Statements of Operations for the nine months ended September 30, 1997 and September 30,
1998................................................................................................... F-83
Consolidated Statement of Shareholders' Deficit as of September 30, 1998................................. F-84
Consolidated Statements of Cash Flows for the nine months ended September 30, 1997 and September 30,
1998................................................................................................... F-85
Notes to Unaudited Consolidated Financial Statements....................................................... F-86
</TABLE>
F-81
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
SEPTEMBER 30,
1998
--------------
(UNAUDITED)
<S> <C>
ASSETS
Current assets:
Cash and cash equivalents....................................................................... $ 1,060,014
Accounts and notes receivable, net of allowance of $477,960..................................... 5,067,599
Prepaid expenses and other...................................................................... 250,902
--------------
Total current assets.......................................................................... 6,378,515
--------------
Property and equipment, net of accumulated depreciation of $3,682,404............................. 1,875,054
Intangible assets, net of accumulated amortization of $1,128,388.................................. 5,557,849
Other assets...................................................................................... 72,963
--------------
Total assets.................................................................................. $ 13,884,381
--------------
--------------
LIABILITIES AND SHAREHOLDERS DEFICIT
Current liabilities:
Trade accounts payable.......................................................................... $ 9,285,690
Other accrued liabilities....................................................................... 798,389
Advance payment from customer................................................................... 1,162,539
Notes and accounts payable to related parties, net.............................................. 1,550,000
Notes payable to STAR Telecommunications, Inc................................................... 4,500,000
Current maturities of long-term obligations..................................................... 1,042,089
Accrued taxes, other than income taxes.......................................................... 575,188
--------------
Total current liabilities..................................................................... 18,913,895
--------------
Long-term obligations............................................................................. 233,463
Shareholders' equity (deficit):
Common stock, $.01 par value, 100,000,000 shares authorized; 7,054,844 issued at September 30,
1998.......................................................................................... 70,548
Additional paid-in capital...................................................................... 13,006,564
Retained deficit................................................................................ (18,340,089)
--------------
Total shareholders' deficit................................................................... (5,262,977)
--------------
Total liabilities and shareholders' deficit................................................... $ 13,884,381
--------------
--------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-82
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
FOR THE NINE MONTHS
ENDED
SEPTEMBER 30,
----------------------------
1997 1998
------------- -------------
(UNAUDITED)
<S> <C> <C>
Telecommunications revenues........................................................ $ 22,249,272 $ 23,811,208
Operating expenses:
Costs of services................................................................ 16,985,736 18,625,545
------------- -------------
Selling, general and administrative.............................................. 5,415,004 5,681,084
Provision for doubtful accounts.................................................. 904,318 720,853
Depreciation and amortization.................................................... 720,363 836,497
------------- -------------
Total operating expenses....................................................... 24,025,421 25,863,979
------------- -------------
Loss from operations before other expenses......................................... (1,776,149) (2,052,771)
Other expenses:
Interest expense, net............................................................ (680,308) (717,531)
Other............................................................................ -- (298,704)
------------- -------------
Total other expenses........................................................... (680,308) (1,016,235)
------------- -------------
Loss before income tax benefit and extraordinary gain.............................. (2,456,457) (3,069,006)
Income tax benefit................................................................. 26,812 --
------------- -------------
Loss before extraordinary gain................................................... (2,429,645) (3,069,006)
------------- -------------
Extraordinary gain on debt restructuring (net of income taxes of $26,812).......... 52,049 --
------------- -------------
Net loss......................................................................... $ (2,377,596) $ (3,069,006)
------------- -------------
------------- -------------
Loss per weighted average common shares outstanding (basic and diluted):
Loss before extraordinary gain on debt restructuring............................. $ (.40) $ (.44)
Extraordinary gain............................................................... .01 --
------------- -------------
Net loss per share............................................................... $ (.39) $ (.44)
------------- -------------
------------- -------------
Weighted average number of common shares outstanding (basic and diluted)......... 6,021,870 6,988,983
------------- -------------
------------- -------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-83
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
CONSOLIDATED STATEMENT OF SHAREHOLDERS' DEFICIT
<TABLE>
<CAPTION>
ADDITIONAL
PAID-IN RETAINED
SHARES AMOUNT CAPITAL DEFICIT TOTAL
---------- --------- ------------- -------------- -------------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Balance at December 31, 1997............... 6,808,594 $ 68,086 $ 12,617,072 $ (15,271,083) $ (2,585,925)
Net loss................................... -- -- -- (3,069,006) (3,069,006)
Issuance of common stock for:
Exercise of options...................... 75,000 750 117,203 -- 117,953
Exercise of warrants..................... 171,250 1,712 272,289 -- 274,001
---------- --------- ------------- -------------- -------------
Balance at September 30, 1998.............. 7,054,844 $ 70,548 $ 13,006,564 $ (18,340,089) $ (5,262,977)
---------- --------- ------------- -------------- -------------
---------- --------- ------------- -------------- -------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-84
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
FOR THE NINE MONTHS
ENDED
SEPTEMBER 30,
----------------------------
1997 1998
------------- -------------
(UNAUDITED)
<S> <C> <C>
Cash flows from operating activities:
Net loss.......................................................................... $ (2,377,596) $ (3,069,006)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization................................................... 720,363 836,497
Extraordinary gain on debt restructuring........................................ (78,861) --
Interest amortization of note discounts......................................... 174,892 55,334
Proceeds from factoring of trade receivables, net............................... 2,189,740 567,688
Other, net...................................................................... 8,138 (5,426)
(Increase) decrease, net of effects of acquisitions:
Unfactored accounts and notes receivable........................................ (4,593,638) (1,826,895)
Prepaid expenses and other assets............................................... (103,959) 241,737
Increase, net of effects of acquisitions:
Accounts and notes payable and accrued expenses................................. 3,410,348 2,070,279
------------- -------------
Net cash used in operating activities....................................... (650,573) (1,129,792)
------------- -------------
Cash flows from investing activities:
Additions to property and equipment............................................... (223,420) (134,995)
Purchase of CTN................................................................... (350,000) --
Proceeds from notes............................................................... 57,592 58,924
------------- -------------
Net cash used in investing activities....................................... (515,828) (76,071)
Cash flows from financing activities:
Proceeds from issuance of common stock............................................ 1,468,946 391,954
Proceeds from issuance of short-term debt......................................... -- 3,000,000
Principal payments on obligations................................................. (1,427,189) (1,171,393)
Private placement advances........................................................ 590,016
------------- -------------
Net cash provided by financing activities................................... 631,773 2,220,561
------------- -------------
(Decrease) increase in cash......................................................... (534,628) 1,014,698
Cash at beginning of period......................................................... 608,141 45,316
------------- -------------
Cash at end of period............................................................... $ 73,513 $ 1,060,014
------------- -------------
------------- -------------
Supplemental disclosure of cash flow information:
Interest paid..................................................................... $ 692,053 $ 424,240
------------- -------------
------------- -------------
</TABLE>
The accompanying notes are integral part of these consolidated financial
statements.
F-85
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(1) DESCRIPTION OF BUSINESS
United Digital Network (the "Company"), formerly Unidex Communications
Corp., operates through its principal subsidiaries, United Digital Network of
Texas, Inc. ("DNI"), Advanced Management Services, Inc. ("AMS") and Custom
Telecom Network ("CTN").
The Company's principal business activity is providing basic long distance
services, travelcard service, international long-distance, and various other
telecommunication services to residential and small to medium sized commercial
customers. The principal markets for its long distance services are the central
and southwest United States as well as customers located nationwide in the motor
freight industry.
The Company has suffered recurring losses from operations that raise
substantial doubt about its ability to continue as a going concern. At September
30, 1998, the Company's current liabilities exceeded its current assets by $12.5
million. The Company is actively pursuing opportunities for a business
combination in order to achieve financial stability. On November 19, 1997, the
Company entered into a merger agreement with STAR Telecommunications, Inc.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries DNI, AMS and CTN. The financial statements and
related footnotes are presented in U.S. dollars, unless otherwise indicated, and
all significant intercompany accounts and transactions are eliminated in
consolidation. The interim financial data as of September 30, 1997 and 1998 and
for the nine month periods then ended is unaudited; however, in the opinion of
the Company, the interim data includes all adjustments, consisting only of
normal recurring adjustments, necessary to present fairly the financial
position, results of operations and cash flows for the interim periods. The
interim consolidated financial statements and the notes thereto should be read
in conjunction with the consolidated financial statements and notes included in
the Company's consolidated financial statements for the eight months ended
December 31, 1997.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents represent cash and short-term, highly liquid
investments with original maturities three months or less.
LOSS PER SHARE
Loss per share is computed by dividing the net loss by the weighted average
number of shares of common stock outstanding during the periods. The effect of
outstanding options and warrants on the computation of net loss per share is
antidilutive and, therefore, is not included in the computation of loss per
share amounts for the nine month periods ended September 30, 1997 and 1998.
NEW ACCOUNTING STANDARDS
On June 15, 1998, the FASB issued Statement of Financial Accounting
Standards No. 133, "Accounting for Derivative Instruments and Hedging
Activities" (SFAS 133). SFAS 133 is effective for all fiscal quarters of all
fiscal years beginning after June 15, 1999. SFAS 133 requires that all
derivative instruments
F-86
<PAGE>
UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES
(FORMERLY UNIDEX COMMUNICATIONS CORP.)
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
be recorded on the balance sheet at their fair value. Changes in the fair value
of derivatives are recorded each period in current earnings or other
comprehensive income, depending on whether a derivative is designated as part of
a hedge transaction and, if it is the type of hedge transaction. Management of
the Company anticipates that, due to its limited use of derivative instruments,
the adoption of SFAS 133 will not have a significant effect on the Company's
results of operations or its financial position.
(3) ADVANCE PAYMENT FROM CUSTOMER
In March 1998, the Company received an advance payment from one customer for
future long distance telephone services through pre-paid calling cards. This
payment will be recognized as revenue when the related services are provided.
(4) SUBSEQUENT EVENTS
In January 1998, the Company entered into an agreement of Compromise,
Settlement and Release (the "Agreement") related to disputes arising under the
AMS stock purchase agreement dated March 5, 1996. Under the Agreement, the
convertible debenture in the amount of $750,000 due in July 1998 was reduced to
$550,000 as a result of allowable adjustments defined in the stock purchase
agreement. On July 30, 1998, the Company signed an extension agreement with the
holder of the debenture under which the right to convert the debenture into
shares of the Company's common stock expired and a $33,000 extension fee was
paid by the Company to the debenture holder. Payment of the $550,000 was
extended to the earlier of December 31, 1998, the tenth day following the
closing of the merger with STAR, or the tenth day following an election not to
proceed with the merger.
On July 21, 1998, the Company issued a promissory note in the principal
amount of $1,000,000 payable to the order of John R. Snedegar, the President of
the Company. The promissory note provides for interest of ten percent and
matures on the earlier of thirty days after the occurrence of a Change of
Control (as defined in the promissory note) and July 21, 1999. Through September
30, 1998, the Company had accrued $16,000 in interest payable under this note.
On September 21, 1998, STAR and the Company entered into a Management
Agreement pursuant to which, among other things, STAR provides billing services
for the Company and the Company is able to buy switch services through STAR and
thereby giving the Company greater access to more competitive buying
arrangements.
F-87
<PAGE>
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
ANNEX A
AMENDED AND RESTATED AGREEMENT AND PLAN OF MERGER
BY AND AMONG
STAR TELECOMMUNICATIONS, INC.
SIERRA ACQUISITION CO., INC.
PT-1 COMMUNICATIONS, INC.
AND
SAMER TAWFIK
PETER M. VITA
DOUGLAS BARLEY
JOSEPH A. PANNULLO
JOHN J. KLUSARITZ
Dated as of August 20, 1998
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE>
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
---------
<S> <C> <C>
ARTICLE I THE MERGER...................................................................................... A-1
1.1 The Merger..................................................................................... A-1
1.2 Filing......................................................................................... A-1
1.3 Effective Time of the Merger................................................................... A-2
1.4 Certificate of Incorporation and Bylaws........................................................ A-2
1.5 Directors and Officers......................................................................... A-2
1.6 Warrants and Options........................................................................... A-2
ARTICLE II CONVERSION OF AND SURRENDER AND PAYMENT FOR COMMON STOCK....................................... A-2
2.1 Conversion..................................................................................... A-2
2.2 Escrow of Shares............................................................................... A-3
ARTICLE III CLOSING; CERTAIN EFFECTS OF MERGER............................................................ A-3
3.1 Closing Date................................................................................... A-3
3.2 Deliveries of the Company's Stockholders....................................................... A-3
3.3 Deliveries of Acquiror......................................................................... A-3
3.4 Effect of Merger............................................................................... A-3
3.5 Further Assurances............................................................................. A-4
ARTICLE IV REPRESENTATIONS AND WARRANTIES OF THE ACQUIROR AND NEWCO....................................... A-4
4.1 Organization................................................................................... A-4
4.2 Capital Stock.................................................................................. A-4
4.3 Authority Relative to Agreement................................................................ A-4
4.4 Acquiror Shares................................................................................ A-5
4.5 No Violations or Consents...................................................................... A-5
4.6 Litigation..................................................................................... A-5
4.7 Financial Statements and Reports............................................................... A-5
4.8 Proxy Statement; Other Information............................................................. A-6
4.9 Brokers........................................................................................ A-6
4.10 Benefit Plans.................................................................................. A-6
4.11 ERISA.......................................................................................... A-6
4.12 Environmental Matters.......................................................................... A-7
4.13 Absence of Certain Changes..................................................................... A-7
4.14 Government Authorizations...................................................................... A-7
ARTICLE V REPRESENTATIONS AND WARRANTIES OF THE STOCKHOLDERS.............................................. A-7
5.1 Ownership and Title to the Shares.............................................................. A-7
5.2 Authority Relative to Agreement................................................................ A-8
5.3 No Violations or Consents...................................................................... A-8
5.4 Rule 501....................................................................................... A-8
5.5 Restricted Securities.......................................................................... A-8
ARTICLE VI REPRESENTATIONS AND WARRANTIES OF THE COMPANY AND THE STOCKHOLDERS............................. A-9
6.1 Corporate Organization; Subsidiaries........................................................... A-9
6.2 Capital Stock.................................................................................. A-9
6.3 Options, Warrants or Other Rights.............................................................. A-9
6.4 Authority Relative to Agreement................................................................ A-10
</TABLE>
i
<PAGE>
<TABLE>
<CAPTION>
PAGE
---------
<S> <C> <C>
6.5 No Violations or Consents...................................................................... A-10
6.6 Governmental Authorizations and Regulations.................................................... A-10
6.7 Litigation..................................................................................... A-11
6.8 Financial Statements and Reports; Material Liabilities; Projections............................ A-11
6.9 Absence of Certain Changes..................................................................... A-11
6.10 Benefit Plans.................................................................................. A-13
6.11 ERISA.......................................................................................... A-13
6.12 Environmental Matters.......................................................................... A-14
6.13 Real Estate Leases............................................................................. A-14
6.14 Title to Properties; Absence of Liens and Encumbrances......................................... A-15
6.15 Tax Matters.................................................................................... A-15
6.16 Proprietary Property........................................................................... A-15
6.17 Labor Matters.................................................................................. A-16
6.18 Insurance...................................................................................... A-16
6.19 Material Contracts............................................................................. A-16
6.20 Proxy Statement; Other Information............................................................. A-17
6.21 Brokers........................................................................................ A-17
6.22 Transactions with Affiliated Parties........................................................... A-17
6.23 Distributors................................................................................... A-18
6.24 Accounts Receivable............................................................................ A-18
6.25 Inventory...................................................................................... A-18
ARTICLE VII COVENANTS AND AGREEMENTS...................................................................... A-18
7.1 Proxy Statement; Special Meeting............................................................... A-18
7.2 Conduct of the Business of the Company Prior to the Effective Time............................. A-18
7.3 Access to Properties and Record................................................................ A-20
7.4 Acquisition Proposals.......................................................................... A-20
7.5 Indemnification by the Stockholders............................................................ A-21
7.6 Confidentiality................................................................................ A-22
7.7 Reasonable Best Efforts........................................................................ A-22
7.8 Withdrawal of Company S-1...................................................................... A-22
7.9 Proxy of Principal Stockholders................................................................ A-22
7.10 Certain Events................................................................................. A-23
7.11 Financial Statements........................................................................... A-23
7.12 Conduct of the Business of Acquiror Prior to the Effective Time................................ A-23
ARTICLE VIII CONDITIONS PRECEDENT......................................................................... A-23
8.1 Conditions to Each Party's Obligation to Effect the Merger..................................... A-23
8.2 Conditions to the Obligation of the Company and the Stockholders to Effect the Merger.......... A-24
8.3 Conditions to Obligations of the Acquiror and Newco to Effect the Merger....................... A-25
ARTICLE IX TERMINATION, AMENDMENT AND WAIVER.............................................................. A-25
9.1 Termination.................................................................................... A-25
9.2 Termination Fee................................................................................ A-26
9.3 Amendment...................................................................................... A-26
9.4 Waiver......................................................................................... A-26
ARTICLE X MISCELLANEOUS................................................................................... A-27
10.1 Survival....................................................................................... A-27
10.2 Expenses and Fees.............................................................................. A-27
10.3 Notices........................................................................................ A-27
</TABLE>
ii
<PAGE>
<TABLE>
<CAPTION>
PAGE
---------
<S> <C> <C>
10.4 Headings....................................................................................... A-28
10.5 Publicity...................................................................................... A-28
10.6 Entire Agreement; Knowledge.................................................................... A-28
10.7 Assignment..................................................................................... A-28
10.8 Counterparts................................................................................... A-28
10.9 Invalidity, Etc................................................................................ A-28
10.10 Specific Performance........................................................................... A-28
10.11 Governing Law.................................................................................. A-28
10.12 Termination of Original Agreement.............................................................. A-28
10.13 No Solicitation................................................................................ A-28
</TABLE>
iii
<PAGE>
EXHIBITS
<TABLE>
<CAPTION>
<S> <C> <C>
Exhibit A Certificate of Merger
Exhibit B Escrow Agreement
Exhibit C Form of Registration Rights and Share Restriction Agreement
Exhibit D Form of Proxy
</TABLE>
iv
<PAGE>
ANNEX A
AMENDED AND RESTATED AGREEMENT AND PLAN OF MERGER
AMENDED AND RESTATED AGREEMENT AND PLAN OF MERGER dated as of August 20,
1998 (this "Agreement"), by and among STAR Telecommunications, Inc., a Delaware
corporation (the "Acquiror"), Sierra Acquisition Co., Inc., a New York
corporation and wholly-owned subsidiary of the Acquiror ("Newco"), PT-1
Communications, Inc., a New York corporation (the "Company"), and Samer Tawfik,
Peter M. Vita, Douglas Barley, Joseph A. Pannullo and John J. Klusaritz
(collectively, the "Stockholders").
R E C I T A L S:
A. Acquiror, Newco, the Company and the Stockholders previously entered
into an Agreement and Plan of Merger dated June 9, 1998 (the "Original
Agreement").
B. After subsequent review and contemplation, the Boards of Directors of
Newco, the Acquiror and the Company deem it advisable and in the best interests
of their respective stockholders to merge Newco with and into the Company (the
"Merger") upon the terms and conditions set forth herein and in accordance with
the New York Business Corporation Law (the "Business Corporation Law") (the
Company and Newco being hereinafter sometimes referred to as the "Constituent
Corporations" and the Company, following the effectiveness of the Merger, being
hereinafter sometimes referred to as the "Surviving Corporation");
C. The Stockholders beneficially own an aggregate of 92.8% of the issued
and outstanding shares (the "Shares") of the Company's Common Stock, $.01 par
value per share (the "Common Stock"), determined on a fully diluted basis,
taking into account all outstanding warrants, options and other rights or
interests to subscribe for shares of Common Stock; and
D. The Boards of Directors of the Acquiror and Newco wish to amend and
restate the Original Agreement and, in that regard, have each approved the
transactions contemplated by this Agreement, including without limitation, the
Merger, upon the terms and subject to the conditions set forth herein, including
without limitation, the approval of the stockholders of the Acquiror. The Board
of Directors of the Company also wishes to amend and restate the Original
Agreement and, in that regard, have each approved the transactions contemplated
by this Agreement, including without limitation, the Merger, upon the terms and
subject to the conditions set forth herein. Such approvals comply in all
respects with the requirements of Sections 912(b) and 913(c)(2)(A) of the
Business Corporation Law.
A G R E E M E N T
NOW, THEREFORE, in consideration of the mutual representations, warranties,
covenants, agreements and conditions contained herein, the sufficiency of which
is hereby acknowledged by the parties, and in order to set forth the terms and
conditions of the Merger and the mode of carrying the same into effect, the
parties hereby agree as follows:
ARTICLE I
THE MERGER
1.1 THE MERGER. Upon the terms and conditions hereinafter set forth and in
accordance with the Business Corporation Law, at the Effective Time, as defined
below, Newco shall be merged with and into the Company and thereupon the
separate existence of Newco shall cease, and the Company, as the Surviving
Corporation, shall continue to exist under and be governed by the Business
Corporation Law.
1.2 FILING. Upon the satisfaction or waiver of the conditions set forth in
Section 8 hereof (other than the condition set forth in Section 8.1(b) which may
not be waived), Newco and the Company will
A-1
<PAGE>
cause a Certificate of Merger, in substantially the form of Exhibit A attached
hereto (the "Certificate of Merger"), to be executed and filed with the
Department of State of the State of New York in accordance with the terms of
Section 904 of the Business Corporation Law.
1.3 EFFECTIVE TIME OF THE MERGER. The Merger shall become effective
immediately upon the filing of the Certificate of Merger with the Department of
State of the State of New York in accordance with Section 904. The date and time
of such filing is herein sometimes referred to as the "Effective Time."
1.4 CERTIFICATE OF INCORPORATION AND BYLAWS. Upon the effectiveness of the
Merger, the Certificate of Incorporation of Newco (as in effect on the date of
the Agreement) shall be the certificate of incorporation of the Surviving
Corporation and the By-Laws of Newco as in effect on the date hereof shall be
the By-Laws of the Surviving Corporation.
1.5 DIRECTORS AND OFFICERS. The persons who are directors of Newco
immediately prior to the Effective Time and the officers of the Company shall,
after the Effective Time and in accordance with the Certificate of Merger, serve
as the directors and officers, respectively, of the Surviving Corporation, in
each case such directors and officers to serve until their successors have been
duly elected and qualified in accordance with the Certificate of Incorporation
and By-Laws of the Surviving Corporation.
1.6 WARRANTS AND OPTIONS. On the Effective Time, the Acquiror shall assume
the duties and obligations of the Company, and the Acquiror shall be vested with
the powers, rights and privileges of the Company, under (a) the warrants of the
Company that remain outstanding at the Effective Time (the "Warrants") and (b)
the options of the Company that remain outstanding at the Effective Time (the
"Options"), as such warrants and options are listed on Schedule 6.3. As of the
Effective Time, the Acquiror shall have reserved for issuance and continue to
maintain sufficient shares of Acquiror Common Stock, as defined below, to issue
the required shares of Acquiror Common Stock pursuant to the exercise of
Warrants and Options after the Effective Time, subject to appropriate adjustment
with respect to the number of shares of Acquiror Common Stock to be acquired
thereunder and the exercise price thereof, based on the Exchange Ratio, as
defined below. Schedule 1.6 sets forth the number of shares of Acquiror Common
Stock that will be subject to each of the Warrants and Options.
ARTICLE II
CONVERSION OF AND SURRENDER AND PAYMENT FOR COMMON STOCK
2.1 CONVERSION. At the Effective Time, by virtue of the Merger and without
any action on the part of the holders thereof:
(a) Each of the issued and outstanding shares of Common Stock shall be
automatically converted into the right to receive consideration per share
equal to (i) 0.303715621 of a share (the "Exchange Ratio") of the Acquiror's
common stock, $0.001 per share ("Acquiror Common Stock") and (ii)
$0.41316724 (the "Cash Component"). The Exchange Ratio shall be adjusted as
may be necessary and appropriate to reflect any and all stock splits,
reverse stock splits, reclassifications, recapitalizations, dividends
payable in shares of Acquiror Common Stock or in any other securities
convertible into or exchangeable for shares of Acquiror Common Stock and
similar capital events that affect Acquiror Common Stock. Additionally, the
Exchange Ratio may be reduced in connection with the issuance by the Company
prior to the Closing Date of additional options to purchase shares of Common
Stock. At the Effective Time, the Cash Component shall, in no circumstances,
exceed $20 million. The aggregate number of shares of Acquiror Common Stock
to be issued in the Merger at the Effective Time shall be referred to herein
as the "Acquiror Shares."
(b) All shares of Common Stock which are held by the Company as treasury
shares shall be canceled and retired and cease to exist, without any
conversion thereof or payment with respect thereto.
A-2
<PAGE>
(c) No fraction of a share of Acquiror Common Stock will be issued in
the Merger, but, in lieu thereof, each holder of Common Stock who would
otherwise be entitled to a fraction of a share of Acquiror Common Stock will
be entitled to receive from the Acquiror an amount of cash (rounded to the
nearest whole $0.01) equal to the product of (i) such fraction of a share
multiplied by (ii) the average closing price of Acquiror Common Stock on The
Nasdaq National Market for the five (5) trading days prior to the Effective
Time (the "Average Price").
2.2 ESCROW OF SHARES. A total of ten percent (10%) of the Acquiror Shares
(the "Escrow Shares") shall be deposited at the Closing Date in an escrow
established with Santa Barbara Bank and Trust, a California bank, or such other
Person mutually agreeable to Acquiror and the Stockholders (the "Escrow Agent"),
such escrow to be pursuant to the terms of that certain escrow agreement to be
entered into by and among Acquiror, the Stockholders and the Escrow Agent, such
agreement in substantially the form attached hereto as Exhibit B (the "Escrow
Agreement"). As further set forth in the Escrow Agreement, the Escrow Shares
shall be held in escrow for a period (the "Escrow Period") commencing at the
Closing Date, as defined below, and ending on the first anniversary thereof. The
Escrow Shares shall be subject to offset pursuant to the terms of Section 7.5,
as further set forth in the Escrow Agreement. Any such offset against the Escrow
Shares shall be calculated as set forth in the Escrow Agreement.
ARTICLE III
CLOSING; CERTAIN EFFECTS OF MERGER
3.1 CLOSING DATE. Subject to the fulfillment of the conditions specified
in Article VIII (any or all of which may be waived in writing by the respective
parties whose performance is conditioned upon satisfaction of such conditions,
except that the condition set forth in Section 8.1(b) may not be waived), the
purchase and sale of the shares of Common Stock shall be consummated at a
closing (the "Closing") to be held at the offices of Acquiror, at 223 East de la
Guerra Street, Santa Barbara, CA 93101 at 11:00 a.m. or at such time as
Acquiror, the Company and the Stockholders shall mutually agree but not later
than March 31, 1999 (such date and time being herein referred to as the "Closing
Date"), providing that if, immediately prior to such date, the conditions set
forth in 8.1(d) have not been satisfied but all other conditions in Article VIII
have been satisfied or waived by the appropriate party thereto, then the Closing
Date may be extended to no later than June 30, 1999.
3.2 DELIVERIES OF THE COMPANY'S STOCKHOLDERS. At the Closing, the
stockholders of the Company shall deliver to Acquiror (a) stock certificates
representing all of the outstanding shares of Common Stock, each of which has
been duly endorsed for transfer and with appropriate stock powers, and (b) all
of the agreements, documents and instruments required to be delivered by the
Company and the Stockholders under Section 8.3.
3.3 DELIVERIES OF ACQUIROR. At the Closing, Acquiror shall deliver to the
stockholders of the Company (a) certificates representing the Acquiror Shares,
(b) his or her pro rata portion of the Cash Component, (c) any cash that may be
due to any of the stockholders of the Company in payment for any fractional
shares, as calculated pursuant to Section 2.1(c), and (d) all of the agreements,
documents and instruments required to be delivered by the Acquiror under
Sections 8.2. Simultaneously therewith, the Stockholders shall deposit with the
Escrow Agent certificates representing the Escrow Shares pursuant to the terms
of the Escrow Agreement.
3.4 EFFECT OF MERGER. On and after the Effective Time, the Surviving
Corporation shall possess all the rights, privileges, powers and franchises, and
be subject to all the restrictions, disabilities and duties of each of the
Constituent Corporations; and all and singular rights, privileges, powers and
franchises of each of the Constituent Corporations, and all property, real,
personal and mixed, and all debts due to either of the Constituent Corporations
on whatever account, as well for stock subscriptions as all other things in
action or belonging to each of the Constituent Corporations, shall be vested in
the Surviving Corporation; and all property, rights, privileges, powers and
franchises, and all and every other interest shall be
A-3
<PAGE>
thereafter the property of the Surviving Corporation as they were of the
Constituent Corporations, and the title to any real estate vested by deed or
otherwise, in either of the Constituent Corporations shall not revert or be in
any way impaired; but all rights of creditors and all liens upon any property of
either of the Constituent Corporations shall be preserved unimpaired, and all
debts, liabilities and duties of the Constituent Corporations shall thenceforth
attach to and be the sole responsibility of the Surviving Corporation and may be
enforced against the Surviving Corporation to the same extent as if said debts,
liabilities and duties had been incurred or contracted by it.
3.5 FURTHER ASSURANCES. If at any time after the Effective Time the
Surviving Corporation shall consider or be advised that any further deeds,
assignments or assurances in law or any other acts are necessary, desirable or
proper to vest, perfect or confirm, of record or otherwise, in the Surviving
Corporation, the title to any property or right of the Constituent Corporations
acquired or to be acquired by reason of, or as a result of, the Merger, the
Constituent Corporations agree that the Surviving Corporation and its proper
officers and directors shall and will execute and deliver all such deeds,
assignments and assurances in law and do all acts necessary, desirable or proper
to vest, perfect or confirm title to such property or right in the Surviving
Corporation and otherwise to carry out the purposes of this Agreement, and that
the proper officers and directors of the Constituent Corporations and the proper
officers and directors of the Surviving Corporation are fully authorized in the
name of the Constituent Corporations or otherwise to take any and all such
action.
ARTICLE IV
REPRESENTATIONS AND WARRANTIES OF THE ACQUIROR AND NEWCO
The Acquiror and Newco jointly and severally represent and warrant to the
Company as follows:
4.1 ORGANIZATION. Each of Acquiror and Newco is a corporation duly
organized, validly existing and in good standing under the laws of the
jurisdiction of its incorporation, and each has the requisite corporate power
and authority to own, lease and operate its assets and to conduct its business
in the manner in which it is presently conducted. Acquiror is qualified or
licensed to do business and is in good standing in each jurisdiction in which
the failure to be so qualified or licensed, in the aggregate, would have a
material adverse effect on the financial condition, results of operations,
business or properties of Acquiror (an "Acquiror Material Adverse Effect"). True
and correct copies of the Certificate of Incorporation Bylaws of Acquiror and
Newco have been delivered or made available to the Company.
4.2 CAPITAL STOCK. The authorized capital stock of the Acquiror consists
in its entirety of (a) 50,000,000 shares of Acquiror Common Stock, $0.001 par
value, of which, as of May 15, 1998, 41,755,594 were issued and outstanding and
(b) 5,000,000 shares of Preferred Stock, $0.001 par value per share, none of
which is issued and outstanding. All outstanding shares of Acquiror Common Stock
have been duly authorized and validly issued, are fully paid and non-assessable,
are free of preemptive rights and were issued in compliance with all applicable
securities laws and regulations. To the knowledge of Acquiror and except as
otherwise contemplated by this Agreement, there are no voting trusts or other
agreements, arrangements or understandings with respect to the voting of
Acquiror Common Stock. The authorized capital stock of Newco consists in its
entirety of 1,000 shares of common stock, $.01 par value, all of which are
issued and outstanding. All of the outstanding shares of Newco common stock are
owned beneficially and of record by the Acquiror.
4.3 AUTHORITY RELATIVE TO AGREEMENT. Each of the Acquiror and Newco has
full corporate power and authority to execute and deliver this Agreement and to
consummate the Merger and the other transactions contemplated on its part
hereby. Except with respect to the approval of the stockholders of Acquiror,
which shall be subject to the Special Meeting, as defined below, the execution,
delivery and performance by each of the Acquiror and Newco of this Agreement and
the consummation of the transactions contemplated hereby have been duly
authorized by all necessary corporate action on the part of the Acquiror and
Newco, including without limitation the affirmative vote of the Board of
Directors as contemplated by
A-4
<PAGE>
Section 203(a)(1) of the Delaware General Corporation Law (the "DGCL"). This
Agreement has been duly executed and delivered by each of the Acquiror and
Newco, and is a legal, valid and binding obligation of each of the Acquiror and
Newco, enforceable against each of the Acquiror and Newco in accordance with its
terms, except to the extent that its enforceability may be limited by applicable
bankruptcy, insolvency, reorganization or other laws affecting the enforcement
of creditors' rights generally or by general equitable principles. Each other
agreement to be executed in connection with this Agreement by the Acquiror and
Newco on or prior to the Closing Date will be duly executed and delivered by
each of Acquiror and Newco, as the case may be, and will constitute a legal,
valid and binding obligation of each of Acquiror and Newco, enforceable against
each of Acquiror and Newco in accordance with its respective terms, subject to
applicable bankruptcy, insolvency, moratorium, reorganization or other laws
affecting the enforcement of creditors' rights generally or by general equitable
principles.
4.4 ACQUIROR SHARES. The Acquiror Shares to be issued in connection with
the Merger have been duly authorized and, when issued as contemplated hereby at
the Effective Time, will be validly issued, fully paid and non-assessable, and
not subject to any preemptive rights or other rights or interests of third
parties.
4.5 NO VIOLATIONS OR CONSENTS. The execution, delivery and performance of
this Agreement by each of the Acquiror and Newco and the consummation by each of
them of the transactions contemplated hereby, will not (i) violate or conflict
with any provision of any charter or bylaws of the Acquiror or Newco, (ii)
require the consent, waiver, approval, license or authorization of or any filing
by the Acquiror or Newco with any public authority, other than (a) the filing of
a pre-merger notification report under The Hart-Scott-Rodino Antitrust
Improvements Act of 1976, as amended, and the rules and regulations promulgated
thereunder (the "HSR Act"), (b) in connection with or in compliance with the
provisions of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"), the Securities Act of 1933, as amended (the "Securities Act"), the
Communications Act of 1934, as amended (the "Communications Act") and the rules
and regulations arising thereunder, the rules and regulations of The Nasdaq
Stock Market, the Business Corporation Law or the "takeover", "blue sky" or
"public utilities" laws of various states and (c) any other filings and
approvals expressly contemplated by this Agreement, (iii) violate, conflict with
or result in a breach of or the acceleration of any obligation under, or
constitute a default (or an event which with notice or the lapse of time or both
would become a default) under, or give to others any right of termination,
amendment, acceleration or cancellation of, or result in the creation of a lien
or other encumbrance on any property or asset of the Acquiror or Newco pursuant
to any provision of any indenture, mortgage, lien, lease, agreement, instrument,
order, judgment or decree to which the Acquiror or Newco is subject or by which
the Acquiror or Newco or any of their property or assets is bound, or (iv)
violate or conflict with any law, rule, regulation, permit, ordinance or decree
applicable to the Acquiror or Newco or by which any property or asset of either
of them is bound or affected except, in each of the instances set forth in items
(i) through (iv) above, where failure to give such notice, make such filings, or
obtain such authorizations, consents or approvals, or where such violations,
conflicts, breaches or defaults, in the aggregate, would not have an Acquiror
Material Adverse Effect.
4.6 LITIGATION. Except as may be disclosed in the Acquiror SEC Filings, as
defined below, there are no actions, proceedings, claims, complaints, grievances
or unfair labor practice complaints pending or, to the best of the Acquiror's
knowledge, threatened or, to the best of the Acquiror's knowledge,
investigations pending or threatened against the Acquiror or with respect to any
of the assets or properties of it before any court or governmental or regulatory
authority or body or arbitrator which, if adversely determined against Acquiror,
would have, individually or in the aggregate, an Acquiror Material Adverse
Effect. There are no such proceedings pending or, to the best knowledge of
Acquiror, threatened against Acquiror or Newco challenging the validity or
propriety of the transactions contemplated by this Agreement.
4.7 FINANCIAL STATEMENTS AND REPORTS. The Acquiror heretofore has
delivered to the Company true and complete copies of (a) its Registration
Statement on Form S-1 dated April 29, 1998, Registration No. 333-48559, (b) its
Registration Statement on Form S-4 dated May 29, 1998, Registration
A-5
<PAGE>
No. 333-53335, (c) its Annual Report on Form 10-K for the fiscal year ended
December 31, 1997 and (d) its Quarterly Reports on Form 10-Q for the quarter
ended March 31, 1998 and June 30, 1998 (collectively,"Acquiror SEC Filings").
The Acquiror SEC Filings made in compliance with the Exchange Act were filed in
a timely manner pursuant to the rules and regulations thereof. As of the
respective times such documents were filed or, as applicable, became effective,
the Acquiror SEC Filings complied as to form and content, in all material
respects, with the requirements of the Securities Act and the Exchange Act, as
the case may be, and the rules and regulations promulgated thereunder, and did
not contain any untrue statement of a material fact or omit to state any
material fact required to be stated therein or necessary to make the statements
therein, in light of the circumstances under which they were made, not
misleading. The consolidated financial statements of the Acquiror included in
the Acquiror SEC Filings were prepared in accordance with generally accepted
accounting principles ("GAAP") applied on a consistent basis and (except as may
be indicated therein or in the notes thereto) present fairly the consolidated
financial position, results of operations and cash flows of the Acquiror and its
consolidated subsidiaries as of the dates and for the periods indicated subject,
in the case of unaudited interim consolidated financial statements, to normal
recurring year-end adjustments.
4.8 PROXY STATEMENT; OTHER INFORMATION. The Proxy Statement, as defined
below, and any other documents to be filed with the Securities and Exchange
Commission (the "SEC") or any regulatory agency in connection with the
transactions contemplated hereby, will not be, at the respective times such
documents are filed with the SEC and, with respect to the Proxy Statement, when
first published, sent or given to the stockholders of Acquiror, false or
misleading with respect to any material fact, or omit to state any material fact
necessary in order to make the statements therein, in light of the circumstances
under which there are made, not misleading. All documents which the Acquiror or
Newco files or is responsible for filing with the SEC and any regulatory agency
in connection with the Merger (including, without limitation, the Proxy
Statement) will comply as to form and content in all material respects with the
provisions of applicable law and regulations. Notwithstanding the foregoing, the
Acquiror and Newco make no representations or warranties with respect to any
information that has been supplied in writing by the Company or its auditors,
attorneys or financial advisors specifically for use in the Proxy Statement or
in any other documents to be filed by the Acquiror with the SEC or any other
regulatory agency in connection with the transactions contemplated hereby.
4.9 BROKERS. Neither the Acquiror nor Newco has paid or become obligated
to pay any fee or commission to any broker, finder, investment banker or other
intermediary in connection with this Agreement, except that the Acquiror has
retained Hambrecht & Quist and Credit Suisse First Boston as its financial
advisors in connection with the transactions contemplated by this Agreement.
4.10 BENEFIT PLANS. Except as described in Acquiror's SEC Filings,
Acquiror does not have outstanding any employment agreement with any officer or
employee of Acquiror, any bonus, incentive compensation, deferred compensation,
profit sharing, stock option, stock bonus, stock purchase, savings, severance,
salary continuation, consulting, retirement (including health and life insurance
benefits provided after retirement) or pension plan (including Acquiror Benefit
Plans, as defined in Section 4.11 hereof) or arrangement with or for the benefit
of any officer, employee or other person, or for the benefit of any group of
officers, employees or other persons that provides for payment of more than
$100,000 in annual benefits.
4.11 ERISA. All of Acquiror's employee benefit plans, as defined in
Section 3(3) of the Employee Retirement Income Security Act of 1974, as amended
("ERISA"), but without regard to whether any such plan is in fact subject to
ERISA, that are sponsored, or being maintained or contributed to, by Acquiror
that provide for payment of more than $25,000 in annual benefits (the "Acquiror
Benefit Plans") are described in Acquiror's SEC Filings. None of the Company
Employee Benefit Plans are "multiemployer plans" as defined in Section 3(37) of
ERISA. No "prohibited transactions" (as such term is defined in Section 4975 of
the Internal Revenue Code (the "IRC"), or in Part 4 of Subtitle B of Title I of
ERISA) have occurred with respect to any Acquiror Benefit Plan that could result
in the imposition of taxes or
A-6
<PAGE>
penalties that, in the aggregate, could have an Acquiror Material Adverse
Effect. Each Acquiror Benefit Plan has been administered in compliance with the
applicable requirements of ERISA and the IRC, and in compliance with all other
applicable provisions of law, except for such noncompliance, if any, that, in
the aggregate, would not have an Acquiror Material Adverse Effect. With respect
to each Acquiror Benefit Plan, Acquiror has not incurred liabilities which, in
the aggregate, could have an Acquiror Material Adverse Effect as a result of the
violation of or the failure to comply with any applicable provision of ERISA,
the IRC, any other applicable provision of law, or any provision of such plan.
There is no pending or, to the best knowledge of Acquiror, threatened legal
action, proceeding or investigation against or involving any Acquiror Benefit
Plan which could result in reduced liabilities.
4.12 ENVIRONMENTAL MATTERS. "Acquiror Real Properties" shall mean all real
property now or previously owned, operated or leased by Acquiror and located in
the United States. Except as set forth in Acquiror's SEC Filings: (i) Acquiror
and, to the best of Acquiror's knowledge, each of the Acquiror Real Properties
is in compliance with, and has no liability under any or all applicable
Environmental Laws, (ii) neither Acquiror nor any of the Acquiror Real
Properties has been alleged in writing by any governmental agency or third party
to be in violation of, to be liable under, or to be subject to any
administrative or judicial proceeding pursuant to, any Environmental Law and
(iii) there are no facts or circumstances which could reasonably form the basis
for the assertion of any claims against Acquiror relating to environmental
matters, except, in any such case, where the failure to comply or such liability
could not be reasonably expected to have an Acquiror Material Adverse Effect. As
used herein, Environmental Law means any federal, state, or local law, statute,
rule or regulation, or the common law governing or relating to the environment
or to occupational health and safety.
4.13 ABSENCE OF CERTAIN CHANGES. Since June 30, 1998, except as
contemplated by this Agreement, the Acquiror has conducted its business in the
ordinary course, consistent with past practices, and there has not been any (a)
material adverse change in the financial condition, results of operations,
business or properties of Acquiror, (b) sale, assignment or transfer of a
material portion of the Company's assets, other than in the ordinary course of
business, consistent with past practices, (c) changes in accounting methods,
principles or practices by Acquiror materially affecting Acquiror's assets,
liabilities or results of operations, except as otherwise required by GAAP, (d)
declaration, setting aside or payment of any dividend or other distribution or
payment (whether in cash, stock or property) with respect to any shares of
Acquiror Common Stock or (e) any other event or condition of any character that
in any one case or in the aggregate has had an Acquiror Material Adverse Effect.
4.14 GOVERNMENT AUTHORIZATIONS. Acquiror has all federal and state
governmental licenses, permits and other authorizations, including without
limitation all licenses and authorizations required by the United States Federal
Communications Commission (the "FCC") and by state public utilities commissions
("Acquiror Permits"), necessary to conduct Acquiror's business as presently
conducted, except where the failure to hold any such licenses, permits and other
authorizations would not result in an Acquiror Material Adverse Effect. Such
Acquiror Permits are valid and in full force and effect and Acquiror is not
aware of any threatened suspension, cancellation or invalidation of any such
Acquiror Permit. Except as set forth in Acquiror's SEC Filings, the Acquiror has
not received notice from either the FCC or any state public utilities
commissions of any complaint filed therewith concerning Acquiror, its operations
or services.
ARTICLE V
REPRESENTATIONS AND WARRANTIES OF THE STOCKHOLDERS
Except as set forth in the disclosure schedules attached hereto (the
"Disclosure Schedules"), the Stockholders, severally but not jointly, represent
and warrant to Acquiror as follows:
5.1 OWNERSHIP AND TITLE TO THE SHARES. As set forth on Schedule 5.1, such
Stockholder is the record and beneficial owner of that number of shares of
Common Stock and of the Options and Warrants, if any, set forth opposite his
name on such schedule and has good and valid title in and to such securities.
Except
A-7
<PAGE>
as set forth on Schedule 5.1, such shares are, and on the Closing Date will be,
free and clear of any and all liens, security interests, mortgages, deeds of
trust, pledges, claims, rights of first refusal, options, encumbrances,
restrictions, preemptive or subscriptive rights or other rights of third parties
("Encumbrances").
5.2 AUTHORITY RELATIVE TO AGREEMENT. Such Stockholder has the full power
and authority to execute this Agreement and the other transactions contemplated
on his part hereby. Such Stockholder has taken all steps that may be necessary
to duly authorize the execution and delivery by the Company and by such
Stockholder of this Agreement and the consummation of the transactions
contemplated on his or its part hereby, in accordance with the provisions of
Section 913(c)(2)(A) of the Business Corporation Law, and no other actions on
the part of such Stockholder is necessary to authorize the execution and
delivery of this Agreement by such Stockholder or the consummation of the
transactions contemplated on his or its part hereby. This Agreement has been
duly executed and delivered by such Stockholder, and constitutes a legal, valid
and binding obligation of such Stockholder, enforceable against such Stockholder
in accordance with its terms, except to the extent that its enforceability may
be limited by applicable bankruptcy, insolvency, reorganization or other laws
affecting the enforcement of creditors' rights generally or by general equitable
principles. Each other agreement to be executed in connection with this
Agreement by such Stockholder on or prior to the Closing Date will be duly
executed and delivered by the Stockholder and will constitute a legal, valid and
binding obligation of each such Stockholder, enforceable against such
Stockholder in accordance with its respective terms, subject to applicable
bankruptcy, insolvency, moratorium, reorganization or other laws affecting the
enforcement of creditors' rights generally or by general equitable principles.
5.3 NO VIOLATIONS OR CONSENTS. The execution, delivery and performance of
this Agreement by such Stockholder and the consummation of the transactions
contemplated hereby will not (i) violate, conflict with or result in a breach of
or the acceleration of any obligation under, or constitute a default (or an
event which with notice or the lapse of time or both would become a default)
under, or give to others any right of termination, amendment, acceleration or
cancellation of, or result in the creation of a lien or other encumbrance on any
property or asset of such Stockholder pursuant to any provision of any contract
to which such Stockholder is bound, lien, order, judgment or decree to which
such party is subject or by which such Stockholder or any of his property or
assets is bound, or (ii) violate or conflict with any law, rule, regulation,
permit, ordinance or regulation applicable to such Stockholder or by which any
property or asset of such Stockholder is bound or affected.
5.4 RULE 501. Such Stockholder is an "accredited investor" within the
meaning of Rule 501 of the Securities Act. In connection with the Merger, each
such Stockholder is acquiring shares of Acquiror Common Stock for investment for
his own account, not as a nominee or agent and not with a view towards the
resale or other distribution of any part thereof, and such Stockholder has no
present intention of selling, granting any participation in, or otherwise
distributing such shares of Acquiror Common Stock.
5.5 RESTRICTED SECURITIES. Such Stockholder understands that the shares of
Acquiror Common Stock he will receive in the Merger will be characterized as
"restricted securities" under the federal securities laws inasmuch as they are
being acquired from Acquiror in a transaction not involving a public offering
and that under such laws and applicable regulations such securities may be
resold without registration under the Securities Act, only in certain limited
circumstances. In this connection, such Stockholder represents that he is
familiar with Rule 145 of the Securities Act, as presently in effect, and
understands the holding period and resale limitations imposed thereby and by the
Securities Act.
A-8
<PAGE>
ARTICLE VI
REPRESENTATIONS AND WARRANTIES OF THE COMPANY AND THE STOCKHOLDERS
Except as set forth in the Disclosure Schedules, the Company and the
Stockholders jointly and severally represent and warrant to Acquiror as follows:
6.1 CORPORATE ORGANIZATION; SUBSIDIARIES.
(a) ORGANIZATION. The Company is a corporation duly organized, validly
existing and in good standing under the laws of the State of New York with
all requisite corporate power and authority to own, operate and lease its
properties and to carry on its business as it is now being conducted, and is
qualified or licensed to do business and is in good standing in each
jurisdiction in which the failure to be so qualified or licensed, in the
aggregate, would have a material adverse effect on the financial condition,
results of operations, business or properties of the Company and its
Subsidiaries (as defined below), taken as a whole (a "Company Material
Adverse Effect"). True and correct copies of the Certificate of
Incorporation and the Bylaws of the Company have been delivered or made
available to Acquiror.
(b) SUBSIDIARIES. Schedule 6.1(b) contains a true and complete list of
all direct and indirect domestic and foreign subsidiaries of the Company
(individually, a "Subsidiary" and collectively, the "Subsidiaries"), listing
the name and jurisdiction of incorporation or organization of each such
Subsidiary. Each Subsidiary is a corporation duly organized and validly
existing and in good standing under the laws of its respective jurisdiction
of incorporation, has the corporate power and authority to own, operate or
lease the properties and assets now owned, operated or leased by such
Subsidiary and to carry on its business as now being conducted by such
Subsidiary, is duly qualified as a foreign corporation to do business, and
is in good standing, in each jurisdiction set forth on Schedule 6.1(b),
which are all of the jurisdictions in which the failure so to qualify would
have a Company Material Adverse Effect. All of the issued and outstanding
capital stock of each Subsidiary is owned by the Company or one of the
Subsidiaries, as the case may be, free and clear of any and all Encumbrances
(as defined below). There are no outstanding rights to purchase or otherwise
receive from any Subsidiary any shares of capital stock or any other
security of such Subsidiary and there are no outstanding securities of any
kind convertible into or exchangeable for such capital stock. The Company
does not own, directly or indirectly, any stock, partnership interest, joint
venture interest or other security, investment or interest in any other
corporation, organization or entity, other than the Subsidiaries.
6.2 CAPITAL STOCK. As of the date hereof, the authorized capital stock of
the Company consists in its entirety of (a) One Hundred Fifty Million
(150,000,000) shares of Common Stock, of which Forty-eight Million Four Hundred
Six Thousand Five Hundred Forty-eight (48,406,548) are issued and outstanding
and (b) Fifteen Million (15,000,000) shares of preferred stock, $.01 par value
per share, none of which are issued and outstanding. All outstanding shares of
Common Stock have been duly authorized and validly issued, are fully paid and
non-assessable, are free of preemptive rights and were issued in compliance with
all applicable securities laws and regulations. Except as otherwise contemplated
by this Agreement, there are no voting trusts or other agreements, arrangements
or understandings with respect to the voting of the Shares to which the Company,
the Stockholders or any other person is a party. Except as set forth on Schedule
6.3 or as otherwise contemplated by this Agreement, there are no preemptive
rights, registration rights, subscriptions, options, warrants, rights,
convertible securities or other agreements or commitments of any character
relating to issued or unissued shares of Common Stock or other securities of the
Company and there are no outstanding contractual obligations of the Company to
repurchase, redeem or otherwise acquire or sell, issue or otherwise transfer any
outstanding securities thereof.
6.3 OPTIONS, WARRANTS OR OTHER RIGHTS. Except as set forth on Schedule 6.3
or as contemplated by this Agreement, there is no outstanding right,
subscription, warrant, call, unsatisfied preemptive right,
A-9
<PAGE>
option or other agreement or arrangement of any kind to purchase or otherwise to
receive from the Company or any Subsidiary any of the outstanding, authorized
but unissued, unauthorized or treasury shares of the capital stock or any other
equity security of the Company or any Subsidiary and there is no outstanding
security of any kind convertible into or exchangeable for such capital stock.
6.4 AUTHORITY RELATIVE TO AGREEMENT. The Company has full corporate power
and authority to execute and deliver this Agreement and to consummate the Merger
and the other transactions contemplated on its part hereby. The execution and
delivery by the Company of this Agreement and the consummation of the
transactions contemplated on its part hereby have been duly authorized by its
Board of Directors and its stockholders, such authorization being in compliance
with the provisions of Sections 912(b) and 913(c)(2)(A) of the Business
Corporation Law, and no other corporate proceedings on the part of the Company
or the stockholders are necessary to authorize the execution and delivery of
this Agreement by the Company or the consummation of the transactions
contemplated on its part hereby. This Agreement has been duly executed and
delivered by the Company, and constitutes a legal, valid and binding obligation
of the Company, enforceable against the Company in accordance with its terms,
except to the extent that its enforceability may be limited by applicable
bankruptcy, insolvency, reorganization or other laws affecting the enforcement
of creditors' rights generally or by general equitable principles. Each other
agreement to be executed in connection with this Agreement by the Company on or
prior to the Closing Date will be duly executed and delivered by the Company,
and will constitute a legal, valid and binding obligation of the Company,
enforceable against each of the Company in accordance with its respective terms,
subject to applicable bankruptcy, insolvency, moratorium, reorganization or
other laws affecting the enforcement of creditors' rights generally or by
general equitable principles.
6.5 NO VIOLATIONS OR CONSENTS. Except as set forth on Schedule 6.5, the
execution, delivery and performance of this Agreement by the Company and the
consummation of the transactions contemplated hereby will not (i) violate or
conflict with any provision of any charter or bylaws of the Company or any
Subsidiary, (ii) require the consent, waiver, approval, license or authorization
of or any filing by the Company or any Subsidiary with any third party or public
authority (other than (a) the filing of a premerger notification report under
the HSR Act, (b) in connection with or in compliance with the provisions of the
Exchange Act, the Securities Act, the Communications Act or the "blue sky" or
"public utility" laws of various states, and (c) any other filings and approvals
expressly contemplated by this Agreement), (iii) violate, conflict with or
result in a breach of or the acceleration of any obligation under, or constitute
a default (or an event which with notice or the lapse of time or both would
become a default) under, or give to others any right of termination, amendment,
acceleration or cancellation of, or result in the creation of a lien or other
encumbrance on any property or asset of the Company or any Subsidiary pursuant
to any provision of any Material Contract (as defined below), lien, order,
judgment or decree to which any such party is subject or by which the Company or
any Subsidiary or any of their property or assets is bound, or (iv) violate or
conflict with any law, rule, regulation, permit, ordinance or regulation
applicable to the Company or any Subsidiary or by which any property or asset of
the Company or any Subsidiary is bound or affected except, in each of the
instances set forth in items (i) through (iv) above, where failure to give such
notice, make such filings, or obtain such authorizations, consents or approvals,
or where such violations, conflicts, breaches or defaults, in the aggregate,
would not have a Company Material Adverse Effect.
6.6 GOVERNMENTAL AUTHORIZATIONS AND REGULATIONS. Schedule 6.6 is a true
and complete list of all material governmental licenses, franchises, permits and
other authorizations, including without limitation any and all licenses issued
to the Company or any Subsidiary by the FCC, by state public utilities
commissions and by all applicable foreign telecommunications regulatory entities
(the "Foreign Agencies") ("Company Permits") held by the Company and the
Subsidiaries. Such Company Permits are all governmental licenses, franchises,
permits and other authorizations necessary to the conduct of the business of the
Company and the Subsidiaries. Such Company Permits are valid and in full force
and effect and the Company knows of no threatened suspension, cancellation or
invalidation of any such Company
A-10
<PAGE>
Permit. Except as set forth on Schedule 6.6, the Company has not received notice
from any of the FCC, any state public utilities commissions or any Foreign
Agencies of any complaint filed therewith concerning the Company, its operations
or services and, to the best knowledge of the Company and the Stockholders,
there is not reasonable basis for the filing of any such complaint. Neither the
Company nor any Subsidiary is in conflict with, or is in default or violation
of, any law, rule, regulation, order, judgment, Company Permit, ordinance,
regulation or decree applicable to the Company or any Subsidiary or by which any
property or asset of either of them is bound or affected, except where such
conflicts, defaults or violations, in the aggregate, would not have a Company
Material Adverse Effect.
6.7 LITIGATION. Except as set forth on Schedule 6.7 hereto, there are no
actions, proceedings, claims, complaints, grievances or unfair labor practice
complaints (collectively, "Actions") pending or, to the best knowledge of the
Company and the Stockholders, threatened, or, to the best knowledge of the
Company and the Stockholders, investigations pending or threatened against the
Company or any of the assets or properties of the Company before any court or
governmental or regulatory authority or body or arbitrator, which, if such
Action were determined adversely to the Company, would have, individually or in
the aggregate, a Company Material Adverse Effect. There are no Actions pending
or, to the best knowledge of the Company and the Stockholders, threatened
against the Company challenging the validity or propriety of the transactions
contemplated by this Agreement. None of the assets, property or other rights of
the Company or any Subsidiaries thereof is subject to any order, judgment,
injunction, writ or decree, which would have, individually or in the aggregate,
a Company Material Adverse Effect.
6.8 FINANCIAL STATEMENTS AND REPORTS; MATERIAL LIABILITIES; PROJECTIONS
(a) FINANCIAL STATEMENTS AND REPORTS. The Company's audited balance
sheets and its audited statements of operations, stockholder's equity and
cash flows as of and for the fiscal years ended March 31, 1995, 1996, 1997
and 1998 (the "Audited Financials"), as well as the Company's unaudited
balance sheet and unaudited statements of operations (the "June Statement of
Operations"), stockholders' equity and cash flows as of and for the quarter
ended June 30, 1998 (collectively with the Audited Financials, the "Company
Financial Statements") were prepared from and are in accordance with the
books and records of the Company and were prepared in accordance with GAAP
applied on a consistent basis and (except as may be indicated therein or in
the notes thereto) present fairly the consolidated financial position,
results of operations and cash flows of the Company and its consolidated
subsidiaries as of the dates and for the periods indicated.
(b) MATERIAL LIABILITIES. Except as set forth on Schedule 6.8(b), the
Company has no material liabilities or obligations (whether fixed, accrued,
contingent or otherwise) that are not fully reflected or provided for on, or
disclosed in the notes to, the Company Financial Statements, except for (i)
liabilities in the ordinary course of business that could not be reasonably
expected to have a Company Material Adverse Effect or (ii) liabilities
incurred in the ordinary course of business that are not required by GAAP to
be reflected thereon and which, individually and in the aggregate, are not
material.
(c) PROJECTIONS. The projections dated May 1, 1998 delivered by the
Company to the Acquiror were prepared in good faith in a manner that was
reasonable in the context of the financial information and data set forth
therein, provided that Acquiror and Newco acknowledge that such projections
are forward-looking statements, are subject to the uncertainties inherent
thereto and that the Company's actual results may differ, perhaps
materially, from such projections.
6.9 ABSENCE OF CERTAIN CHANGES. Except as set forth on Schedule 6.9, since
April 1, 1998, the Company has conducted its business in the ordinary course and
there has not been any:
(a) material adverse change in the financial condition, assets,
liabilities, business or results of operations of the Company or any
Subsidiary, provided that the financial information set forth in the
A-11
<PAGE>
June Statement of Operations previously provided to the Company shall not be
deemed a material adverse change for purposes of this Agreement;
(b) addition to or modification of employee benefits plans, arrangements
or practices, other than in the ordinary course of business;
(c) sale, assignment or transfer of any of the material assets of the
Company or any Subsidiary, other than in the ordinary course of business,
consistent with past practice;
(d) cancellation of any indebtedness owed to the Company in an aggregate
amount greater than Seventy-five Thousand Dollars ($75,000), or waiver of
any rights of similar value to the Company relating to any of its business
activities or properties, other than in the ordinary course of business;
(e) amendment, cancellation or termination of any Material Contract,
other than in the ordinary course of business, consistent with past
practice;
(f) any breach of, or default under, any Material Contract by the
Company or any Subsidiary;
(g) change in accounting methods, principles or practices by the Company
materially affecting its assets, liabilities or results of operations;
(h) material revaluation by the Company or any Subsidiary of its assets,
including without limitation, any material write-offs, material increases in
any reserves or any material write-up of the value of inventory, property,
equipment or any other asset;
(i) material damage, destruction or loss (if not covered by insurance)
affecting any office or other facility maintained by the Company or any
other material asset of the Company and resulting in a loss in an aggregate
amount in excess of One Hundred Thousand Dollars ($100,000);
(j) Encumbrance with respect to any assets of the Company or any
Subsidiary, except Encumbrances arising in the ordinary course of business;
(k) declaration, setting aside or payment of any dividend or other
distribution or payment (whether in cash, stock or property) with respect to
any shares of Common Stock, or any redemption, purchase or other acquisition
of any of such shares, or any other payment to the stockholders of the
Company with respect to the shares of Common Stock held thereby;
(l) issuance by the Company of, or commitment by it to issue, any shares
of Common Stock or other equity securities or any securities convertible
into or exchangeable or exercisable for shares of the Common Stock or other
equity securities;
(m) indebtedness for borrowed money incurred by the Company or any
Subsidiary or any commitment to incur indebtedness for borrowed money
entered into by the Company or any Subsidiary, or any loans made or agreed
to be made by the Company, including without limitation, any loans made to
any of the Company's executive officers;
(n) incurrence of other liabilities by the Company or any Subsidiary
involving an aggregate amount in excess of One Hundred Fifty Thousand
Dollars ($150,000) or more, except in the ordinary course of business, or
any material increase or change in any assumptions underlying, or methods of
calculating, any bad debt, contingency or other reserves;
(o) payment, discharge or satisfaction of any liabilities other than the
payment, discharge or satisfaction in the ordinary course of business,
consistent with past practice, of liabilities reserved against in the
Financial Statements or of liabilities incurred in the ordinary course of
business, consistent with past practice, since such date or of other
liabilities involving Fifty Thousand Dollars ($50,000) or less individually
and One Hundred Fifty Thousand Dollars ($150,000) or less in the aggregate;
A-12
<PAGE>
(p) increase in the compensation of officers or employees (including any
such increase pursuant to any bonus, pension, profit sharing or other plan
or commitment) or any increase in the compensation payable or to become
payable to any officer or employee or any severance or termination pay,
except for increases in the ordinary course of business, consistent with
past practice or as required by law or any existing agreement;
(q) granting of any bonus, incentive compensation, service, award or
other like benefit to any officer or employee except in accordance with
plans or arrangements disclosed on Schedule 6.11; or
(r) other event or condition of any character which in any one case or
in the aggregate could be reasonably expected to have a Company Material
Adverse Effect.
6.10 BENEFIT PLANS. Except as disclosed on Schedule 6.10, the Company does
not have outstanding any employment agreement with any officer or employee of
the Company or any Subsidiary any bonus, incentive compensation, deferred
compensation, profit sharing, stock option, stock bonus, stock purchase,
savings, severance, salary continuation, consulting, retirement (including
health and life insurance benefits provided after retirement) or pension plan
(including Company Employee Benefit Plans, as defined in Section 6.11 hereof) or
arrangement with or for the benefit of any officer, employee or other person, or
for the benefit of any group of officers, employees or other persons that
provides for payment of more than $100,000 in annual benefits. Neither the
Company nor any Subsidiary has made, or entered into any agreement to make, any
payment that becomes payable as a result of the consummation of the transactions
contemplated by this Agreement which would be treated as an "excess parachute
payment" as defined in Section 280G of the IRC. There are no such agreements,
plans or other arrangements entered into with or provided for any independent
contractors with whom the Company or any Subsidiary has a business relationship.
6.11 ERISA. Set forth on Schedule 6.11 are all of the employee benefit
plans, as defined in Section 3(3) of ERISA, but without regard to whether any
such plan is in fact subject to ERISA, that is sponsored, or is being maintained
or contributed to, by the Company or any Subsidiary that provides for payment of
more than $25,000 in annual benefits (the "Company Employee Benefit Plans").
None of the Company Employee Benefit Plans are "multiemployer plans" as defined
in Section 3(37) of ERISA. The Company has furnished or made available or will
promptly after the date hereof make available to Newco and the Acquiror (a) a
true and complete copy of the plan document and summary plan description for
each Company Employee Benefit Plan, (b) a true and complete copy of the most
recently filed Form 5500 (including the related schedules) with respect to each
Company Employee Benefit Plan for which such form is required to be filed, (c) a
true and complete copy of any trust agreement, insurance contract or other
agreement or arrangement serving as (a) source of funding any benefits payable
under any Company Employee Benefit Plan, and (d) the most recently issued
financial statement and actuarial report, if any, for each Company Employee
Benefit Plan. No "prohibited transactions" (as such term is defined in Section
4975 of the IRC, or in Part 4 of Subtitle B of Title I of ERISA) have occurred
with respect to any Company Employee Benefit Plan that could result in the
imposition of taxes or penalties that, in the aggregate, could have a Company
Material Adverse Effect. With respect to each of the Company Employee Benefit
Plans that is intended to qualify for favorable income tax treatment under
Section 401(a) of the IRC, (i) the Internal Revenue Service ("IRS") has issued a
favorable determination letter with respect to such plan; (ii) except as set
forth on Schedule 6.10, the Company has furnished Newco and Acquiror with a copy
of the determination letter most recently issued by the IRS with respect to such
plan and the application filed with the IRS for such determination letter; and
(iii) to the best knowledge of the Company, no event has occurred from the date
of each such favorable determination letter that would adversely affect the
tax-qualified status of the plan in question. Each Company Employee Benefit Plan
has been administered in compliance with the applicable requirements of ERISA
and the IRC, and in compliance with all other applicable provisions of law,
except for such noncompliance, if any, that, in the aggregate, would not have a
Company Material Adverse Effect. With respect to each Company Employee Benefit
Plan, neither the Company nor any Subsidiary has incurred liabilities which, in
the
A-13
<PAGE>
aggregate, could have a Company Material Adverse Effect as a result of the
violation of or the failure to comply with any applicable provision of ERISA,
the IRC, any other applicable provision of law, or any provision of such plan.
None of the Company Employee Benefit Plans which is an "employee pension benefit
plan", as that term is defined in Section 3(2) of ERISA (a "Company Employee
Pension Benefit Plan"), has incurred an "accumulated funding deficiency," within
the meaning of Section 3(2) of ERISA or Section 412 of the IRC. Neither the
Company nor any Subsidiary has failed to make any contribution to, or to make
any payment under, any Company Employee Benefit Plan that it was required to
make pursuant to the terms of the plan or pursuant to applicable law in any
amount which, in the aggregate, could have a Company Material Adverse Effect. To
the best knowledge of the Company, no "reportable events," with respect to which
a notice must be filed with the Pension Benefit Guaranty Corporation ("PBGC"),
has occurred with respect to any Company Employee Pension Benefit Plan subject
to Title IV of the ERISA. No proceedings by the PBGC to terminate any Company
Employee Pension Benefit Plan pursuant to Subtitle C of Title IV of ERISA have
to the best of the Company's knowledge, been instituted or threatened. Except
for any liabilities in an amount which, in the aggregate, would not have a
Company Material Adverse Effect, neither the Company nor any Subsidiary (1) has
incurred any liability to the PBGC in connection with any Company Employee
Pension Benefit Plan, including any liability under Section 4069 of ERISA and
any penalty imposed under Section 4071 of ERISA, (2) has terminated any Company
Employee Pension Benefit Plan, or ceased operations at any facility or withdrawn
from any Company Employee Pension Benefit Plan, in a manner that could subject
it to liability or any liens under Section 4062, 4063, 4064 or 4068 of ERISA or
(3) has any knowledge as to the existence of any state of facts, or as to the
occurrence of any transactions, that might reasonably be anticipated to result
in any liability of the Company or any Subsidiary to the PBGC under any other
provision of Title IV of ERISA. There is no pending or, to the best knowledge of
the Company, threatened legal action, proceeding or investigation against or
involving any Company Employee Benefit Plan which could result in liabilities to
the Plan, the Company or any Subsidiary. Except as disclosed on Schedule 6.10,
the present value of accrued benefits of each Company Employee Benefit Plan that
is a defined benefit plan as defined in Section 3(35) of ERISA does not exceed
the value of the assets of such plan available to pay such benefits by an amount
that, in the aggregate for all such plans, could have a Company Material Adverse
Effect. All representations made by the Company in this Section 6.11 are
likewise true with respect to each Subsidiary.
6.12 ENVIRONMENTAL MATTERS. "Company Real Properties" shall mean all real
property now or previously owned, operated or leased by the Company, any
Subsidiary or any predecessor-in-interest. Except as set forth on Schedule 6.12:
(i) the Company, each of the Subsidiaries, and to the best of the Company's
knowledge, each of the Company Real Properties is in compliance with, and has no
liability under any or all applicable Environmental Laws, (ii) none of the
Company, any Subsidiary or any of the Company Real Properties has been alleged
in writing by any governmental agency or third party to be in violation of, to
be liable under, or to be subject to any administrative or judicial proceeding
pursuant to, any Environmental Law and (iii) there are no facts or circumstances
which could reasonably form the basis for the assertion of any claims against
the Company or any Subsidiary relating to environmental matters, except, in any
such case, where the failure to comply or such liability could not be reasonably
expected to have a Company Material Adverse Effect. As used herein,
Environmental Law means any federal, state, or local law, statute, rule or
regulation, or the common law governing or relating to the environment or to
occupational health and safety.
6.13 REAL ESTATE LEASES. Schedule 6.13 sets forth a complete and accurate
list, copies of which have been delivered to the Acquiror, of (i) all leases and
subleases under which the Company or any Subsidiary is lessor or lessee of any
real property, together with all amendments, supplements, nondisturbance
agreements and other agreements pertaining thereto; (ii) all material options
held by the Company or any Subsidiary or contractual obligations on the part of
the Company or any Subsidiary to purchase or acquire any interest in real
property; and (iii) all options granted by the Company or any Subsidiary or
contractual obligations on the part of the Company or any Subsidiary to sell or
dispose of any material interest in real
A-14
<PAGE>
property in each such instance in items (i) through (iii) above, which provides
for a payment of more than $25,000. Such leases, subleases and other agreements
are in full force and constitute binding obligations of the Company and, to the
best of its knowledge, the other parties thereto, and (i) there are no defaults
thereunder by the Company or any Subsidiary or, to the best of Company's
knowledge, by any other party thereto and (ii) no event has occurred which (with
notice, lapse of time or both or occurrence of any other event) would constitute
a default by the Company or any Subsidiary or, to the best of the Company's
knowledge, by any other party thereto, except, in either such instance, for
defaults or events that could not be reasonably expected to have a Company
Material Adverse Effect. The Company or a Subsidiary has good, valid and
insurable leasehold title to all such leased property, free and clear of all
encumbrances, liens, charges or other restrictions of any kind or character,
except for Permitted Liens, as defined below.
6.14 TITLE TO PROPERTIES; ABSENCE OF LIENS AND ENCUMBRANCES. The Company
does not own any real property. Except for leased assets, the Company and the
Subsidiaries have good and insurable title to all of their material tangible
personal property used in their businesses, including, without limitation, those
reflected in the balance sheet of the Company as of March 31, 1998 (the "Company
Balance Sheet") (other than assets disposed of in the ordinary course of
business since March 31, 1998), free and clear of all Encumbrances, except liens
for taxes not yet due and payable and such liens or other imperfections of
title, if any, as would not, in the aggregate, have a Company Material Adverse
Effect on the operation of the business of the Company or any Subsidiary, and
except as reflected or disclosed in the Company Balance Sheet, or on Schedule
6.14.
6.15 TAX MATTERS. Except as set forth on Schedule 6.15, the Company has
paid, or the Company Balance Sheet contains adequate provision for, all federal,
state, local, foreign or other governmental income, excise, franchise, payroll,
F.I.C.A., unemployment, withholding, real property, personal property, sales,
payroll, disability and all other taxes imposed on the Company or any Subsidiary
or with respect to any of their respective properties, or otherwise payable by
them, including interest and penalties, if any, in respect thereof
(collectively, "Company Taxes"), for the Company taxable period ended on the
date of the Company Balance Sheet and all fiscal periods of the Company prior
thereto. Company Taxes paid and/or incurred from the date of the Company Balance
Sheet until the Effective Time will include only Company Taxes incurred in the
ordinary course of business determined in the same manner as in the taxable
period ending on the date of the Company Balance Sheet. Except as disclosed on
Schedule 6.15, the Company and its Subsidiary have timely filed all income tax,
excise tax, sales tax, use tax, gross receipts tax, franchise tax, employment
and payroll related tax, property tax, and all other tax returns which the
Company and/or each Subsidiary (as the case may be) are required to file ("Tax
Returns"), and have paid or provided for all the amounts shown to be due
thereon. Except as set forth on Schedule 6.15, (i) neither the Company nor any
Subsidiary has filed or entered into, or is otherwise bound by, any election,
consent or extension agreement that extends any applicable statute of
limitations with respect to taxable periods of the Company, (ii) the Company is
not a party to any contractual obligation requiring the indemnification or
reimbursement of any person with respect to the payment of any Tax, (iii) no
claim has ever been made or threatened by an authority in a jurisdiction where
the Company or any Subsidiary do not file Tax Returns that they are or may be
subject to Taxes by that jurisdiction, (iv) no issues have been raised by the
relevant taxing authorities on audit that are of a recurring nature and that
would have an effect upon the Taxes of the Company or any Subsidiary. Except as
set forth on Schedule 6.15, to the best of the Company's and each Subsidiary's
knowledge, no action or proceeding is pending or threatened by any governmental
authority for any audit, examination, deficiency, assessment or collection from
the Company or any Subsidiary of any Company Taxes, no unresolved claim for any
deficiency, assessment or collection of any Company Taxes has been asserted
against the Company or any Subsidiary, and all resolved assessments of Company
Taxes have been paid or are reflected in the Company Balance Sheet.
6.16 PROPRIETARY PROPERTY. Schedule 6.16 contains a complete and accurate
list of all material trade names, trademarks, service marks, copyrights, trade
names, brand names, software and proprietary and other technical information
(collectively "Proprietary Property"), including all contracts, agreements and
A-15
<PAGE>
licenses relating thereto, owned by the Company or the Subsidiaries or in which
any of them has any rights to any such Proprietary Property. To the Company's
knowledge, none of the Company or the Subsidiaries has infringed or is now
infringing on any Proprietary Property belonging to any other person, firm or
corporation. The Company and the Subsidiaries own or hold adequate licenses or
other rights to use all Proprietary Property necessary for them to conduct their
respective businesses as they are being conducted, including without limitation,
all such rights relating to all software and related Proprietary Property used
in and necessary for the operation of the Company's debit card platform and the
Company's billing system relating to its 10XXX program, except where the failure
to hold such rights could not be reasonably expected to result in a Company
Material Adverse Effect. Except as disclosed on Schedule 6.16, none of the
Company or the Subsidiaries has granted any licenses with respect to any of
their respective Proprietary Property. None of the Company or the Subsidiaries
has received any notice of, nor does the Company have any knowledge with respect
to, any claim of infringement or other conflict or claimed conflict with respect
to the rights of others to the use of the corporate name of the Company or any
Subsidiary or any of their Proprietary Property, except such conflicts or
claimed conflicts which, in the aggregate, would not result in a Company
Material Adverse Effect. No Proprietary Property is subject to any outstanding
order, judgment, decree, stipulation or agreement restricting the use thereof by
the Company or any Subsidiary or restricting the licensing thereof by the
Company or any Subsidiary to any Person. Except as set forth on Schedule 6.16,
neither the Company nor any Subsidiary has entered into any agreement to
indemnity any other party against any charge of infringement of any patent,
trademark, service mark or copyright.
6.17 LABOR MATTERS. Neither the Company nor any Subsidiary is a party to
any collective bargaining agreement with respect to any of their employees. None
of the employees of the Company or any Subsidiary are represented by any labor
union and, as of the date hereof, neither the Company nor any Subsidiary has any
knowledge of any union organizational efforts involving the Company's employees
during the past five years. Except as set forth on Schedule 6.17, neither the
Company nor any Subsidiary has received written notice of any claim, or has
knowledge of any facts which are likely to give rise to any claim, that they
have not complied in any material respect with any laws relating to the
employment of labor, including, without limitation, any provisions thereof
relating to wages, hours, collective bargaining, the payment of social security
and similar taxes, equal employment opportunity, employment discrimination or
employment safety.
6.18 INSURANCE. Schedule 6.18 lists, as of the date of this Agreement, all
material policies of fire, products liability, general liability, vehicle,
worker's compensation, directors' and officers' liability, title and other
insurance owned or held by or covering the Company or any Subsidiary or any of
their property or assets which are material to the business of the Company and
any Subsidiary, taken as a whole. As of the date hereof, all of such policies
are in full force and effect, except as to matters or defaults which, in the
aggregate, would not have a Company Material Adverse Effect, and no written
notice of cancellation or termination has been received with respect to any such
policy which has not been replaced or cannot be replaced on substantially
similar terms prior to the date of such cancellation or termination.
6.19 MATERIAL CONTRACTS. Schedule 6.19 lists, as of the date of this
Agreement, the following contracts or agreements to which the Company or a
Subsidiary is a party or is bound (collectively, the "Material Contracts"), (i)
all contracts or other agreements, whether or not made in the ordinary course of
business, which are material to the business of the Company and the Subsidiaries
taken as a whole; (ii) all contracts in the nature of mortgages, indentures,
promissory notes, loan or credit agreements or similar instruments under which
the Company and the Subsidiaries have borrowed or may borrow at least
$1,000,000; (iii) any personal property lease providing for annual rentals of
$500,000 or more; (iv) any agreement with a term of at least one year for the
purchase of materials, supplies, goods, services, equipment or other assets
providing for either annual payments by the Company and the Subsidiaries of
$500,000 or more or aggregate payments by the Company and the Subsidiaries of
$1,000,000 or more; (v) any sales, distribution or other similar agreement with
a term of at least six months, providing for the
A-16
<PAGE>
sale by the Company or any Subsidiary of materials, supplies, goods, services,
equipment or other assets that provides for (A) annual payments to the Company
and the Subsidiaries of $200,000 or more and (B) does not by its terms permit
the Company or any Subsidiary to pass any increase in the costs of such
materials, supplies, goods, services, equipment or other assets on to the
counterpart thereto; (vi) any material partnership, joint venture or other
similar agreement or arrangement; (vii) any material agreement relating to the
acquisition or disposition of any business (whether by merger, sale of stock,
sale of assets or otherwise) entered into since April 1, 1997; (viii) any and
all carrier services agreements, operating agreements and agreements with
vendors; (ix) any material option, license, franchise or similar agreement; (x)
any material agency, dealer, sales representative, marketing or other similar
agreement; (xi) any agreement that limits the freedom of the Company or any
Subsidiary to compete in any line of business or with any Person or in any area
or which would so limit the freedom of the Company or any Subsidiary after the
Effective Date; (xii) all agreements with qualified independent distributors;
(xiii) any agreement with any person directly or indirectly owning, controlling
or holding with power to vote, 5% or more of the outstanding voting securities
of the Company. Except as set forth on Schedule 6.19, each of the Material
Contracts is valid and binding and in full force and effect, enforceable by the
Company in accordance with its terms, except to the extent that such
enforceability may be subject to applicable bankruptcy, insolvency, moratorium,
reorganization or other laws affecting the enforcement of creditors' rights
generally or by general equitable principles. None of the Company or the
Subsidiaries or, to the knowledge of the Company, any other party thereto, is in
default in any respect, and no event has occurred which (whether with or without
notice, lapse of time or the happening or occurrence of any other event) would
constitute a default of the Company or any Subsidiary or, to the knowledge of
the Company, any third party, under any of the Material Contracts, except such
defaults which, in the aggregate, would not result in a Company Material Adverse
Effect. True and complete copies of each of the Material Contracts have been
delivered or made available to the Acquiror.
6.20 PROXY STATEMENT; OTHER INFORMATION. The information supplied or to be
supplied in writing by the Company specifically for inclusion in the Proxy
Statement and any other documents to be filed with the SEC or any other
regulatory agency in connection with the transactions contemplated hereby will,
at the respective times such documents are filed, or, as applicable, declared
effective, and on the Effective Time, and, with respect to the Proxy Statement,
when first published, sent or given to stockholders of the Acquiror, not be
false or misleading with respect to any material fact, or omit to state any
material fact necessary in order to make the statements therein not misleading
or, in the case of the Proxy Statement or any amendment thereof or supplement
thereto, be false or misleading with respect to any material fact, or omit to
state any material fact necessary to correct any statement in any earlier
communication with respect to the solicitation of any proxy for such meeting.
If, at any time prior to the Effective Time, any event relating to the Company
or any of its affiliates, officers or directors is discovered by the Company
that should be set forth in a supplement to the Proxy Statement, the Company
will promptly inform the Acquiror.
6.21 BROKERS. Except as set forth in Schedule 6.21, neither the Company
nor any Subsidiary has paid or become obligated to pay any fee or commission to
any broker, finder, investment banker or other intermediary in connection with
this Agreement. The Company has delivered to the Acquiror copies of all current
engagement letters that the Company has entered with BT Alex. Brown
Incorporated.
6.22 TRANSACTIONS WITH AFFILIATED PARTIES. Schedule 6.22 sets forth a true
and complete list and description of all transactions engaged in since April 1,
1996 between the Company and any director, officer, employee, stockholder,
partner or agent of the Company, or any of their respective spouses or children,
any trust of which any such person is the grantor, trustee or beneficiary, any
corporation of which any such person or party is a stockholder, employee,
officer or director, or any partnership or other person in which any such person
or party owns an interest (all such persons, trusts, corporations and
partnerships being herein referred to collectively as "Affiliated Parties" and
individually as an "Affiliated Party"). No
A-17
<PAGE>
Affiliated Party is a party to any agreement, contract or commitment with the
Company except as set forth in Schedule 6.22.
6.23 DISTRIBUTORS. Schedule 6.23 hereto sets forth the Company's five (5)
largest distributors for the fiscal year ended March 31, 1998 and for the fiscal
quarter ended June 30, 1998 (the "Large Distributors").
6.24 ACCOUNTS RECEIVABLE. The accounts receivable of the Company set forth
on the Company Balance Sheet or which have arisen since April 1, 1998 have
arisen only from bona fide transactions in the ordinary course of business. The
services sold and delivered that gave rise to such accounts were sold and
delivered in conformity in all material respects with applicable Material
Contracts and, except as set forth on Schedule 6.24, as of March 31, 1998 there
were no refunds, rebates, discounts or other adjustments payable with respect to
any such accounts receivable.
6.25 INVENTORY. As of the date of the Company Balance Sheet, inventories
set forth on the Company Balance Sheet consisted in all material respects of
items of a quantity and quality saleable in the ordinary course of business net
of applicable reserves. All such inventories are valued on the Company Balance
Sheet in accordance with GAAP applied on a basis consistent with past practices.
ARTICLE VII
COVENANTS AND AGREEMENTS
7.1 PROXY STATEMENT; SPECIAL MEETING. As promptly as practicable following
the execution of this Agreement, Acquiror agrees that this Agreement shall be
submitted at a special meeting of its stockholders duly called and held pursuant
to Section 251(c) of the DGCL (the "Special Meeting") to consider and vote upon
the approval of the Merger. In connection with the Original Agreement, on July
14, 1998 the Acquiror filed the Proxy Statement in its preliminary form with the
SEC. In connection with the execution of this Agreement, the Acquiror shall, as
expeditiously as possible, prepare and file with the SEC an amendment to the
preliminary Proxy Statement and all other filings relating to the Special
Meeting as required by the Exchange Act and the rules and regulations of the SEC
promulgated thereunder and, in that regard, the Company will provide all
necessary assistance as may be requested by the Acquiror with respect to such
filing. Acquiror shall use all commercially reasonable efforts to solicit from
its stockholders proxies to be voted at the Special Meeting in favor of this
Agreement and the transactions contemplated hereby, including without
limitation, the Merger, which solicitation shall include the recommendations of
the Company's Board of Directors in favor of this Agreement, the Merger and such
other transactions. Acquiror will provide the Company and its advisors drafts of
the revised preliminary Proxy Statement and will provide the Company and its
advisors a reasonable opportunity to participate in such drafting process. The
Acquiror will notify the Company promptly of the receipt of any comments from
the SEC or its staff and of any request by the SEC or its staff for amendments
or supplements to the Proxy Statement or for additional information, and will
supply the Company and its legal counsel with copies of all correspondence
between the Acquiror or any of its representatives, on the one hand, and the SEC
or its staff, on the other hand, with respect to the Proxy Statement. The term
"Proxy Statement" shall mean such proxy statement at the time it initially is
mailed to the stockholders of Acquiror and all duly filed amendments or
revisions made thereto, if any, similarly mailed.
7.2 CONDUCT OF THE BUSINESS OF THE COMPANY PRIOR TO THE EFFECTIVE
TIME. The Company and the Stockholders agree that prior to the Effective Time,
except as set forth on Schedule 7.2, otherwise consented to or approved in
writing by the Acquiror or expressly permitted by this Agreement:
(a) the business of the Company and the Subsidiaries shall be conducted
only in the ordinary course and consistent with past practice;
(b) each of the Company and each Subsidiary shall not (i) amend its
Certificate of Incorporation or Bylaws, (ii) change the number of
authorized, issued or outstanding shares of its capital stock, except upon
the exercise of stock options or warrants outstanding on the date hereof,
(iii) declare, set
A-18
<PAGE>
aside or pay any dividend or other distribution or payment in cash, stock or
property in respect of shares of its capital stock, (iv) make any direct or
indirect redemption, retirement, purchase or other acquisition of any of its
capital stock or (v) split, combine or reclassify its outstanding shares of
capital stock;
(c) neither the Company nor any Subsidiary shall, directly or
indirectly, (i) issue, grant, sell or pledge or agree or propose to issue,
grant, sell or pledge any shares of, or rights of any kind to acquire any
shares of the capital stock of the Company or any Subsidiary, except that
the Company may issue shares of Common Stock upon the exercise of stock
options or warrants outstanding on the date hereof, (ii) incur any material
indebtedness for borrowed money, except material indebtedness for borrowed
money incurred under credit facilities existing as of the date hereof, (iii)
waive, release, grant or transfer any rights of material value or (iv)
transfer, lease, license, sell, mortgage, pledge, dispose of or encumber any
material assets of the Company or any Subsidiary other than in the ordinary
course of business and consistent with past practice;
(d) the Company and the Subsidiaries shall preserve intact the business
organization of the Company and the Subsidiaries, use their respective best
efforts to keep available the services of its operating personnel and use
their respective best efforts to preserve the goodwill of those having
business relationships with each of them, including, without limitation, the
Large Distributors;
(e) neither the Company nor any Subsidiary will, directly or indirectly,
(i) increase the compensation payable or to become payable by it to any of
its employees, officers or directors, except in accordance with employment
agreements, welfare and benefit plans set forth on Schedule 6.10, (ii) adopt
additional, or make any payment or provision, other than as required by
existing plans or agreements, including provisions and actions under
existing stock option plans in connection with the Merger, in the ordinary
course of business and consistent with prior practice, with respect to any
stock option, bonus, profit sharing, pension, retirement, deferred
compensation, employment or other payment or employee compensation plan,
agreement or arrangement for the benefit of employees of the Company or any
Subsidiary, (iii) grant any stock options or stock appreciation rights or
issue any warrants, (iv) enter into or amend any employment or severance
agreement or arrangement or (v) make any loan or advance to, or enter into
any written contract, lease or commitment with, any officer or director of
the Company or its Subsidiary or any Stockholder;
(f) neither the Company nor any Subsidiary shall, directly or
indirectly, assume, guarantee, endorse or otherwise become responsible for
the obligations of any other individual, firm or corporation other than a
Subsidiary or make any loans or advances to any individual, firm or
corporation except in the ordinary course of its business and consistent
with past practices;
(g) neither the Company nor any Subsidiary shall make any investment of
a capital nature either by purchase of stock or securities, contributions to
capital, property transfers, acquisition or financing of equipment or any
other assets or otherwise by the purchase of any property or assets of any
other individual, firm or corporation, except with respect to capital
expenditures incurred in the ordinary course of business under Material
Contracts in place on the date of this Agreement;
(h) neither the Company nor any Subsidiary shall enter into, modify or
amend in any material respect or take any action to terminate their
respective Material Contracts, except in the ordinary course of business;
(i) neither the Company nor any Subsidiary shall take any action, other
than reasonable and usual actions in the ordinary course of business and
consistent with past practice, with respect to accounting policies or
procedures, except for changes required by GAAP;
(j) neither the Company nor any Subsidiary shall settle or compromise
any material federal, state, local or foreign income or excise tax
proceeding or audit;
A-19
<PAGE>
(k) the Company and the Subsidiaries will promptly advise the Acquiror
in writing of any Company Material Adverse Effect or any breach of the
Company's representations or warranties, or any material breach of a
covenant contained herein of which the Company or any Subsidiary has
knowledge; and
(l) neither the Company nor any Subsidiary shall enter into any
agreement, commitment or arrangement to do any of the things described in
clauses (a) through (k).
From time to time, at the request of Acquiror, representatives of the Company
shall be available to meet with the chief executive officer or chief financial
officer of the Acquiror to discuss the Company and all ongoing operational
issues and matters and to provide such periodic financial information and data
as may be requested by the Acquiror. Following the execution of this Agreement,
the Company and Acquiror shall commence negotiations with respect to the terms
and conditions of a route management agreement to be entered into between such
parties prior to the Closing Date.
7.3 ACCESS TO PROPERTIES AND RECORD. Each party to this Agreement shall
afford to the other parties hereto and their respective accountants, financial
advisors, counsel and representatives, reasonable access during normal business
hours throughout the period prior to the Effective Time to all of their
properties, books, contracts, commitments and written records, including without
limitation, all regulatory filings with the FCC, state public utilities
commissions and Foreign Agencies from the last four years and all tax returns
for the preceding six years), and shall make reasonably available their officers
and employees to answer fully and promptly questions put to them thereby;
provided that no investigation pursuant to this Section 7.3 shall alter any
representation or warranties of any party hereto or conditions to the obligation
of the parties hereto; provided, further, that such access shall not
unreasonably interfere with the normal business operations of any of the parties
hereto.
7.4 ACQUISITION PROPOSALS. Following the execution of this Agreement, none
of the Company, any Subsidiary, the Stockholders nor any of the Company's or any
Subsidiary's directors, partners, officers, employees or other representatives
or agents shall, directly or indirectly, communicate, solicit, initiate,
encourage or participate in discussions or negotiations with or the submission
of any offer or proposal by or provide any information or access to, any
corporation, partnership, person, or other entity or group (other than Newco or
Acquiror or an officer or other authorized representative of Newco or Acquiror)
concerning any Acquisition Proposal. The Company will promptly, and in no event
later than 24 hours after receipt of the relevant Acquisition Proposal, notify
(which notice shall be provided orally and in writing) the Acquiror after (i)
the Company has received any Acquisition Proposal, (ii) the Company has actual
knowledge that any person is considering making an Acquisition Proposal, or
(iii) the Company has received any request for information relating to the
Company or any Subsidiary, or for access to the properties, books or records of
the Company or any Subsidiary, by any person that the Company has actual
knowledge is considering making, or has made, an Acquisition Proposal. Such
notice shall contain, among other things, the identity of the person making or
considering an Acquisition Proposal and the terms and conditions of such
Acquisition Proposal, including without limitation the consideration offered or
to be offered in connection therewith. The Company will keep the Acquiror fully
informed of the status and details of any such Acquisition Proposal or request.
The Company and the Stockholders shall, and shall cause the Company's and each
Subsidiary's directors, officers, employees, financial advisors and other agents
or representatives to, cease immediately and cause to be terminated all
activities, discussions or negotiations, if any, with any persons heretofore
conducted with respect to any Acquisition Proposal. For purposes of this
Agreement, "Acquisition Proposal" means any offer or proposal for a merger or
other business combination involving the Company or any Subsidiary or the
acquisition of any equity interest in, or a substantial portion of the assets
of, the Company or any Subsidiary, other than the transactions contemplated by
this Agreement.
A-20
<PAGE>
7.5 INDEMNIFICATION BY THE STOCKHOLDERS.
(a) Following the Effective Time, the Stockholders agree, (i) with
respect to the representations and warranties set forth in Article V,
severally but not jointly, and (ii) with respect to the representations and
warranties set forth in Article VI, jointly and severally, to indemnify
Acquiror, and each of Acquiror's respective officers, directors, employees,
agents and representatives (collectively, the "Acquiror Indemnitees"),
against, and hold such Acquiror Indemnitees harmless from any and all
claims, obligations, losses, damages, costs, expenses (including without
limitation, reasonable attorneys' fees and expenses) and other liabilities
of Acquiror (collectively, the "Losses") arising out of the breach of any
representation, warranty, covenant or agreement of the Company or the
Stockholders herein, whether or not such Losses arise as a result of third
party claims asserted against the Company. Notwithstanding the foregoing,
the Stockholders shall not be liable to the Acquiror Indemnitees under this
Section 7.5(a) until the aggregate of all such Losses exceeds One Million
Dollars ($1,000,000) (the "Stockholders's Threshold Amount"), in which case
the Stockholders shall be required to indemnify the Acquiror Indemnitees for
the full amount of such Losses, including the Stockholders's Threshold
Amount. Notwithstanding the foregoing, no claim for indemnification under
this Section 7.5(a) may be made after the Escrow Period.
(b) Each of the Acquiror Indemnitees agrees to give the Stockholders
prompt written notice of any claim, assertion, event or proceeding by or in
respect of a third party of which it has knowledge concerning any Loss as to
which it may request indemnification hereunder with respect to any such
third party claim. The Stockholders shall have the right to direct, through
counsel of their own choosing, the defense or settlement of any such third
party claim or proceeding (provided that the Stockholders shall have first
acknowledged its indemnification obligations hereunder specifically in
respect of such claim or proceeding) at its own expense, which counsel shall
be reasonably satisfactory to the Acquiror Indemnitees. If the Stockholders
elect to assume the defense of any such claim or proceeding, the Acquiror
Indemnitees may participate in such defense, but in such case the expenses
of the Acquiror Indemnitees incurred in connection with such participation
shall be paid by the Acquiror Indemnitees. The Acquiror Indemnitees shall
reasonably cooperate with the Stockholders in the defense or settlement of
any such claim, assertion, event or proceeding. If the Stockholders elect to
direct the defense of any such claim or proceeding, the Acquiror Indemnitees
shall not pay, or permit to be paid, any part of any claim or demand arising
from such asserted Loss, unless the Stockholders consent in writing to such
payment or unless the Stockholders withdraws from the defense of such
asserted Loss, or unless a final judgment from which no appeal may be taken
by or on behalf of the Stockholders is entered against any Acquiror
Indemnitee for such Loss. The Stockholders will not settle or compromise any
claim subject to this Section 7.5(b) without the prior consent of the
affected Acquiror Indemnitees, such consent not to be unreasonably withheld,
provided that such consent shall not be necessary if such settlement or
compromise includes (i) the payment of monetary damages by the Stockholders
on behalf of such Acquiror Indemnitees and (ii) the full release of such
Persons. If the Stockholders shall fail to defend, or if, after commencing
or undertaking any such defense, the Stockholders fail to prosecute or
withdraws from such defense, the Acquiror Indemnitees shall have the right
to undertake the defense or settlement thereof at the Stockholders's
expense.
(c) Any Loss subject to indemnification pursuant to this Section 7.5
shall be offset against any appropriate number of Escrow Shares pursuant to
the terms and conditions of the Escrow Agreement.
(d) Notwithstanding any other provision herein to the contrary, (i)
following the Effective Time, the indemnification of Acquiror by the
Stockholders in this Section 7.5 shall be the exclusive remedy for any
breach of any representation, warranty, covenant or agreement of the Company
or the Stockholders in this Agreement or the Escrow Agreement, (ii) recourse
for any Loss shall be limited exclusively to the right to receive Escrow
Shares in accordance with the terms of this Agreement and the Escrow
Agreement and (iii) in determining the number of Escrow Shares required to
satisfy any Loss, the Escrow Shares shall be valued at the average closing
price of Acquiror Common Stock on
A-21
<PAGE>
The Nasdaq Stock Market for the five (5) trading days prior to the date on
which such Escrow Shares are delivered in satisfaction of a claim in respect
of such Loss.
7.6 CONFIDENTIALITY.
(a) Subject to applicable law and to subpoena, the Acquiror and Newco
will hold, and will cause each of their affiliates, employees, officers,
directors and other representatives to hold, in strict confidence, and to
not use to the detriment of the Company or the Subsidiaries, any information
or data concerning the Company or the Subsidiaries furnished to them in
connection with the transactions contemplated by this Agreement, except for
information or data generally known or available to the public; and if the
transactions contemplated by this Agreement are not consummated, such
confidence shall be maintained and the Acquiror and Newco will return to the
Company or the Subsidiaries all such information and data as the Company or
the Subsidiaries may request.
(b) Subject to applicable law and to subpoena, each of the Company, its
Subsidiaries and the Stockholders will hold, and will cause each of the
Company's and each Subsidiary's employees, officers, directors and other
representatives to hold, in strict confidence, and to not use to the
detriment of the Acquiror or Newco, any information or data concerning the
Acquiror or Newco furnished to them in connection with the transactions
contemplated by this Agreement, except for information or data generally
known or available to the public; and if the transactions contemplated by
this Agreement are not consummated, such confidence shall be maintained and
the Company and the Subsidiaries will return to the Acquiror or Newco all
such information and data as the Acquiror or Newco may request.
7.7 REASONABLE BEST EFFORTS. Subject to the terms and conditions hereof,
each of the parties hereto agrees to use their reasonable best efforts to take,
or cause to be taken, all action and to do, or cause to be done, all things
necessary to satisfy the conditions set forth herein as soon as practicable,
including, without limitation, reasonable best efforts necessary to have removed
or rescinded any temporary, preliminary or permanent injunction, including the
injunctions or other orders described in Section 8.1(b). The Acquiror and the
Company each agree to take, or cause to be taken, all action, and to do, or
cause to be done, all things necessary or required by (a) the United States
Federal Trade Commission or the United States Department of Justice in
connection with the expiration or termination of the waiting period under the
HSR Act and (b) the FCC and applicable state regulatory agencies and public
utilities commissions in connection with the transfer of any licenses required
hereunder, including without limitation, any license held by the Company under
Section 214 of the Communications Act, provided that neither party will be
required to take any action or to do anything in connection with the foregoing
which would materially impair the Acquiror's or the Surviving Corporation's
ownership or operation of all or a material portion of the business and assets
of the Company and its Subsidiary taken as a whole, or compel the Acquiror to
dispose of all or a material portion of the business or assets of the Acquiror
and its subsidiaries, taken as a whole. No party hereto will take any action for
the purpose of delaying, impairing or impeding the receipt of any required
consent, authorization, order or approval or the making of any required filing
or registration.
7.8 WITHDRAWAL OF COMPANY S-1. Prior to the Closing Date, the Company
shall file all necessary documents with the SEC and take all other necessary
steps to terminate the registration process with respect to the registration of
the shares of the Company's Common Stock under the Securities Act.
7.9 PROXY OF PRINCIPAL STOCKHOLDERS. On or prior to its execution of this
Agreement, Acquiror shall receive from Chris Edgecomb, Mary Casey and David Vaun
Crumly proxies, substantially in the form of Exhibit C hereto (the "Proxies"),
which Proxies shall include, among other things, the agreement of such parties
to vote in favor of this Agreement and the transactions contemplated hereby,
including without limitation, the Merger.
A-22
<PAGE>
7.10 CERTAIN EVENTS. Acquiror will promptly advise the Company and the
Stockholders in writing of any event or condition that would have a material
adverse effect on the ability of Acquiror to consummate the transactions
contemplated hereby, including without limitation, the Merger, or of any
material breach of Acquiror's representations or warranties or any material
breach of a covenant contained herein of which Acquiror has knowledge.
7.11 FINANCIAL STATEMENTS. As promptly as practical but no later than
forty five days following the end of each of the Company's fiscal quarters, the
Company shall deliver to Acquiror the Company's balance sheet and its statements
of operations, stockholders' equity and cash flows for such fiscal quarter,
which financial statements shall be accompanied by the certification of the
Company's chief financial officer that such financial statements have been
prepared in accordance with GAAP, consistently applied, subject only to normal
year-end adjustments.
7.12 CONDUCT OF THE BUSINESS OF ACQUIROR PRIOR TO THE EFFECTIVE
TIME. Acquiror agrees that prior to the Effective Time, except as expressly
permitted by this Agreement or as otherwise consented to by the Company, which
consent shall not apply to Section 7.12(e), Acquiror:
(a) shall preserve intact its business organization and shall use all
reasonable efforts to keep available the services of its key operating
personnel and to preserve the goodwill of those parties having a material
business relationship with Acquiror;
(b) shall not change in any material respect Acquiror's accounting
methods, principles or practices, except for actions taken in the ordinary
course of business and actions consistent with or required by GAAP;
(c) shall not enter into a plan of dissolution or liquidation or
otherwise commence the winding down of Acquiror's operations;
(d) shall not, except with respect to options granted and/or exercised
in the ordinary course of business, issue a material number of shares of
Acquiror Common Stock at a price that is more than 10% below the last
closing sales price of Acquiror Common Stock, as quoted on The Nasdaq Stock
Market on the trading day immediately prior to the date of issuance; and
(e) shall not enter into any transaction or series of relating
transactions with an aggregate purchase price of more than $100 million
without notifying the Company prior thereto.
ARTICLE VIII
CONDITIONS PRECEDENT
8.1 CONDITIONS TO EACH PARTY'S OBLIGATION TO EFFECT THE MERGER. The
respective obligations of each party to effect the Merger shall be subject to
the fulfillment at or prior to the Effective Time of the following conditions:
(a) This Agreement and the Merger contemplated hereby shall have been
approved and adopted by the requisite vote of the holders of the outstanding
shares of Acquiror Common Stock entitled to vote thereon at the Special
Meeting.
(b) No United States or state governmental authority or other agency or
commission or United States or state court of competent jurisdiction shall
have enacted, issued, promulgated, enforced or entered any statute, rule,
regulation, injunction or other order (whether temporary, preliminary or
permanent) which is in effect and has the effect of making the acquisition
of Common Stock by Newco illegal or otherwise prohibiting consummation of
the transactions contemplated by this Agreement.
(c) Any waiting period applicable to the Merger under the HSR Act shall
have expired or been terminated.
A-23
<PAGE>
(d) All material filings with the FCC required under the Communications
Act, with state agencies under state public utility statutes and with
Foreign Agencies under applicable foreign statutes shall have been made, and
all approvals with respect to such material filings shall have been
received.
(e) The shares of Acquiror Common Stock issuable in the Merger or
thereafter shall have been authorized for listing on the Nasdaq National
Market, upon official notice of issuance.
(f) There shall not have been instituted or pending any action or
proceeding by or before any court or governmental authority or other
regulatory or administrative agency or commission, domestic or foreign, by
any government or governmental authority, nor shall there be any
determination by any government, governmental authority, regulatory or
administrative agency or commission which, in either case, would require
either party to take any action or do anything in connection with the
foregoing which would result in a material adverse effect to their
respective businesses or materially impair Acquiror's or the Surviving
Corporation's ownership or operation of all or a material portion of the
business or assets of the Company and the Subsidiary, taken as a whole, or
compel Acquiror to dispose of all or a material portion of the business or
assets of Acquiror and the Subsidiaries, taken as a whole.
8.2 CONDITIONS TO THE OBLIGATION OF THE COMPANY AND THE STOCKHOLDERS TO
EFFECT THE MERGER. The obligation of the Company to effect the Merger shall be
subject to the fulfillment at or prior to the Effective Time of the following
additional conditions:
(a) Each of the Acquiror and Newco shall have performed in all material
respects its obligations under this Agreement required to be performed by it
on or prior to the Effective Time pursuant to the terms hereof.
(b) All representations or warranties of the Acquiror and Newco in this
Agreement which are qualified with respect to an Acquiror Material Adverse
Effect or materiality shall be true and correct, and all such
representations or warranties that are not so qualified shall be true and
correct in all material respects, in each case as if such representation or
warranty was made as of the Effective Time, except to the extent that any
such representation or warranty is made as of a specified date, in which
case such representation or warranty shall have been true and correct as of
such specified date.
(c) Since the date of this Agreement, there shall not have been any
material adverse change in the financial condition, results of operations,
properties or business of the Acquiror and its Subsidiaries, taken as a
whole, excluding any such change caused by a general change in the economy
or in the telecommunications industry served by the Acquiror and its
Subsidiaries.
(d) Each of the Acquiror and Newco shall have delivered a certificate of
its President or Vice President to the effect set forth in paragraphs (a),
(b) and (c) of this Section 7.2.
(e) Acquiror and each Stockholder shall have entered into a registration
rights and share restriction agreement in the form of Exhibit D hereto.
(f) The Company shall have received from Riordan & McKinzie, counsel to
the Acquiror and Newco, an opinion dated the Effective Time and covering
such matters as may be reasonably requested by the Company and the
Stockholders.
(g) The Acquiror shall have taken all necessary steps such that ST will
become a member of the Board of Directors of the Acquiror immediately
following the Effective Time.
(h) The Company shall have received reasonably satisfactory evidence
that, following the Effective Date, (i) the shares of Acquiror Common Stock
issuable on exercise of the Options and Warrants will be subject to an
effective Registration Statement on Form S-8 filed by Acquiror pursuant to
the Securities Act, (ii) 250,000 shares of Acquiror Common Stock have been
reserved for issuance to selected distributors of the Company in the form of
restricted shares pursuant to restricted
A-24
<PAGE>
stock purchase agreements to be entered into between such distributors and
the Acquiror, at no consideration per share to such distributors and with a
pro rata vesting schedule of no more than four years, such distributors to
be designated by the Company and reasonably acceptable to the Acquiror and
(iii) 100,000 shares of Acquiror Common Stock have been reserved for
issuance to selected employees in the form of stock options under the
Acquiror's presently outstanding employee stock option plan, with such
selected employees to be designated by the Company and reasonably acceptable
to the Acquiror.
8.3 CONDITIONS TO OBLIGATIONS OF THE ACQUIROR AND NEWCO TO EFFECT THE
MERGER. The obligations of Acquiror and Newco to effect the Merger shall be
subject to the fulfillment at or prior to the Effective Time of the following
additional conditions:
(a) Each of the Company and its Subsidiaries shall have performed in all
material respects each of its obligations under this Agreement required to
be performed by it on or prior to the Effective Time pursuant to the terms
hereof.
(b) All representations or warranties of the Company in this Agreement
which are qualified with respect to a Company Material Adverse Effect or
materiality shall be true and correct, and all such representations or
warranties that are not so qualified shall be true and correct in all
material respects, in each case as if such representation or warranty were
made as of the Effective Time except to the extent that any such
representation or warranty is made as of a specified date, in which case
such representation or warranty shall have been true and correct as of such
specified date.
(c) Since the date of this Agreement, there shall not have been any
material adverse change in the financial condition, results of operations,
properties or business of the Company and its Subsidiaries, taken as a
whole, excluding any such change caused by a general change in the economy
or in the telecommunications industry served by the Company and its
Subsidiaries and other than any such change approved by the Acquiror.
(d) The Company shall have delivered a certificate of its President or
Vice President to the effect set forth in paragraphs (a), (b) and (c) to
this Section 8.3.
(e) Newco shall have received letters of resignation addressed to the
Company from those members of the Company's board of directors as listed on
Schedule 8.3(e), which resignations shall be effective as of the Effective
Time.
(f) The Acquiror shall have received from Swidler & Berlin, Chartered,
and Rakisons, domestic and foreign counsel to the Company, respectively,
opinions dated the Effective Time and covering such matters as may be
reasonably requested by Acquiror, such matters to include, among other
things, opinions relating to all federal, state and foreign regulatory
approvals.
ARTICLE IX
TERMINATION, AMENDMENT AND WAIVER
9.1 TERMINATION. This Agreement may be terminated and the Merger
contemplated herein may be abandoned at any time prior to the Effective Time and
before approval by the stockholders of Acquiror:
(a) by the mutual consent of Acquiror and the Company, acting through
their respective Boards of Directors;
(b) by Acquiror if (i) there has occurred a material adverse change in
the financial condition, results of operations, business or properties of
the Company and its Subsidiaries, taken as a whole, except for any change
caused by a general change in the economy of the United States or in the
telecommunications industry served by the Company, and except as otherwise
approved in writing by Acquiror, (ii) there is a breach of any of the
representations and warranties of the Company which are qualified with
respect to a Company Material Adverse Effect or materiality or if the
Company shall
A-25
<PAGE>
have breached in any material respect any of such representations or
warranties which are not so qualified, or (iii) the Company or the
Stockholders fail to comply in any material respect with any of the
covenants or agreements contained herein applicable thereto or otherwise
wilfully breach or fail to perform pursuant to the terms hereof, which
breaches or failures, as the case may be, are, in the aggregate, material in
the context of the transactions contemplated by this Agreement;
(c) by the Company (i) if there has occurred a material adverse change
in the financial condition, results of operations, business or properties of
the Acquiror, except for any change caused by a general change in the
economy of the United States or in the telecommunications industry served by
Acquiror, and except as otherwise approved in writing by the Company, (ii)
there is a breach of any of the representations and warranties of the
Acquiror or Newco which are qualified with respect to an Acquiror Material
Adverse Effect or materiality or if the Acquiror or Newco shall have
breached in any material respect any of such representations or warranties
which are not so qualified or (iii) the Acquiror or Newco fails to comply in
any material respect with any of its covenants or agreements contained
herein or otherwise wilfully breaches or fails to perform pursuant to the
terms hereof, which breaches or failures, as the case may be, are, in the
aggregate, material in the context of the transactions contemplated by this
Agreement; and
(d) by either Newco or the Company, if on or before March 31, 1999 the
Merger shall not have been consummated, except as otherwise set forth in
that last clause of Section 3.1 and provided that neither party may
terminate under this Section 9.1(d) if such failure has been caused by that
party's material breach of this Agreement; provided further that if any
condition to this Agreement shall fail to be satisfied by reason of the
existence of an injunction or order of any court or governmental or
regulatory body resulting from an action or proceeding commenced by any
party which is not a government or governmental authority, then at the
request of either party the deadline date referred to above shall be
extended for a reasonable period of time, not in excess of 120 days, to
permit the parties to have such injunction vacated or order reversed.
In the event of such termination and abandonment, no party hereto (or any of
its directors or officers) shall have any liability or further obligation to any
other party to this Agreement except as provided in Section 9.2, and except that
nothing herein will relieve any party from liability for any willful breach of
this Agreement prior to such termination or abandonment.
9.2 TERMINATION FEE. If (a) this Agreement is terminated by Acquiror
pursuant to Section 9.1(b)(iii), (b) within six (6) months following such
termination, the Company and/or the Stockholders enter into an agreement or
series of related agreements contemplating the acquisition, by means of a tender
or exchange offer, merger, consolidation, business combination or otherwise, all
or a substantial portion of the outstanding shares of Common Stock or of the
assets of the Company and the Subsidiaries and (c) the value of the
consideration to be received by the stockholders of the Company with respect to
such transaction or transactions equals or exceeds $500 million (determined on
the execution of the agreement or agreements relating to such transaction or
transactions), then the Company shall, simultaneously with consummation of such
transaction or transactions, pay to Acquiror $20 million by wire transfer in
immediately available funds.
9.3 AMENDMENT. Subject to the applicable provisions of the Business
Corporation Law, this Agreement may be amended by the parties hereto solely by
action taken by their respective Boards of Directors. This Agreement may not be
amended except by an instrument in writing signed on behalf of each of the
parties hereto.
9.4 WAIVER. At any time prior to the Effective Time, the parties hereto,
by action taken by their respective Boards of Directors, may (i) extend the time
for the performance of any of the obligations or other acts of the other parties
hereto, (ii) waive any inaccuracies in the representations and warranties of the
other party contained herein or in any documents delivered pursuant hereto, and
(iii) waive compliance by the other party with any of the agreements or
conditions herein. Any agreement on the part of a
A-26
<PAGE>
party hereto to any such extension or waiver shall be valid only if set forth in
an instrument in writing signed on behalf of such party.
ARTICLE X
MISCELLANEOUS
10.1 SURVIVAL. All representations, warranties and agreements contained in
this Agreement or in any instrument delivered pursuant to this Agreement shall
terminate and be extinguished at the end of the Escrow Period.
10.2 EXPENSES AND FEES. Each party to this Agreement shall bear his or its
own fees and expenses incurred in the connection with the transactions
contemplated hereby, provided that, in the context of the enforcement of the
terms and conditions of this Agreement, the prevailing party shall be entitled
to the payment of its reasonable legal fees and expenses incurred in connection
with the enforcement of such rights.
10.3 NOTICES. All notices and other communications given or made pursuant
hereto shall be in writing and shall be deemed to have been given or made if in
writing and delivered personally or sent by registered or certified mail
(postage prepaid, return receipt requested) or by telecopier to the parties at
the following addresses and facsimile numbers:
(a) if to Newco or the Acquiror to:
STAR Telecommunications, Inc.
233 East De La Guerra Street
Santa Barbara, California 93101
Attention: Chief Financial Officer
Fax: (805) 966-7593
with copies to:
Riordan & McKinzie
300 South Grand Avenue, 29th Floor
Los Angeles, California 90071
Attention: Timothy F. Sylvester, Esq.
Fax: (213) 229-8550
(b) if to the Company or the Stockholders, to:
PT-1 Communications, Inc.
30-50 Whitestone Expressway
Flushing, NY 11354
Attention: General Counsel
Fax: (718) 939-4976
with copies to:
Swidler & Berlin, Chartered
3000 K Street, N.W., Suite 300
Washington, D.C. 20007-5116
Attention: Morris DeFeo, Esq.
Fax: (202) 424-7643
or at such other addresses as shall be furnished by the parties by like notice,
and such notice or communication shall be deemed to have been given or made as
of the date so delivered or mailed or confirmation of transmission.
A-27
<PAGE>
10.4 HEADINGS. The headings contained in this Agreement are inserted for
convenience only and do not constitute a part of this Agreement.
10.5 PUBLICITY. The parties hereto shall not, and shall cause their
affiliates not to, issue or cause the publication of any press release or other
announcement with respect to the Merger or this Agreement without delivering a
draft of any such press release to such parties.
10.6 ENTIRE AGREEMENT; KNOWLEDGE. This Agreement constitutes the entire
agreement among the parties and supersedes all other prior agreements and
understandings, both written and oral, among the parties, or any of them, with
respect to the subject matter hereof. For purposes of this Agreement,
"knowledge" of any party shall mean the actual knowledge of such party or, in
the case of Acquiror or the Company, the actual knowledge of the executive
officers thereof.
10.7 ASSIGNMENT. This Agreement and all of the provisions hereof shall be
binding upon and inure to the benefits of the parties hereto and their
respective successors and permitted assigns. Neither this Agreement nor any of
the rights, interests or obligations shall be assigned by any of the parties
hereto without the prior written consent of the other. This Agreement is not
intended to confer upon any other person any rights or remedies hereunder.
10.8 COUNTERPARTS. This Agreement may be executed in one or more
counterparts, all of which shall be considered one and the same agreement and
each of which shall be deemed an original.
10.9 INVALIDITY, ETC. In the event that any provision of this Agreement
shall be deemed contrary to law or invalid or unenforceable in any respect by a
court of competent jurisdiction, the remaining provisions shall remain in full
force and effect to the extent that such provisions can still reasonably be
given effect in accordance with the intentions of the parties, and the invalid
and unenforceable provisions shall be deemed, without further action on the part
of the parties, modified, amended and limited solely to the extent necessary to
render the same valid and enforceable.
10.10 SPECIFIC PERFORMANCE. Each of the parties hereto acknowledges and
agrees that the other parties hereto would be irreparably damaged in the event
any of the provisions of this Agreement were not performed in accordance with
their specific terms or were otherwise breached. Accordingly, each of the
parties hereto agrees that they each shall be entitled to an injunction or
injunctions to prevent breaches of the provisions of this Agreement and to
enforce specifically this Agreement and the terms and conditions hereof in any
action instituted in any court of the United States or any state having
competent jurisdiction, in addition to any other remedy to which such party may
be entitled, at law or in equity.
10.11 GOVERNING LAW. The validity and interpretation of this Agreement
shall be governed by and construed in accordance with the laws of the State of
New York, without reference to the conflict of laws principles thereof.
10.12 TERMINATION OF ORIGINAL AGREEMENT. On the execution and delivery of
this Agreement, the Original Agreement shall terminate and shall have no further
force or effect.
10.13 NO SOLICITATION. Following the termination of this Agreement
pursuant to Section 9.1., for a period of one (1) year thereafter, the Aquiror
will not, directly or indirectly, initiate contact with any officer, director or
employee of the Company regarding the business, operations, prospects or
finances of the Company, or directly or indirectly solicit, for the purpose of
hiring, any such person.
[THE REMAINDER OF THIS PAGE IS LEFT BLANK INTENTIONALLY]
A-28
<PAGE>
IN WITNESS WHEREOF, Acquiror, Newco, the Company and the Stockholders have
caused this Agreement to be signed by their respective officers thereunto duly
authorized, all as of the date first written above.
ACQUIROR: STAR TELECOMMUNICATIONS, INC.
By: /s/ CHRISTOPHER E. EDGECOMB
-----------------------------------------
Christopher E. Edgecomb
NEWCO:
SIERRA ACQUISITION CO., INC.
By: /s/ CHRISTOPHER E. EDGECOMB
-----------------------------------------
Christopher E. Edgecomb
COMPANY:
PT-1 COMMUNICATIONS, INC.
By: /s/ SAMER TAWFIK
-----------------------------------------
Samer Tawfik
THE STOCKHOLDERS:
/s/ SAMER TAWFIK
-----------------------------------------
Samer Tawfik
/s/ PETER M. VITA
-----------------------------------------
Peter M. Vita
/s/ DOUGLAS BARLEY
-----------------------------------------
Douglas Barley
/s/ JOSEPH A. PANNULLO
-----------------------------------------
Joseph A. Pannullo
/s/ JOHN J. KLUSARITZ
-----------------------------------------
John J. Klusaritz
A-29
<PAGE>
FIRST AMENDMENT TO AMENDED AND RESTATED AGREEMENT AND PLAN OF MERGER
FIRST AMENDMENT TO AMENDED AND RESTATED AGREEMENT AND PLAN OF MERGER dated
as of September 1, 1998 (the "First Amendment"), by and among STAR
Telecommunications, Inc., a Delaware corporation (the "Acquiror"), Sierra
Acquisition Co., Inc., a New York corporation and wholly-owned subsidiary of the
Acquiror ("Newco"), PT-1 Communications, Inc., a New York corporation (the
"Company"), and Samer Tawfik, Peter M. Vita, Douglas Barley, Joseph A. Pannullo
and John J. Klusaritz (collectively, the "Stockholders").
R E C I T A L S:
A. Acquiror, Newco, the Company and the Stockholders previously entered into
an Amended and Restated Agreement and Plan of Merger dated August 20, 1998 (the
"Amended Merger Agreement").
B. The parties to the Amended Merger Agreement wish to enter into this
First Amendment to modify the terms of the Amended Merger Agreement, to the
extent set forth below.
C. Capitalized terms not otherwise defined herein shall have the meanings
therefor as set forth in the Amended Merger Agreement.
A G R E E M E N T
NOW, THEREFORE, in consideration of the mutual representations, warranties,
covenants, agreements and conditions contained herein, the sufficiency of which
is hereby acknowledged by the parties, the parties hereby agree as follows:
1. SHARE ISSUANCE; CASH COMPONENT. Section 2.1(a) of the Amended Merger
Agreement shall be deleted in its entirety and shall be replaced with the
following:
"(a) The issued and outstanding shares of the capital stock of the
Company outstanding at the Effective Time shall be automatically converted
into the right to receive an aggregate of (i) 15,050,000 shares (the "Share
Issuance") of the Acquiror's common stock, $0.001 par value per share
("Acquiror Common Stock"), based on an exchange ratio determined by the
Company and the Stockholders immediately prior to the Effective Time, taking
into account all Warrants and Options then outstanding, and (ii) $19,500,000
(the "Cash Component"), which shall be allocated in a manner determined by
the Company and the Stockholders immediately prior to the Effective Time.
The number of shares of Acquiror Common Stock subject to the Share Issuance
shall be adjusted as may be necessary and appropriate to reflect any and all
stock splits, reverse stock splits, reclassifications, recapitalizations,
dividends payable in shares of Acquiror Common Stock or in any other
securities convertible into or exchangeable for shares of Acquiror Common
Stock and similar capital events that affect Acquiror Common Stock.
Notwithstanding anything contained in this Agreement to the contrary, under
no circumstance shall the number of shares of Acquiror Common Stock subject
to the Share Issuance or the Cash Component exceed the amounts set forth in
the first sentence of this Section 2.1(a)."
2. ESCROW. The first clause of Section 2.2 of the Amended Merger Agreement
shall be deleted in its entirety and replaced with the following clause, "A
total of One Million Five Hundred and Five Thousand (1,505,000) shares of
Acquiror Common Stock (the "Escrow Shares")...." The third sentence of Section
2.2 of the Amended Merger Agreement shall be modified by adding the following
proviso at the end thereof, "provided that a portion of the Escrow Shares may be
released to the Stockholders on a quarterly basis during the Escrow Period, as
further set forth in the Escrow Agreement."
3. CONDUCT OF BUSINESS. The first clause of Section 7.2 of the Amended
Merger Agreement shall be deleted in its entirety and replaced with the
following:
A-30
<PAGE>
"The Company and the Stockholders agree that, prior to the Effective Time,
all material managerial and operational matters shall be presented to and
subject to the reasonable review and approval of the Acquiror. In that
regard, except as otherwise consented to or approved in writing by the
Acquiror or expressly permitted by this Agreement:"
4. MANAGEMENT MEETINGS. The penultimate sentence of Section 7.2 of the
Amended Merger Agreement shall be deleted in its entirety and replaced with the
following sentence:
"On a weekly basis, representatives of the Company shall meet with the chief
executive officer or chief financial officer of the Acquiror to discuss the
Company and all ongoing operational issues and matters and shall provide
such periodic financial information and data as may be requested by the
Acquiror. Each such meeting shall be scheduled at a time that is mutually
convenient to the respective representatives of each of the Company and the
Acquiror. Any such meeting may, at the election of the parties, be held via
telephonic conference call."
5. MATERIAL ADVERSE CHANGE. Section 8.3(c) of the Amended Merger Agreement
shall be deleted in its entirety and replaced with the following:
"(c) Since the date of this Agreement, there shall not have been any
material adverse change in the financial condition, results of operations,
properties or business of the Company and its Subsidiaries, taken as a
whole, other than any change arising from any action authorized, directed or
otherwise approved by the Acquiror pursuant to Section 7.2 or from the
Acquiror's express refusal to approve any action proposed by the Company
under Section 7.2 and excluding any such change caused by a general change
in the economy or in the telecommunications industry served by the Company
and its Subsidiaries."
6. TERMINATION. Section 9.1(b)(i) of the Amended Merger Agreement shall be
deleted in its entirety and replaced with the following:
"(i) there has occurred a material adverse change in the financial
condition, results of operations, business or properties of the Company and
its Subsidiaries, taken as a whole, other than any change arising from any
action authorized, directed or otherwise approved by the Acquiror pursuant
to Section 7.2 or from the Acquiror's express refusal to approve any action
proposed by the Company under Section 7.2 and except for any change caused
by a general change in the economy of the United States or in the
telecommunications industry served by the Company,"
7. EXCHANGE RATIO INFORMATION. A new Section 8.3(g) should be added to the
Amended Merger Agreement and should read as follows:
"(g) The Acquiror shall have received from the Company and the
Stockholders the allocation of shares of Acquiror Common Stock subject to
the Share Issuance and the allocation of the Cash Component."
8. HICKEY SHARES. A new Section 9.5 shall be added to the Amended Merger
Agreement to read as follows:
"9.5 HICKEY SHARES. Notwithstanding anything contained in this Agreement to
the contrary, if any shares of Common Stock held by Thomas Hickey, any trust
affiliated therewith and/or any successors and assigns thereof do not vote
in favor of the Merger, such failure to vote in favor of the Merger (a)
shall not be deemed a breach of this Agreement by the Company or by the
Stockholders, (b) shall not be deemed a failure of a condition precedent to
the Acquiror's obligation to otherwise consummate the Merger pursuant to the
terms hereof, (c) shall not be a basis for termination of this Agreement by
the Acquiror and (d) shall not alter the consideration to be received in the
Merger by any other stockholder of the Company."
9. NO FURTHER AMENDMENT. Except as otherwise modified above, the Amended
Merger Agreement shall remain in full force and effect without further
amendment, modification or alteration thereof.
A-31
<PAGE>
IN WITNESS WHEREOF, Acquiror, Newco, the Company and the Stockholders have
caused this First Amendment to be signed by their respective officers thereunto
duly authorized, all as of the date first written above.
ACQUIROR: STAR TELECOMMUNICATIONS, INC.
By: /s/ KELLY ENOS
-----------------------------------------
Kelly Enos
CHIEF FINANCIAL OFFICER
NEWCO:
SIERRA ACQUISITION CO., INC.
By: /s/ KELLY ENOS
-----------------------------------------
Kelly Enos
CHIEF FINANCIAL OFFICER
COMPANY:
PT-1 COMMUNICATIONS, INC.
By: /s/ SAMER TAWFIK
-----------------------------------------
Samer Tawfik
CHIEF EXECUTIVE OFFICER
/s/ PETER M. VITA
-----------------------------------------
Peter M. Vita
/s/ DOUGLAS BARLEY
-----------------------------------------
Douglas Barley
/s/ JOSEPH A. PANNULLO
-----------------------------------------
Joseph A. Pannullo
/s/ JOHN J. KLUSARITZ
-----------------------------------------
John J. Klusaritz
A-32
<PAGE>
SECOND AMENDMENT TO AMENDED AND RESTATED AGREEMENT AND PLAN OF MERGER
SECOND AMENDMENT TO AMENDED AND RESTATED AGREEMENT AND PLAN OF MERGER dated
as of December 29, 1998 (the "Second Amendment"), by and among STAR
Telecommunications, Inc., a Delaware corporation (the "Acquiror"), Sierra
Acquisition Co., Inc., a New York corporation and wholly-owned subsidiary of the
Acquiror ("Newco"), PT-1 Communications, Inc., a New York corporation (the
"Company"), and Samer Tawfik, Peter M. Vita, Douglas Barley, Joseph A. Pannullo
and John J. Klusaritz (collectively, the "Stockholders").
R E C I T A L S:
A. Acquiror, Newco, the Company and the Stockholders previously entered into
an Amended and Restated Agreement and Plan of Merger dated August 20, 1998, as
amended on September 1, 1998 (the "Amended Merger Agreement").
B. The parties to the Amended Merger Agreement wish to enter into this
Second Amendment to modify the terms of the Amended Merger Agreement, to the
extent set forth below.
C. Capitalized terms not otherwise defined herein shall have the meanings
therefor as set forth in the Amended Merger Agreement.
A G R E E M E N T
NOW, THEREFORE, in consideration of the mutual representations, warranties,
covenants, agreements and conditions contained herein, the sufficiency of which
is hereby acknowledged by the parties, the parties hereby agree as follows:
1. SHARE ISSUANCE; CASH COMPONENT. Section 2.1(a) of the Amended Merger
Agreement shall be amended by adding the following text to the end of such
Section:
"At the Effective Time, Acquiror may, at its option, deliver to the
Stockholders promissory notes in the form of Exhibit E hereto, in lieu of
the payment of the Cash Component."
2. NO FURTHER AMENDMENT. Except as otherwise modified above, the Amended
Merger Agreement shall remain in full force and effect without further
amendment, modification or alteration thereof.
A-33
<PAGE>
IN WITNESS WHEREOF, Acquiror, Newco, the Company and the Stockholders have
caused this Second Amendment to be signed by their respective officers thereunto
duly authorized, all as of the date first written above.
ACQUIROR: STAR TELECOMMUNICATIONS, INC.
By: /s/ KELLY ENOS
-----------------------------------------
Kelly Enos
CHIEF FINANCIAL OFFICER
NEWCO:
SIERRA ACQUISITION CO., INC.
By: /s/ KELLY ENOS
-----------------------------------------
Kelly Enos
CHIEF FINANCIAL OFFICER
COMPANY:
PT-1 COMMUNICATIONS, INC.
By: /s/ SAMER TAWFIK
-----------------------------------------
Samer Tawfik
CHIEF EXECUTIVE OFFICER
/s/ PETER M. VITA
-----------------------------------------
Peter M. Vita
/s/ DOUGLAS BARLEY
-----------------------------------------
Douglas Barley
/s/ JOSEPH A. PANNULLO
-----------------------------------------
Joseph A. Pannullo
/s/ JOHN J. KLUSARITZ
-----------------------------------------
John J. Klusaritz
A-34
<PAGE>
ANNEX B
August 20, 1998
Confidential
The Board of Directors
STAR Telecommunications, Inc.
223 East De La Guerra Street
Santa Barbara, California 93101
Ladies and Gentlemen:
You have requested our opinion as to the fairness from a financial point of
view to STAR Telecommunications, Inc. ("STAR" or the "Company") of the
consideration to be paid by the Company in connection with the proposed
acquisition by STAR of the common stock of PT-1 Communications, Inc ("PT-1")
(the "Proposed Transaction") under the terms of the Amended and Restated
Agreement and Plan of Merger, dated as of August 20, 1998, among STAR, Sierra
Acquisition Co., Inc., PT-1, and certain shareholders of PT-1 and the related
Exhibits and Schedules thereto (the "Agreement"). The Agreement provides, among
other things, that STAR will, upon consummation of the Proposed Transaction,
issue 15,000,000 shares of STAR common stock (the "Shares") and pay $20,000,000
in cash in exchange for all of the outstanding common stock of PT-1. In
addition, STAR and certain shareholders of PT-1 have entered into a Registration
Rights and Restricted Share Agreement dated as of August 20, 1998 (the "Lock-up
Agreement") pursuant to which the Shares will be subject to certain resale
restrictions for a period of up to two years, as more fully described in the
Lock-up Agreement. For purposes of this opinion, we have assumed that the
Proposed Transaction will qualify as a tax-free reorganization under the United
States Internal Revenue Code and that the Proposed Transaction will be accounted
for as a purchase.
Hambrecht & Quist LLC ("Hambrecht & Quist"), as part of its investment
banking services, is regularly engaged in the valuation of businesses and their
securities in connection with mergers and acquisitions, strategic transactions,
corporate restructurings, negotiated underwritings, secondary distributions of
listed and unlisted securities, private placements and valuations for corporate
and other purposes. We have acted as a financial advisor to the Board of
Directors of STAR in connection with the Proposed Transaction, and we will
receive a fee for our services, which include the rendering of this opinion.
In the past, we have provided investment banking and other financial
advisory services to STAR and have received fees for rendering these services.
In particular, Hambrecht & Quist acted as lead managing underwriter in the
Company's initial public offering in 1997 and as co-managing underwriter in the
Company's follow-on offering in 1998. In the ordinary course of business,
Hambrecht & Quist acts as a market maker and broker in the publicly traded
securities of STAR and receives customary compensation in connection therewith,
and also provides research coverage for STAR. In the ordinary course of
business, Hambrecht & Quist actively trades in the equity and derivative
securities of STAR for its own account and for the accounts of its customers
and, accordingly, may at any time hold a long or short position in such
securities. Hambrecht & Quist may in the future provide additional investment
banking or other financial advisory services to STAR. Hambrecht & Quist is also
familiar with PT-1, having participated in the preparation of a registration
statement on Form S-1 in connection with its potential initial public offering.
In connection with our review of the Proposed Transaction, and in arriving
at our opinion, we have, among other things:
(i) reviewed the publicly available financial statements of STAR for recent
years and interim periods to date and certain other relevant financial
and operating data of STAR made available to us from published sources
and from the internal records of STAR;
(ii) reviewed certain internal financial and operating information,
including certain projections, relating to STAR prepared by the
management of STAR;
B-1
<PAGE>
(iii) discussed the business, financial condition and prospects of STAR with
certain of its officers;
(iv) reviewed the financial statements of PT-1 for recent years and interim
periods to date and certain other relevant financial and operating
data of PT-1 made available to us from published sources and from the
internal records of PT-1;
(v) reviewed certain internal financial and operating information,
including certain projections, relating to PT-1 prepared by the
management of PT-1;
(vi) discussed the business, financial condition and prospects of the PT-1
with certain of its officers;
(vii) reviewed the recent reported prices and trading activity for the
common stock of STAR and compared such information and certain
financial information for STAR with similar information for certain
other companies engaged in businesses we consider comparable;
(viii) reviewed the financial terms, to the extent publicly available, of
certain comparable merger and acquisition transactions;
(ix) reviewed the Agreement and the Lock-up Agreement; and
(x) performed such other analyses and examinations and considered such
other information, financial studies, analyses and investigations and
financial, economic and market data as we deemed relevant.
In rendering our opinion, we have assumed and relied upon the accuracy and
completeness of all of the information concerning STAR or PT-1 considered in
connection with our review of the Proposed Transaction, and we have not assumed
any responsibility for independent verification of such information. We have not
undertaken any independent valuation or appraisal of any of the assets or
liabilities of STAR or PT-1; nor have we conducted a physical inspection of the
properties and facilities of either company. With respect to the financial
forecasts and projections made available to us and used in our analysis, we have
assumed that they reflect the best currently available estimates and judgments
of the expected future financial performance of STAR and PT-1. For purposes of
this opinion, we have assumed that neither STAR nor PT-1 is a party to any
pending transactions, including external financings, recapitalizations or
material merger discussions, other than the Proposed Transaction and those
activities undertaken in the ordinary course of conducting their respective
businesses. Our opinion is necessarily based upon market, economic, financial
and other conditions as they exist and can be evaluated as of the date of this
letter and any change in such conditions would require a reevaluation of this
opinion.
It is understood that this letter is for the information of the Board of
Directors in connection with its evaluation of the Proposed Transaction and may
not be used for any other purpose without our prior written consent; provided,
however, that this letter may be reproduced in full in the Proxy Statement
relating to the Proposed Transaction. This letter does not constitute a
recommendation to any stockholder as to how such stockholder should vote on the
Proposed Transaction.
Based upon and subject to the foregoing and after considering such other
matters as we deem relevant, we are of the opinion that as of the date hereof
the consideration to be paid by STAR in the Proposed Transaction is fair to the
Company from a financial point of view.
Very truly yours,
HAMBRECHT & QUIST LLC
By: /s/ DAVID G. GOLDEN
-----------------------------------------
David G. Golden
MANAGING DIRECTOR
B-2
<PAGE>
ANNEX C
September 10, 1998
Board of Directors
STAR Telecommunications, Inc.
223 East De La Guerra Street
Santa Barbara, California 93101
Dear Sirs and Madam:
You have asked us to advise you with respect to the fairness to STAR
Telecommunications, Inc. (the "Acquiror") from a financial point of view of the
consideration to be paid by the Acquiror pursuant to the terms of the Amended
and Restated Agreement and Plan of Merger, dated as of August 20, 1998, (the
"Merger Agreement"), among PT-1 Communications, Inc. (the "Company"), the
Acquiror, Sierra Acquisition Co., Inc. (the "Sub") and certain stockholders of
the Company named therein. The Merger Agreement provides for the merger (the
"Merger") of the Sub with and into the Company pursuant to which the Company
will be the surviving entity and will become a wholly owned subsidiary of the
Acquiror. The Merger Agreement also provides that STAR will issue 15 million
shares of its common stock and pay $20 million (the Acquiror common stock and
the cash, collectively the "Merger Consideration") in exchange for all of the
outstanding common stock of the Company.
In arriving at our opinion, we have reviewed certain publicly available
business and financial information relating to the Company and the Acquiror, as
well as the Merger Agreement. We have also reviewed certain other information,
including financial forecasts, provided to us by the Company and the Acquiror,
and have met with the Company's and the Acquiror's managements to discuss the
business and prospects of the Company and the Acquiror.
We have also considered certain financial and stock market data, as
applicable, of the Company and the Acquiror, and we have compared those data
with similar data for other publicly held companies in businesses similar to the
Company and the Acquiror and we have considered the financial terms of certain
other business combinations and other transactions which have recently been
effected. We also considered such other information, financial studies, analyses
and investigations and financial, economic and market criteria which we deemed
relevant.
In connection with our review, we have not assumed any responsibility for
independent verification of any of the foregoing information and have relied on
its being complete and accurate in all material respects. With respect to the
financial forecasts, we have assumed that they have been reasonably prepared on
bases reflecting the best currently available estimates and judgments of the
Company's management and the Acquiror's management as to the future financial
performance of the Company and the Acquiror, respectively. In addition, we have
not been requested to make, and have not made, an independent evaluation or
appraisal of the assets or liabilities (contingent or otherwise) of the Company
or the Acquiror, nor have we been furnished with any such evaluations or
appraisals. Our opinion is necessarily based upon financial, economic, market
and other conditions as they exist and can be evaluated on the date hereof. We
are not expressing any opinion as to the actual value of the Acquiror's common
stock when issued to the Company's stockholders pursuant to the Merger or the
prices at which such common stock will trade subsequent to the Merger.
We have acted as financial advisor to the Acquiror in connection with the
Merger and will receive a fee for our services, which fee is contingent upon the
consummation of the Merger.
In the ordinary course of our business, we and our affiliates may actively
trade the debt and equity securities of both the Company and the Acquiror for
our and such affiliates' own accounts and for the accounts of customers and,
accordingly, may at any time hold a long or short position in such securities.
C-1
<PAGE>
It is understood that this letter is for the information of the Board of
Directors of the Acquiror in connection with its consideration of the Merger and
is not to be quoted or referred to, in whole or in part, in any registration
statement, prospectus or proxy statement, or in any other document used in
connection with the offering or sale of securities, nor shall this letter be
used for any other purposes, without our prior written consent.
Based upon and subject to the foregoing, it is our opinion that, as of the
date hereof, the Merger Consideration to be paid by the Acquiror in the Merger
is fair to the Acquiror from a financial point of view.
Very truly yours,
CREDIT SUISSE FIRST BOSTON CORPORATION
C-2
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of
STAR Telecommunications, Inc. and Subsidiaries
We have audited in accordance with generally accepted auditing standards the
consolidated financial statements of STAR Telecommunications, Inc. and
Subsidiaries, included in this proxy statement and have issued our report
thereon dated February 12, 1998 (except with respect to the T-One acquisition as
described in Note 1 and to the stock split discussed in Note 14 as to which the
date is March 31, 1998). Our audits were made for the purpose of forming an
opinion on the basic consolidated financial statements taken as a whole. The
schedule of valuation and qualifying accounts is the responsibility of the
Company's management and is presented for the purpose of complying with the
Securities and Exchange Commission's rules and is not part of the basic
consolidated financial statements. This schedule has been subjected to the
auditing procedures applied in the audits of the basic consolidated financial
statements and, in our opinion, fairly states, in all material respects, the
financial data required to be set forth therein in relation to the basic
consolidated financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Los Angeles, California
February 12, 1998
(except with respect
to the T-One acquisition as
described in Note 1 and to
the stock split discussed in
Note 14 as to which the
date is March 31, 1998)
S-1
<PAGE>
SCHEDULE II
STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
<TABLE>
<CAPTION>
BALANCE AT
BEGINNING BALANCE AT
OF END OF
PERIOD PROVISION WRITE-OFF PERIOD
----------- ----------- ---------- -----------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Allowance for doubtful accounts
Year ended December 31, 1995................................... $ 81 $ 217 $ -- $ 298
Year ended December 31, 1996................................... $ 298 $ 16,284 $ (10,320) $ 6,262
Year ended December 31, 1997................................... $ 6,262 $ 7,941 $ (6,248) $ 7,955
Nine months ended September 30, 1998 (unaudited)............... $ 7,955 $ 1,922 $ (2,099) $ 7,778
Deferred tax asset valuation allowance
Year ended December 31, 1995................................... $ -- $ 30 $ -- $ 30
Year ended December 31, 1996................................... $ 30 $ 3,354 $ -- $ 3,384
Year ended December 31, 1997................................... $ 3,384 $ (1,268) $ -- $ 2,116
Nine months ended September 30, 1998 (unaudited)............... $ 2,116 $ 528 $ -- $ 2,644
Note Receivable
Year ended December 31, 1997................................... $ -- $ 2,500 $ -- $ 2,500
Nine months ended September 30, 1998 (unaudited)............... $ 2,500 $ 2,000 $ -- $ 4,500
</TABLE>
S-2
<PAGE>
STAR TELECOMMUNICATIONS, INC.
SPECIAL MEETING OF STOCKHOLDERS FEBRUARY 3, 1999
THIS PROXY IS SOLICITED ON BEHALF OF THE BOARD OF DIRECTORS
The undersigned stockholder of STAR Telecommunications, Inc., a Delaware
corporation (the "Company") hereby acknowledges receipt of the Notice of Special
Meeting of Stockholders and Proxy Statement, each dated January 15, 1999, and
hereby appoints Christopher E. Edgecomb, Mary A. Casey and Kelly D. Enos, and
each of them, the true and lawful attorneys and proxies of the undersigned, with
full power of substitution, to vote all shares of the Common Stock, $.001 par
value ("Common Stock"), of the Company which the undersigned is entitled to
vote, at the Special Meeting of the Stockholders of the Company to be held at
801 Garden Street, Room 203, Santa Barbara, California on Wednesday, February 3,
1999 at 9:00 a.m., Pacific Time, and at any and all adjournments thereof, on the
proposals set forth below:
THIS PROXY WILL BE VOTED AS DIRECTED AND AS SAID PROXIES DEEM ADVISABLE ON
SUCH OTHER MATTERS AS MAY PROPERLY COME BEFORE THE MEETING OR ANY POSTPONEMENTS
OR ADJOURNMENTS THEREOF. ANY PROPOSAL WITH RESPECT TO WHICH A STOCKHOLDER FAILS
TO SO SPECIFY WILL BE VOTED IN ACCORDANCE WITH THE RECOMMENDATION OF THE BOARD.
(SEE REVERSE SIDE)
<PAGE>
(CONTINUED ON REVERSE SIDE)
THE DIRECTORS UNANIMOUSLY RECOMMEND A VOTE FOR THE APPROVAL OF PROPOSAL 1.
1. Proposal to approve and adopt an Amended and Restated Agreement and Plan of
Merger (the "Merger Agreement") by and among the Company, Sierra Acquisition
Co., Inc., a New York corporation and wholly-owned subsidiary of the Company
("Newco"), PT-1 Communications, Inc., a New York corporation ("PT-1") and
certain stockholders of PT-1, as amended, and the transactions contemplated
thereby, including the merger of Newco with and into PT-1, after which PT-1
will survive as a wholly-owned subsidiary of the Company, and the issuance
of 15.3 million shares of Common Stock.
2. Such other matters as may properly come before the Meeting.
/ / FOR / / AGAINST / / ABSTAIN
Dated: __________________, 1999
_______________________________
(Signature)
_______________________________
(Signature)
Please sign exactly as your
name appears hereon. When
shares are held by joint
tenants, both should sign. When
signing as attorney, as
executor, administrator,
trustee or guardian, please
give full title as such. If a
corporation, please sign in
full corporate name by
President or other authorized
officer. If a partnership,
please sign in partnership name
by authorized person.
